Today Bill Gates expressed some very mild-mannered criticism of Warren’s wealth tax plan, claiming that he paid about $10 billion in tax in his lifetime and that his wealth is about $100 billion. Some said this corresponds approximately to a low 9% tax rate (10/(100+10)), evidence a wealth tax is needed. Some proposed “practical” alternatives to the wealth tax such as taxing unrealized income on listed shares. Before we can have a conversation on the optimal way to tax rich people, however, we should make sure we are all on the same page about realized income, unrealized income, and wealth, and the respective taxes thereupon.
First, how are capital gains calculated? Suppose Bill Gates (“Bill”) founded Microsoft in his garage as a C-corporation (i.e. an incorporated entity for tax purposes, not a passthrough) without contributing any meaningful capital and held his shares ever since. Then, his “tax basis” in the shares is zero. Upon a sale (IPO or not) the entirety of proceeds will be a capital gain. If Bill had founded Microsoft as a passthrough, his basis would be equal to Microsoft’s book value (i.e., cumulated retained earnings), but even in this case the market value of Microsoft at the time of IPO would have been magnitudes larger than its book value, resulting in a substantial capital gain.
Second, the capital gains tax applies only to the shares that are sold, i.e. to realized gains. Bill has retained the majority of the shares of Microsoft throughout. Proposals to tax unrealized capital gains on liquid listed shares must specify what happens upon the listing to pre-listing investors, including founders like Bill. Some have proposed treating the entire market value of their shares (sold or not) as realized. Even after crediting any basis, this treatment would trigger a one-time gargantuan taxable event. Note that in the typical IPO only a small fraction of the shares (say 5%) is sold. If this triggers a gain on 100% of the shares, the minimum amount of shares to be sold at IPO may be as high as 25% (5% + 20% to pay capital gains tax, in the extreme case of zero basis). Further, in order to sell that many more shares, the price would have to go down. If the firm has a capital raising target, it will have to sell even more shares!1
Third, early investors’ gains are treated extremely favorably for the explicit policy goal of stimulating entrepreneurship. Current tax policy (§1202) provides a tax exemption for 100% of the realized gain up to $10 million or ten times the base investment, whichever is greater. We should have a policy debate about priorities.
Fourth, it is not obvious to me that we are calculating correctly how much tax billionaires are paying. Consider a world in which you can’t buy and sell businesses, but everything else is the same. Microsoft would not have a market value. It would simply belong to Bill, then to his children, then to the grandchildren, etc.. Microsoft would make earnings, pay corporate tax, and pay dividends out of earnings; the Gateses would then pay tax on dividends. At current rates of ~20% for both corporate income and dividends, the total tax is about 36%. Clearly no one would say that’s low. (Whether in practice the total rate is 36% is a very different question). Instead, in reality, businesses are traded so we say that Bill has “earned income” simply because Microsoft’s market value went up. If we count that as “income” that Bill has earned during his lifetime (even though it is the capitalized value of future earnings that will last long after Bill is gone), we should also count as “taxes” not just all past corporate, dividend, and capital gains taxes that Bill paid, but we should also capitalize all future taxes that Microsoft and its shareholders will pay.
Finally, if this thread has convinced you that a wealth tax is a simple and elegant solution, think again! Unless I’m missing something big, a large wealth tax (e.g. 6%) based on the unrealized value of Microsoft’s stock would almost surely have caused the government to expropriate the majority of Bill’s stock. Upon the 1986 IPO, Bill’s 49% position was worth ~$200m. If a wealth tax had been introduced in 1986 it wouldn’t have been “only for billionaires”, so let’s assume all of it was likely subject to the tax. (If you want to redo the math with rate thresholds be my guest.) Microsoft’s dividend yield has been 0% from its 1986 IPO to its first dividend in 2003 and about 1.5-2% thereafter. Assuming Bill used all dividend proceeds to pay wealth taxes, that leaves between 4 and 6% to be paid in shares. At this rate, and ignoring donations to his foundation, by now he would own only 9% of Microsoft and the government would have taken the remaining 40%. This calculation ignores exemption thresholds. In other words, founders of very successful businesses who keep most of their wealth concentrated in them would face gradual expropriation (or, more likely, find clever ways to not pay taxes).