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The Meaning of "Income" Suddenly Becomes Very Important For Tax Purposes

“We probably will have a wealth tax,”House Speaker Nancy Pelosi told CNN. But there is no constitutional provision for a wealth tax.
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Taxes - Wealth

Wealth Tax on Billionaires' Unrealized Gains is On the Way

Yesterday, I commented Nancy Pelosi Says a Wealth Tax on Billionaires' Unrealized Gains is On the Way

A new annual tax on billionaires’ unrealized capital gains is likely to be included to help pay for the vast social policy and climate package lawmakers hope to finalize this week, senior Democrats said Sunday. 

We probably will have a wealth tax,” House Speaker Nancy Pelosi (D., Calif.) said Sunday on CNN, noting that Senate Democrats were still working on their proposal, which isn’t technically a wealth tax but bears a strong resemblance to that idea.

I wouldn’t call that a wealth tax, but it would help get at capital gains, which are an extraordinarily large part of the incomes of the wealthiest individuals and right now escape taxation until they’re realized,” Ms. Yellen said.

16th Amendment 

The 16th Amendment makes no provision for a wealth tax. 

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

16th Amendment Background

The Sixteenth Amendment (Amendment XVI) to the United States Constitution allows Congress to levy an income tax without apportioning it among the states on the basis of population. It was passed by Congress in 1909 in response to the 1895 Supreme Court case of Pollock v. Farmers' Loan & Trust Co. The Sixteenth Amendment was ratified by the requisite number of states on February 3, 1913, and effectively overruled the Supreme Court's ruling in Pollock.

Prior to the early 20th century, most federal revenue came from tariffs rather than taxes, although Congress had often imposed excise taxes on various goods. The Revenue Act of 1861 had introduced the first federal income tax, but that tax was repealed in 1872. During the late nineteenth century, various groups, including the Populist Party, favored the establishment of a progressive income tax at the federal level. These groups believed that tariffs unfairly taxed the poor, and they favored using the income tax to shift the tax burden onto wealthier individuals. The 1894 Wilson–Gorman Tariff Act contained an income tax provision, but the tax was struck down by the Supreme Court in the case of Pollock v. Farmers' Loan & Trust Co. In its ruling, the Supreme Court did not hold that all federal income taxes were unconstitutional, but rather held that income taxes on rents, dividends, and interest were direct taxes and thus had to be apportioned among the states on the basis of population.

For several years after Pollock, Congress did not attempt to implement another income tax, largely due to concerns that the Supreme Court would strike down any attempt to levy an income tax. In 1909, during the debate over the Payne–Aldrich Tariff Act, Congress proposed the Sixteenth Amendment to the states. Though conservative Republican leaders had initially expected that the amendment would not be ratified, a coalition of Democrats, progressive Republicans, and other groups ensured that the necessary number of states ratified the amendment. Shortly after the amendment was ratified, Congress imposed a federal income tax with the Revenue Act of 1913. The Supreme Court upheld that income tax in the 1916 case of Brushaber v. Union Pacific Railroad Co., and the federal government has continued to levy an income tax since 1913.

Are Unrealized Gains Income?

Treasury Secretary Yellen was far more careful in her wording than Pelosi. The reason being that a wealth tax is likely to be found unconstitutional.

Q: Is this a wealth tax?
A: My guess is no because it's a tax on gains, not wealth.

A proposal by Senator Elizabeth Warren is a genuine wealth tax and easily could be tossed by the Supreme Court. Warren obviously does not give a damn.

Regardless, expect legal challenges based on the 16th Amendment.

The proposal taxes unrealized gains. But is there "income" before gains are realized? The courts will decide if this goes forward, but the idea is dubious at best.

What is Income?

  1. For households and individuals, income is a sum that includes any wage, salary, profit, interest payment, rent, or other form of earnings received in a given period of time (also known as gross income). Net income is defined as the gross income minus taxes and other deductions (e.g., mandatory pension contributions), and is usually the basis to calculate how much income tax is owed.
  2. In the field of public economics, the concept may comprise the accumulation of both monetary and non-monetary consumption ability, with the former (monetary) being used as a proxy for total income.
  3. For a firm, gross income can be defined as sum of all revenue minus the cost of goods sold. Net income nets out expenses: net income equals revenue minus cost of goods sold, expenses, depreciation, interest, and taxes.

Those definitions are from Wikipedia. Nowhere does it discuss unrealized gains as "income".

Numerous other definitions failed to mention unrealized gains as income. I did locate one discussion on the idea.

Accounting Income vs Economic Income Definition

Please consider the Strategic CFO discussion of Accounting Income vs Economic Income.

Accounting income or loss recognizes realized gains and losses, and does not recognize unrealized gains and losses. Economic income or loss recognizes all gains and losses, whether realized or unrealized.

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Finding a definition somewhere out of hundreds that don't is not an indication of accuracy. 

It seems to me that "accounting income" sounds more like a balance sheet idea than an income idea. 

Indeed, one would normally find such gains or losses on the balance sheet, not on the corporate income sheet. But that does not make the practice universal.

Proposed Tax on Billionaires Raises Question

The New York Times asks Proposed Tax on Billionaires Raises Question: What’s Income?

Treasury Secretary Janet Yellen said in an appearance Sunday on CNN, “It would help get at capital gains, which are an extraordinarily large part of the incomes of the wealthiest individuals, and right now escape taxation.”

The proposal raises conceptual questions about what counts as income. When Americans buy assets — shares of stock, a piece of real estate, a business — that become more valuable over time, they owe tax only on the appreciation when they sell the asset. This is a longstanding feature of the capital gains tax, true throughout its century-plus history. By contrast, those who earn their money from working owe income taxes every year on those earnings.

The rationale is that just because something has increased in value doesn’t mean the owner has the cash on hand to pay taxes. Moreover, for those with complex holdings, like interests in multiple privately held companies, it could be onerous to calculate the change in valuations every year, with ambiguous results.

By charging capital gains tax only when an asset is sold, both problems are solved — the taxpayer has the money to pay the tax bill, and the sales price is presumably a fair market value. 

“If you have a threshold, you’re giving people a really strong incentive to rearrange their affairs to keep their income and wealth below the threshold,” said Leonard Burman, institute fellow at the Tax Policy Center. “People might do things to keep their income just below the threshold that could be really inefficient.”

It also raises conceptual questions given its similarity to another idea that has emerged among left-of-center tax experts in recent years: a wealth tax.

That idea, embraced by Elizabeth Warren and Bernie Sanders in their campaigns for the presidency, would require the very wealthy to pay some small percentage of their net worth each year. Senator Warren advocated a 3 percent tax for billionaires, for example. The Wyden plan, by contrast, would tax only the unrealized gain a billionaire family had — but the long-term capital gains rate is 20 percent.

What About a Court Challenge?

Politico asks Will Wyden's New Wealth Tax Survive the Courts?

The hard-to-understand part: Why would Sinema prefer something complicated and comparatively unvetted to something like a simple increase in the top individual and corporate rates?

The basic issue: The Constitution mandates that a direct tax has to be evenly apportioned among the states, which is hard to do when some states are richer than others. (This is why the income tax needed its own amendment.)

Now, most scholars think that a mark-to-market system would be less at risk in the judiciary than a Warren-style wealth tax. But whether the high court would bless a yearly tax on unrealized gains is a much less certain thing, even if they think perhaps such a tax is justified.

Joseph Bishop-Henchman of the conservative National Taxpayers Union cited a century-old case that found that unrealized gains weren’t income, and thus couldn’t be taxed under the Sixteenth Amendment. Interestingly enough, Chief Justice John Roberts cited that case, Eisner v. Macomber, while upholding Obamacare.

“Now Eisner is an old case and some academics think it's outdated but it's never been overruled,” Bishop-Henchman wrote in an email, later adding: “A direct tax on an individual that isn't an income tax is unconstitutional.”

Final point from the legal weeds: Lily Batchelder, now Treasury’s assistant secretary for tax policy, pooh-poohed the idea that Eisner could be used to undercut a mark-to-market system, as Alex Parker of Capitol Counsel noted on Twitter. Bur that all said, Democrats wouldn't drop this idea right now just because of constitutional concerns, even if they ran deep. Why not try to get it done now, during all this social spending haggling, and see just what happens in the courts?

Twitter Opinions

Only Applies to Billionaires

Excuse me for asking "For How Long"?

Unintended Consequences

Please consider The Billionaire Tax: The Worst Tax Idea Ever?

The new feature of this law is its attempt to tax unrealized capital gains on assets. The problem with taxing "unrealized" gains or income is that since they are unrealized, and taxes have to be paid with cash, the question of how to come up with the cash becomes an issue, making it a central challenge for any plan, built around it. In fact, there are two practical problems with the proposal, at least as described in the press. 

After a decade of rising stock and bond prices, I guess that many have forgotten that not only can what goes up come down, but also that you can have extended periods where assets stagnate or drop in value. While there is airy talk of being allowed to claim unrealized losses as deductions, how exactly would this work? Put simply, if stocks are up 20% in 2021 and down in 2022, would taxpayers get refunds on their taxes paid in 2021? It is also not clear what the tax code writers are assuming about what the market will do over the next decade, when they estimate that this tax will deliver about $200 billion in revenues, but are they assuming that the good times will continue? Stock and bonds have a really good run, but history suggests that there will be not just bad times, but extended bad times for markets.

There may be no revenues at all from this tax code change, if the market has a decade like the 1970-1979 or 2000-2009, and if that happens, what are the contingency plans for the expenditure that is being funded by these revenues? 

The administration is trying hard to avoid using the words "wealth taxes" to describe this proposal, but that is sophistry. Janet Yellen's claims notwithstanding, this is a wealth tax, albeit on incremental wealth, rather than total wealth. 

If there is a billionaire tax on unrealized gains, some or even many of these billionaires will have to sell portions of their asset holdings to pay taxes dues. There is no way that an Elon Musk would have been able to pay taxes on the unrealized gains on his Tesla holdings in 2020, without selling a portion of his holding. While there may be enough liquidity in a stock like Tesla to absorb that selling, there are other assets where the liquidity effect is going to be larger and more permanent. 

Good intentions about creating a better social safety net cannot excuse the writing of tax laws that are inefficient at collecting revenues, ineffective even in their punitive intent and potentially dangerous for the rest of us, in terms side costs. 

I believe I struck the right balance in Nancy Pelosi Says a Wealth Tax on Billionaires' Unrealized Gains is On the Way

Expect legal challenges based on the 16th Amendment.

The proposal taxes unrealized gains. But is there "income" before gains are realized? The courts will decide if this goes forward, but the idea is dubious at best.

Hang on to your wallets. This is how the original income tax was shackled to us. The original tax in 1913 applied only to the super wealthy and topped out at 7%. The average American would never be taxed.

We all know how that worked out. We will all be paying on unrealized gains before the decade is out.

Also recall that big gains on December 31, 1999 would have been big losses by the first months into next year (and about ten years for the Nasdaq to get back to where it was). But a tax would have been assessed for 1999. No one can say with certainty how a conservative court might rule. 

All this grief for $200 billion or so... Assuming it stops at billionaires. 

Bad assumption?

Perhaps this is nothing more than a back door idea by Elizabeth Warren that has no real end.

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