Monthly Archives: September 2024

Joy-Politik: Taxing Unrealized Capital Gains

25 Wednesday Sep 2024

Posted by in Wealth Taxes

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Kamala Harris’ campaign platform lifts several tax provisions from Joe Biden’s ill-fated campaign. The most pernicious of these are lauded by observers on the Left for their “fairness”, but they dismiss some rather obvious economic damage these provisions would inflict. Here, I’ll cover Harris’ proposal to tax unrealized capital gains of the rich in two different ways:

  1. A minimum 25% “billionaire tax” on the “incomes” of taxpayers with net worth exceeding $100 million. This definition of income would include unrealized capital gains.
  2. A tax of 28% at the time of death on unrealized capital gains in excess of $5 million ($10 million for joint returns).

Why Bother?

To get a whiff of the complexity involved, take a look at the description on pp. 79 – 85 of this document, to which the Harris proposal seems to correspond. It’s not fully fleshed out, but it’s easy to imagine the lucrative opportunities this would create for tax attorneys and accountants, to say nothing of job openings at the IRS!

On the other hand, there’s little chance these proposals would be approved by Congress, no matter which party holds a majority. Harris knows that, or at least her advisors do. That taxation of unrealized gains is even part of the conversation in a presidential election year tells us how normalized the idea has become within the Democrat Party, which seems to have lost all regard for private property rights. These are classist proposals designed to garner the votes of the “tax-the-rich” crowd, who either aren’t aware or haven’t come to grips with the fact that the U.S. already has a very progressive income tax system. “The rich” already pay a disproportionately high share of taxes.

Taxable Income

These provisions would complicate and corrupt the income tax code by distorting the definition of income for tax purposes. The Internal Revenue Code has always been consistent in defining taxable income as realized income. One might use the expression “mark-to-market taxation” to characterize a tax on unrealized gains from tradable assets. It’s much more difficult to estimate unrealized gains on non-tradable or infrequently traded investments, for which there is no ready market value.

There is one type of income that some believe to be taxed as unrealized. A few weeks ago, in a post about Sam Altman’s infatuation with a wealth tax, I cited a recent Supreme Court decision that has been mistakenly interpreted as favoring income taxation of unrealized gains or a wealth tax. In fact, Moore v. United States involved the undistributed profits of a foreign pass-through entity (i.e., not a C corporation) for purposes of the mandatory repatriation tax. The foreign firm’s profits were realized, and its pass-through status meant that the U.S. owners had also, by definition, realized the profits. So this case did not set a precedent or create an exception to the rule that income taxation applies only to realized income.

Forced Sales

Tradable assets with easily recorded market values will often have unrealized gains in a given year. While tax payments might be spread over the current and future tax years, these taxes could necessitate asset sales to pay the taxes owed. If unrealized losses are treated symmetrically, they would require either future deductions or possibly credits for prior tax payments.

Estimates of unrealized gains on illiquid or private investments like closely-held business interests, artwork, or real estate are highly uncertain and subject to dispute. A large tax liability on such an asset could be especially burdensome. Cash must be raised, which might require a forced sale of other assets. And again, these valuations often come with great complexity and exorbitant administrative costs, not just for the IRS, but especially for taxpayers.

Economic Downsides

As I noted above, additional taxes on unrealized gains would create an obvious need for liquidity, if not immediately then at death. With or without careful planning, sales of assets by wealthy investors to pay the tax would undermine market values of equity (and other assets), producing a broader loss of wealth economy-wide.

Avoidance schemes would be heavily utilized. For example, a wealthy investor could borrow heavily against assets so as to offset unrealized gains with deductible debt-service costs.

Capital flight is likely to be intense if a Harris tax regime began to take shape in Congress. This might be the best avoidance scheme of all. The U.S. is likely to experience massive capital outflows. Furthermore, investment in new physical capital will decline, ultimately leading to lower productivity and real wages.

Entrepreneurial activity would also take a hit. In a critique of Jason Furman’s effort to justify Harris’ proposal, Tyler Cowen asks why we should be so eager to “whack” venture capital. He also quotes an email from Alex Tabarrok on the detrimental policy effects on rapidly growing start-ups:

“What’s really going on is that you are divorcing the entrepreneur from their capital at precisely the moment that the team is likely most productive. Separation of capital from entrepreneur could negatively impact the company’s growth or the entrepreneur’s ability to manage effectively. The entrepreneur could lose control, for example. If you wait until the entrepreneur realizes the gain that’s the time that the entrepreneur wants out and is ready to consume so it’s closer to taxing consumption and better timed in the entrepreneurial growth process.“

Or the entrepreneur might just decide that a startup would be more rewarding in a tax-friendly environment, perhaps somewhere overseas.

Interest Rates and Tax Receipts

Tabarrok notes in a separate post that much of the variation in stock prices is caused by changes in interest rates. Investors use market rates to determine discount rates at which a firm’s future cash flows can be valued. Thus, changes in rates engender changes in stock prices, capital gains, and capital losses.

A decline in interest rates can raise market valuations without any change in dividends. However, a long-term investor would see no change in pre-tax income or consumption, so the tax could force a series of premature sales. A change in a firm’s expected growth rate would also create an unrealized gain (or loss), but the tax would undermine U.S. equity values. Taxing an actual increase in the dividend is one thing, but taxing a change in expectations of future dividends is another. As Tabarrok puts it, “It’s taxing the chickens before the eggs have hatched.“

Dangerous Narrative, Dangerous Policy

A final objection to taxing unrealized capital gains is that it would cross the line into a form of wealth taxation. Assets come in many forms, but the only time realized values can be discerned are when they are traded. That goes for collectibles, homes, boats, and the full array of financial assets. A corollary is that a very large percentage of wealth is unrealized.

A tax on unrealized gains would be the proverbial camel’s nose under the tent and another incursion into the private realm. So often in the history of taxation we’ve seen narrow taxes expand into broad taxes. This is one more opportunity for the state to extend its dominance and control.

I’ve written in the past about the economic dangers of a wealth tax. First, every dollar of income used to purchase capital is already taxed once. In that sense, the cost basis of wealth would be double taxed under a wealth tax. Second, the supply of capital is highly elastic. This implies a high propensity for capital flight, shallowing of productive physical capital, and reduced productivity and real wages. Avoidance schemes would rapidly be put into play. Given these limitations, the revenue raising potential of a wealth tax is unlikely to live up to expectations. Finally, a wealth tax is unconstitutional, but that won’t stop the Left from pushing for one, especially if they first get a tax on unrealized gains. Even if they are unsuccessful now, the conversation tends to normalize the idea of a wealth tax among low-information voters, and that is a shame.

JoyPolitik: Greed, Gouging, and Gullability

18 Wednesday Sep 2024

Posted by in Inflation, Price Controls

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Economic ignorance and campaign politics seem to go hand-in-hand, especially when it comes to the rhetoric of avowed interventionists. They love “easy” answers. If they get their way, negative but predictable consequences are always “unintended” and/or someone else’s fault. Unfortunately, too many journalists and voters like “easy” answers, and they repeatedly fall for the ploy.

This post highlights one of many bad ideas coming out of the Kamala Harris campaign. I probably won’t have time to cover all of her bad ideas before the election. There are just too many! I hope to highlight a few from the Trump campaign as well. Unfortunately, the two candidates have more than one bad idea in common.

Price Gouging

Here I’ll focus on Harris’ destructive proposal for a federal ban on “price gouging”. Unfortunately, she has yet to define precisely what she means by that term. On its face, she’d apparently support legislation authorizing the DOJ to go after grocers, gas stations, or other sellers in visible industries charging prices deemed excessive by the federal bureaucracy. This is a form of price control and well in keeping with the interventionist mindset.

As Michael Munger has said, when you charge “too much” you are “gouging”; when you charge “too little” you are “predatory”; and when you charge the same price as competitors you’ve engaged in a price fixing conspiracy. The fact that Harris’ proposal is deliberately vague is an even more dangerous invitation to arbitrary caprice by federal enforcers. It might be hard to price a ham sandwich without breaking such a law.

The great advantage of the price system is its impersonal coordination of the actions of disparate agents, creating incentives for both buyers and sellers to direct resources toward their most valued uses. Price controls of any kind short circuit that coordination, inevitably leading to shortages (or surpluses), misallocations, and diminished well being.

Inflation As Aggregate Macro Gouging

Aside from vote buying, Harris has broader objectives than the usual “anti-gouging” sentiment that accompanies negative supply shocks. She’s faced mounting pressure to address prices that have soared during the Biden Administration. The inflation during and after the COVID pandemic was induced by supply shortfalls first and then a spending/money-printing binge by the federal government. The pandemic induced shortages in some key areas, but the Treasury and the Fed together engineered a gigantic cash dump to accommodate that shock. This stimulated demand and turned temporary dislocations into permanently higher prices.

There were howls from the Left that greed in the private sector was to blame, despite plentiful evidence to the contrary. Blaming “price gouging” for inflated prices dovetails with Harris’ proclivity to inveigh against “corporate greed”. It’s typical leftist blather intended to appeal to anyone harboring suspicions of private property and the profit motive.

The profit motive is a compelling force for social good, motivating the performance of large corporations and small businesses alike. Diatribes against “greed” coming from the likes of a career politician with no private sector experience are not only unconvincing. They reveal childlike misapprehensions regarding economic phenomena.

More substantively, some have noted that mark-ups rose during and after the pandemic, but these markups are explained by normal cyclical fluctuations and the growing dominance of services in the spending mix. High margins are difficult to sustain without persistently high levels of demand. The Fed’s shift toward monetary restraint has dissipated much of that excessive demand pressure, but certainly not enough to bring prices back to pre-pandemic levels, which would require a severe economic contraction.

Claims that concentration among sellers has risen in some markets are also cited as evidence that greedy, price-gouging corporations are fueling inflation. If that is a real concern, then we might expect Harris to lean more heavily on antitrust policy. She should be circumspect in that regard: antitrust enforcement is too often used for terrible reasons (and also see here). In any case, rising market concentration does not necessarily imply a reduction in competitive pressures. Indeed, it might reflect the successful efforts of a strong competitor to please customers, delivering better value via quality and price. Moreover, mergers and acquisitions often result in stronger challenges to dominant players, energizing innovation, improved quality, and price competition.

If Harris is serious about minimizing inflation she should advocate for fiscal and monetary restraint. We’ve heard nothing of that from her campaign, however. No credible plans other than vaguely-defined price controls and promises to tax and spend our way to a joyful “opportunity economy”.

Disaster Supply Gouging

There is already a federal law against hoarding “scarce items” in times of war or national crisis and reselling at more than the (undefined) “prevailing market price”. There are also laws in 34 states with varying “anti-gouging” provisions, mostly applicable during emergencies only. These laws are counterproductive as they tend to “gouge” the flow of supplies.

In the aftermath of terrible storms or earthquakes, there are almost always shortages of critical goods like food, water, and fuel, not to mention specialized manpower, machinery, and materials needed for cleanup and restoration. As I pointed out some time ago, retailers often fail to adjust their prices under these circumstances, even as shelves are rapidly emptied. They are sometimes prohibited from repricing aggressively. If not, they are conflicted by the predictable hoarding that empties shelves, the higher costs of replenishing inventory, and the knowledge that price rationing creates undeservedly bad public relations. So retailers typically act with restraint to avoid any hint of “gouging” during crises.

Disasters often disrupt production and create physical barriers that hinder the very movement of goods. When prices are flexible and can respond to scarcity on the ground, suppliers can be very creative in finding ways to deliver badly needed supplies, despite the high costs those are likely to entail. Private sellers can do all this more nimbly and with greater efficiency than government, but they need price incentives to cover the costs and various risks. Price controls prevent that from happening, prolonging shortages at the worst possible time.

The chief complaint of those who oppose this natural corrective mechanism is that higher prices are “unfair”. And it is true that some cannot afford to pay higher prices induced by severe scarcity. The answer here is that government can write checks or even distribute cash, much as the government did nationwide during the pandemic. That’s about the only thing at which the state excels. Then people can afford to pay prices that reflect true levels of scarcity. If done selectively and confined to a regional level, the broader inflationary consequences are easily neutralized.

Instead, the knee-jerk reaction is to short-circuit the price mechanism and insist that available supplies be rationed equally. That might be a fine way for retailers to respond in the short run. Share the misery and prevent hoarding. But supplies will run low. When the shelves are empty, the price is infinite! That’s why sellers must have flexibility, not prohibitions.

Blame Game

Harris is engaged in a facile blame game at both the macro and micro level. She claims that inflation could be controlled if only corporations weren’t so greedy. Forget that they must cover their own rising costs, including the costs of compensating risk-averse investors. For that matter, she probably hasn’t gathered that a return to capital is a legitimate cost. Like many others, Harris seems ignorant of the elevated costs of bringing goods to market following either unpredictable disasters or during a general inflation. She also lacks any understanding of the benefits of relying on unfettered markets to bridge short-term gaps in supply. But none of this is surprising. She follows in a long tradition of ignorant interventionism. Let’s hope we have enough voters who aren’t that gullible.

The Fed Tiptoes Through Lags and an Endless Fiscal Thicket

04 Wednesday Sep 2024

Posted by in Inflation, Monetary Policy

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The late, great Milton Friedman said monetary policy has “long and variable lags” in its effect on the economy. Easy money might not spark an inflation in goods prices for two years or more, though the typical lag is thought to be more like 15-20 months. Tight money seems to have similar lags in its effects. Debates surround the division and timing of these effects between inflation and real GDP, and too many remain convinced that a reliable tradeoff exists between inflation and unemployment.

With that preface, where do we stand today? The Fed executed a veritable helicopter drop of cash during the pandemic, in concert with support payments by the Treasury, with predictable inflationary results. It was also, in part, an accommodation to supply-side pressures. Then the tightening of policy began in the spring of 2022. How will the timing and strength of these shifting policies ultimately play out, as well as the impact of expectations regarding future policy moves?

Help On the Way?

Federal Reserve Chairman Jerome Powell and the Fed’s Open Market Committee (FOMC) are now poised to ease policy after three-plus years of a tighter policy stance. The FOMC is widely expected to cut its short-term interest rate target by a quarter point at the next FOMC on September 17-18. There is an outside chance that the Fed will cut the target by a half point, depending on the strength of new data to be released over the next couple of weeks. In particular, this Friday’s employment report looms large.

What sometimes goes unacknowledged is that the Fed will be following market rates downward, not leading them. The chart below shows the steep drop in the one-year Treasury yield over the past couple of months. Other rates have declined as well. Granted, longer rates are determined in large part by expectations of future short-term rates over which the Fed has more control.

And yet the softening of market rates may well be a signal of weaker economic activity. There is certainly concern among investors that a failure by the Fed to ease policy might jeopardize the much hoped-for “soft landing”. The lagged effects of the Fed’s tighter policy stance may drag on, with damage to the real economy and the labor market. Indeed, some assert that a recession remains a strong possibility (and see here), and the manufacturing sector has been in a state of contraction for five months.

On the other hand, the Fed has fallen short of its 2% inflation goal. The core PCE deflator, the Fed’s preferred inflation gauge, was up 2.6% for the year ending in July. Some observers fear that easing policy prematurely will lead to a new acceleration of inflation.

Powell Gives the Nod

Nevertheless, markets were relieved when Jerome Powell, in his recent speech in Jackson Hole, Wyoming, indicated his determination that a shift in policy was appropriate. From Bloomberg:

“Federal Reserve Chair Jerome Powell said ‘the time has come’ for the central bank to start cutting interest rates.

“Powell’s comments cemented expectations for a rate cut at the central bank’s next gathering in September. The Fed chief said the cooling of the labor market is ‘unmistakable,’ adding, ‘We do not seek or welcome further cooling in labor market conditions.’ Powell also said his confidence has grown that inflation is on a ‘sustainable path’ back to the Fed’s goal of 2%.“

The “sustainable path back to … 2%” might imply a view inside Fed that policy will remain somewhat restrictive even after a quarter or half-point rate cut in September. Or perhaps the “sustainable path” has to do with the aforementioned lags, which might continue to be operative regardless of any immediate change in policy. The feasibility of a “soft landing” depends on whether policy is indeed still restrictive or on how benign those lagged effects turn out to be. But if we take the lags seriously, an easing of policy wouldn’t have real economic force for perhaps 15 months. Still, the market puts great hope in the salutary effects of a move by the Fed to ease policy.

Big Balance Sheet

It can be argued that the Fed already took a step toward easing policy in May when it reduced the rate at which it was allowing runoff in its portfolio of Treasury and mortgage-backed securities. Prior to that, it had been redeeming $95 billion of maturing securities a month. The new runoff amount is $60 billion per month. Unless neutralized in other ways, the runoff has a contractionary effect on bank reserves and the money supply. It is known as “quantitative tightening” (QT). but then the May announcement was a de facto easing in the degree of QT.

Thus far, the total reduction in the Fed’s portfolio has amounted to only $1.7 trillion from the original high-water mark of $8.9 trillion. Here is a chart showing the recent evolution in the size of the Fed’s securities holdings.

The Fed’s current balance sheet of $7.2 trillion is gigantic by historical standards. It’s reasonable to ask why the Fed considers what we have now to be a more “normalized” portfolio, and whether its size (and correspondingly, the money supply) represents potential “dry tinder” for future inflation. It remains to be seen whether the Fed will further pare the rate of portfolio runoff in the months ahead.

Money growth had been running negative for roughly a year and a half, but it edged closer to zero in late 2023 before accelerating to a slow, positive rate a few months into 2024. The timing didn’t exactly correspond to the Fed’s slowing of portfolio runoff. Nevertheless, the Fed’s strong preference is to supply the banking system with “ample reserves”, and reserves drive money growth. Thus, the Fed’s reaction to conditions in the market for reserves was a factor allowing money growth to accelerate.

A Cut Too Soon?

A rate cut later this month will make reserves still more ample and support additional money growth. And again, this will be an effort to mediate the negative impact of earlier policy tightness, but the effect of this move on the economy will be subject to similar lags.

A danger is that the Fed might be easing too soon, so that inflation will fail to taper to the 2% goal and possibly accelerate again. And perhaps policy was not quite as tight as it needed to be to achieve the 2% goal. Now, new supply bottlenecks are cropping up, including a near shutdown of shipping through the Suez Canal and a potential strike by east coast dockworkers.

Fiscal Incontinence

An even greater threat now, and in the years ahead, is the massive pressure placed on the economy and the Fed by excessive federal spending and Treasury borrowing. The growth of federal debt over the 12 months ending in July was almost 10%. Total federal debt stands at about $35 trillion. According to the Congressional Budget Office (CBO) projections, federal debt held by the public will be almost $28 trillion by the end of 2024 (the rest the public debt is held by the Fed or federal agencies). The CBO also projects that the federal budget deficit will average almost $1.7 trillion annually through 2027 before rising to $2.6 trillion by 2034. That would bring federal debt held by the public to more than $48 trillion.

Inflation is receding ever so slowly for now, but it’s unclear that investors will remain comfortable that growth in the public debt can be paid down by future surpluses. If not, the only way its real value can be reduced is through higher prices. Most observers believe such an inflation requires that the Fed monetize federal debt (buy it from the public with printed money). Tighter credit markets will increase pressure on the Fed to do so, but the growing debt burden is likely to exert upward pressure on the prices of goods with or without accommodation by the Fed.

Hard, Soft, Or Aborted Landing?

Some economists are convinced that the Fed has successfully engineered a “soft landing”. I might have to eat some crow…. I felt that a “hard landing” was inevitable from the start of this tightening phase. Even now I would not discount the possibility of a recession late this year or in early 2025. And perhaps we’ll get no “landing” at all. The Fed’s expected policy shift together with the fiscal outlook could presage not just a failure to get inflation down to the Fed’s 2% target, but a subsequent resurgence in price inflation.