David Gamage is a professor of law at Indiana University Maurer School of Law, and Darien Shanske is a professor at the University of California, Davis, School of Law (King Hall).
In this installment of Academic Perspectives on SALT, Gamage and Shanske advocate for phased mark-to-market as a mechanism for reforming the taxation of investment gains of billionaires and megamillionaires.
Voters and politicians increasingly understand how the U.S. income tax system is broken at the top — especially when it comes to the investment gains of billionaires and megamillionaires — at both the federal and state levels.1 Accordingly, proposals for mark-to-market reforms to address this brokenness have emerged in the past few years. For simplicity, we will refer to the entire category of recent mark-to-market income tax reform proposals targeted at billionaires and megamillionaires as billionaire income tax (BIT) reforms, regardless of the design mechanics and of whether these proposals target just billionaires or would also apply to megamillionaires.
The first prominent BIT proposal that we are aware of was the New York State Billionaire Mark-to-Market Tax Act (S. 8277B/A. 10414) introduced in 2020. This was followed by the Illinois Extremely High Wealth Mark-to-Market Tax Act (H.B. 3475) in 2021. At the federal level, the first prominent BIT proposal that we are aware of was the Billionaires Income Tax, introduced by U.S. Sen. Ron Wyden, D-Ore., in October 2021. This was followed by the Babies Over Billionaires Act (H.R. 7502) introduced by U.S. Rep. Jamaal Bowman, D-N.Y., in April. Most recently, President Biden proposed a billionaire minimum income tax as part of his federal budget this year, and legislation to enact that reform was introduced by U.S. Rep. Steve Cohen, D-Tenn., in July.2
Along with others, we co-designed and co-drafted all these BIT reform proposals except Wyden’s, which one of us consulted and advised on but did not co-draft. In this article, we explain a novel mechanism that we developed as part of drafting the Babies Over Billionaires Act.
We call this novel mechanism phased mark-to-market. The basic idea is that mark-to-market rules need not be all or nothing. Rather, for investment gains that would be considered unrealized under current law, we can conceive of mark-to-market rules as consisting of (first) deemed realization and then (second) either full recognition or partial nonrecognition. The key to phased mark-to-market is that the recognition component of this two-step process can be made only partial rather than full.
For instance, a simple phased mark-to-market rule could be designed to annually recognize only half of gains that are deemed realized by the reform, leaving the other half unrecognized (similar to how existing nonrecognition rules operate). Thus, a taxpayer with $100 million of deemed realized gains would only recognize $50 million of those gains in the first year. Assuming no change of value, the $50 million of unrecognized gains would then again be deemed realized in the next applicable year, with half — $25 million — thus recognized in that year.
The primary purpose of this partial nonrecognition step in phased mark-to-market reforms is to spread out the recognition of gains and losses over time. This substantially reduces the volatility that would otherwise result from BIT reforms, making subsequent loss deductions much less likely. As Joseph Thorndike recently discussed, volatility and resulting loss deductions pose both political and tax administrative challenges for BIT reforms.3 The phased mark-to-market mechanism mitigates these challenges.
In the remainder of this article, after more fully explaining the phased mark-to-market mechanism, we discuss the promise of this mechanism for federal-level BIT reforms. We then also discuss some complications involved in applying this mechanism for state-level BIT reforms.
I. Preliminary Comments
In tax, as in so many other parts of life, perfection should not be the goal. In the realm of the sales tax, for example, it is understood that many cash transactions escape taxation. Though there are attempts to deal with this issue, our impression is that these are mostly modest, consistent with a cost-benefit analysis weighing the cost of compliance with expected revenue yield.
Of course, at some point, modest fissures blossom into crevasses that threaten the integrity of the entire system. For example, we think this would be a fair way to characterize the threat posed by the physical presence rule in the age of the internet. It took a while, but the fissure has now been patched by the state laws enabled by Wayfair. Note that in our post-Wayfair world, some remote transactions probably remain untaxed even though they should be. The new laws don’t close the gap completely, just return it to a tolerable size.
In the world of the income tax, something similar has happened with the realization rule. Permitting deferral of gain until sale was a sensible enough rule to deal with valuation and liquidity issues in the early 20th century, even if it meant an imperfect — and artificially reduced — measure of income. But with increased wealth inequality and sophisticated tax planning, the costs of this flawed rule have grown enormously — even as the cost of compliance in our world of many markets has, in many cases, declined considerably.
Like many others, we think it is time to shore up the fissure caused by the realization rule. But the patch need not be perfect; it only needs to be good enough.
II. The Babies Over Billionaires Act
As noted, the essence of phased mark-to-market is a deemed realization rule followed by partial nonrecognition of the deemed realized gains. There are many ways to implement this basic idea. We now explain how the phased mark-to-market mechanism is implemented in the Babies Over Billionaires Act, which uses different rules for traded assets and non-traded assets.
A. Traded Assets
For traded assets, the reform would deem realized gains annually but only recognize 30 percent of the deemed realized gains each year. Among other benefits, this approach would alleviate liquidity concerns, because a taxpayer would need to come up with substantially less money to pay the initial year’s tax liability (or tax liability in any later year with large investment gains) as compared with a non-phased mark-to-market reform. More importantly, only recognizing 30 percent of deemed realized gains annually would substantially reduce volatility concerns, because unless asset prices later fell quite dramatically, it would be a lot less likely that a taxpayer would end up paying taxes on temporary gains from market fluctuations.
Over a decade-plus time frame, most of the gains that were deemed realized in the initial years would eventually be recognized — albeit more gradually over time in a phased manner.
B. Non-Traded Assets
Whereas traded assets are relatively easy to value, valuation can be considerably more difficult for many non-traded assets. Some BIT reform proposals — like Wyden’s — would thus apply mark-to-market only to traded assets, using other rules, like deferral charges, for non-traded assets. But this raises the concern that taxpayers might shift from owning traded assets to non-traded assets, as it is difficult to design a deferral charge or other retrospective regime that would not raise serious issues of gaming and political optionality.4 By political optionality, we mean that regimes that push off large tax liabilities are vulnerable to political pressure from taxpayers that will be subject to those liabilities — and that sophisticated taxpayers may face incentives to defer tax liabilities while waiting for future legal or political changes that are favorable to them.5
To address these concerns, a phased mark-to-market regime can require deemed realization and valuation for non-traded assets less frequently than annually. For instance, the Babies Over Billionaires Act requires deemed realization and valuation for non-traded assets only every five years, and then recognizes only 50 percent of the deemed realized gains from non-traded assets in each five-year deemed realization period.
The goal is to alleviate the costs of requiring valuations by only requiring them every five years, but without creating problematic incentives to convert traded assets into non-traded assets. Although the recognition of gains would occur more slowly for non-traded assets under this rule than for traded assets, most deemed realized gains would eventually be recognized for both traded and non-traded assets.
III. The Promise of Phased Mark-to-Market for Federal BIT Reforms
Of course, other percentages for nonrecognition and other time periods for how often deemed realization and valuation could be required are also possible. The choices made for the Babies Over Billionaires Act are merely attempts at balancing competing concerns. There is nothing magical about these choices. Selecting lower recognition percentages for the portions of deemed realized gains would further alleviate volatility and liquidity concerns, whereas selecting higher recognition percentages would accelerate revenue raising and better alleviate gaming and political optionality concerns. Our main point here is to emphasize that there are many ways to structure solutions to the realization problem that are good enough, and that phased mark-to-market has promise for balancing competing concerns in designing a federal BIT reform.
As Thorndike concludes, “The ‘lesson’ of this historical snapshot is clear: Falling stock markets can be dangerous to any tax law that allows for large loss deductions. That’s something that mark-to-market champions should probably keep in mind. . . . However the deductibility of losses might be structured, it’s almost certain to encounter impressive political headwinds from progressive forces eager to limit those deductions even further.”6
Phased mark-to-market makes loss deductions much less likely and much less common. It also alleviates liquidity concerns and can be designed to reduce the costs of valuation (by requiring deemed realization less frequently than annually for non-traded assets). For all these reasons, we think phased mark-to-market has great promise for federal BIT reforms.
IV. Phased Mark-to-Market and State-Level BIT Reforms
If the federal government were to actually implement a BIT reform, many states would likely conform. As we noted, there have also already been prominent state-level BIT reform proposals for New York and Illinois. However, state-level implementation of phased mark-to-market would need to look a little different for taxpayers who might move out of state after enactment.
As we noted at the outset, phased mark-to-market has two steps: (1) the deemed realization and (2) the partial nonrecognition. A state could thus deem all the gains of a resident billionaire as realized and then subject those gains to only partial recognition. So far, this looks just like a federal system. But if the taxpayer later leaves the state, then matters become somewhat more complex.
Specifically, the question then arises as to whether the original state where the gains were realized, but not fully recognized, should relinquish its claim to tax those unrecognized gains to the state the taxpayer moves to. This would be a mistake in terms of both fairness and broader tax policy. That is, we think the original state should have the priority claim to the deemed realized gains, including the portions that were not recognized as a courtesy to the taxpayer and to alleviate volatility and liquidity concerns.
How to achieve this result? A state-level, phased mark-to-market reform might make the partial nonrecognition of gains that are deemed realized only an option made available to taxpayers, with the taxpayers agreeing to reporting and payment obligations for these gains that would continue even after the taxpayer left the state.7 Some taxpayers already need to engage in similar recordkeeping and related continuing tax obligations for deferred compensation they earned while a resident of a state.8 A state-level phased mark-to-market reform could function similarly.
V. Conclusion
As the recent passage of the federal Inflation Reduction Act (H.R. 5376) demonstrates, one never knows when the stars might align for a policy proposal. We hope the time will eventually come for fixing the problem of systematic undertaxation of the most wealthy that results from our flawed realization-based tax system. When that time comes, we think serious consideration should be given to phased mark-to-market as a mechanism for reform.
FOOTNOTES
1 See, e.g., David Gamage and John R. Brooks, “Tax Now or Tax Never: Political Optionality and the Case for Current-Assessment Tax Reform,” 100 N.C. L. Rev. 487, 497-505 (2022) (explaining how the income tax system is broken); Goldburn P. Maynard Jr. and Gamage, “Wage Enslavement: How the Tax System Holds Back Historically Disadvantaged Groups of Americans,” 110 Ky. L.J. 670, 673 (2021-2022) (explaining that calls for reforms like wealth taxes have gained newfound prominence in recent years).
2 Cohen, “Congressmen Cohen and Beyer Introduce Billionaire Minimum Income Tax Act,” July 28, 2022.
3 Joseph J. Thorndike, “Will Slumping Stocks Doom Mark-to-Market Tax Reforms?” Tax Notes State, July 18, 2022, p. 331.
4 Gamage and Brooks, supra note 1, at 538-544. But see Brian Galle, Gamage, and Darien Shanske, “Solving the Valuation Challenge: A Feasible Method for Taxing Extreme Wealth,” Duke L.J. (forthcoming) (proposing a novel valuation regime with deferral and retrospective components to address gaming and political optionality concerns). A form of this plan was included in the Billionaire Minimum Income Tax proposal.
5 For further discussion of political optionality, see Gamage and Brooks, supra note 1.
6 Thorndike, supra note 3, at 333.
7 Cf. Andrew Appleby, “No Migration Without Taxation: State Exit Taxes,” Harv. J. Legis., at *22 (forthcoming) (“[It] appears a continuation-type tax that imposes only a reporting obligation would easily pass muster.”).
8 Shail P. Shah and Campbell McLaren, “California’s ‘Long Range’ Taxing Scheme: Taxation of Nonresident Equity-Based Compensation,” Tax Notes State, Jan. 24, 2022, p. 351.
END FOOTNOTES