A recent ProPublica report has uncovered shocking details about how little Elon Musk, Jeff Bezos, Warren Buffet and Michael Bloomberg have paid in taxes. Obviously the report was limited to cherry-picked information. Nonetheless, it reveals an underlying problem in the tax code that can be solved with a few reforms.
Cherry-picked Information:
All the billionaires covered in the report had most of their wealth in stock. This is because all the men were either investors like Buffet or controlling shareholders in companies they founded, like Bezos. The way they would earn income would mainly be by selling stock or earning dividends and this would mean the income they earned would be less stable than the income a normal person earns through wages. Hence, there were some years where these billionaires technically didn’t have any income (trust me they were fine) and paid no taxes.
That they had no income means that in any given tax year, the stocks they were selling had an overall level of gains on them that was negative enough to cancel out all the dividend income they were earning. So if Warren Buffet, for instance, realized he had made a bad investment and sold a lot of losing stocks in a given year, his taxable income that year might have been negative. The ProPublica report covers the years when any one of these men paid no income taxes but not the years when they paid a lot of income.
The ProPublica report also covers the income taxes paid for all four men from the years 2014 to 2018. Why did they choose those cutoff years? Well, I have a sense the end year, 2018, was chosen because those men paid higher income taxes in 2019. Going into 2018, income and capital gains tax rates were lower thanks to the Trump tax cuts. At the same time, there were indications that Republicans might try a second tax cut. Therefore, rich people like Elon Musk, who donates to Republicans for tax cuts opportunities like this, waited to sell their stocks until the start of the next tax year. As a result, leading up to the next tax year their taxable income was small and they paid little taxes.
The ProPublica measurement of the billionaires incomes was different from their taxable incomes. The ProPublica relied upon Forbes estimates of the net worth of these men to estimate income. Under current tax law, rich people are not on the hook to pay taxes on money made in the stock market until they sell their stock.
A Loophole That Can Be Closed:
In spite of my criticisms, the ProPublica report does reveal two well known problems with the stock market.
First, billionaires are smart about when to realize stock market gains as actual income. They do not sell their stock and pay taxes on capital gains when tax rates are high. This problem can be dealt with easily. We simply have to tax people at the end of each calendar year for their stock market (or housing market or bond market, etc…) profits, even if they haven’t sold their shares yet.
To do this, we should remove capital gains from income taxes and add the highest marginal income tax rate to the capital gains rate. We should also compensate people for losses through negative taxation at the same tax rate.
By applying a negative tax on negative capital gains we can remove the disincentive for risk the current system has. Currently, if a billionaire investor realizes negative capital gains on their investment, their negative income will not lead to negative taxation. Meanwhile, if they realize a huge profit, their positive income will largely be subject to the highest marginal tax rate. Hence, billionaires currently receive a disincentive to take on risk with their personal wealth because they will only pay a tax on earnings and not on losses. So even if a venture is expected to deliver positive pre-tax returns (say 50% chance $10 billion in earnings with a 50% chance of $8 billion in losses), the after-tax returns may be negative (50% change of $5 billion in earning and 50% chance of $8 billion in losses). This problem would get worse if they had to pay taxes each year. The solution of negative taxation on negative earnings removes that disincentive
Secondly, billionaires keep most of their income in the stock market and won’t pay taxes on it until their death. This is a problem because capital gains are applied on a “stepped up” basis. The stepped up basis system means that capital gains taxes on inherited assets are a tax on the difference between the sale value of an asset and the inheritance value of the asset.
For example, imagine, If Jeff Bezos buys a stock portfolio for $1 billion and dies, leaving it to his son when it’s worth $2 billion and his son sells it at a price of $3 billion. Under current law, Bezos’ son will only pay capital gains on $1 billion in capital gains because the “basis” is the $2 billion value he inherited the stocks at.
We can end the second issue easily as well. We just have to get rid of the stepped up basis provision in our tax system. The basis for the capital gains tax should be the original purchase price, not the inheritance value. Returning to our example, in the new system Jeff Bezos’ son’s capital gains basis will be the original price his father bought the stock at ($1 billion), so Jeff Bezos’ son will have to pay capital gains on the entire $2 billion in capital gains he and his father earned together. Then, rich people would have no incentive to hold onto capital gains until their death.
Overall these two reforms would reduce the amount of investment activity performed simply to evade taxes and increase tax revenues, without raising the tax rates on investment.