Taxpayer Realization, Unrealized Capital Gains, and Economic Welfare

Abstract

Should we tax unrealized capital gains? This Article provides a new perspective on this controversial issue by evaluating the realization requirement as applied in modern taxation in terms of conventional measures of economic welfare. Drawing on recent academic research that measures economic welfare when asset prices can change either because of changes in discount rates or changes in cash flows, it provides new insights into the wisdom of taxing unrealized gains or losses. The bottom line from this literature is that in the absence of changes in expected cash flows, economic welfare is directly related to the value of asset transactions (sales or purchases), not to changes in asset values. In particular, if asset values increase solely because of discount rate changes, taxpayer realization of the gain tracks economic welfare. Modern finance theory suggests that much of the variation in asset prices occurs because of changes in discount rates. Unrealized gains in this case should not be subject to tax if economic welfare is the primary criteria for taxation.

On the other hand, if asset prices do increase because of changes in cash flows, then unrealized gains may reflect changes in economic welfare. In this case, taxation of unrealized gains is consistent with taxation based on economic welfare. A key contribution of this Article is to explain the intuition behind the recent academic research and discuss in detail its relationship to the tax law concept of realization.

Our realization-based tax system in practice, however, does not systematically track measures of economic welfare. The links between realization as embedded in the current tax code and measures of economic welfare are complex. Another contribution of this Article is to use the insights from the recent research on asset price changes to provide an assessment of how realization, as applied in the tax law, may deviate from measures of economic welfare.

Finally, the Article provides new insights into the realization requirement itself; its application and refinement in case law; and the related concepts of non-recognition, like-kind exchanges, and wash sales. These applications demonstrate how the insights from our approach are valuable to scholars who do not necessarily wish to base their normative theory of taxation strictly on measures of economic welfare.