The investment tax plan: implications for lower rates on capital gains?

House Ways and Means Committee Chairman Dave Camp's investment tax plan implicitly challenges our most basic and firmly held beliefs about why we tax investment gains the way we do, Sanchirico writes.

House Ways and Means Committee Chairman Dave Camp (R-MI) has proposed requiring most derivatives investors to pay tax on their annual returns even if they don’t realize their gains by selling their securities. This proposal, which requires investors to mark-to-market the value of financial derivatives, has ramifications far beyond the heady world of high-tech finance. It implicitly challenges our most basic and firmly held beliefs about why we tax investment gains the way we do.

Camp’s plan raises two key questions: First, should mark-to-market be required for all investment assets, not just derivatives? Second, does his proposal fracture one of the main justifications for taxing long term capital gains at roughly half the rate on ordinary income?

Ask most tax experts why, in a nutshell, rates should be lower for capital gains, and you’re liable to get a mini-lesson on the “lock-in effect.” There’ll be other reasons too. But the lock-in effect is going to be pulling some serious weight.

What the lock-in effect is and how it relates to mark-to-market—and why Camp’s proposal calls it into serious question—is best explained by way of analogy. 

Imagine you’re a law professor, and your student comes to you with a note from the Dean saying that he should be allowed to take as much time as he needs on your upcoming exam. You shake your head, but decide it’s not worth bothering the Dean. The next day the student returns to your office to argue that his exam should also be graded more leniently. After all, given that he has as long as he likes on the exam, he’ll be temped to work on it an inordinate amount of time to the detriment of his other classes—unless, that is, he knows that he’ll get a decent grade in any event.

You’re astounded by the student’s audacity. Think of it: arguing that one problematic advantage, dubiously secured, deserves another. Rather than agreeing to grade more leniently, you resolve to call the Dean to question why the student is getting extra time in the first place.  (And you make a note to hire the student should you ever need legal help.)

The “lock-in” argument has the same basic structure as the student’s argument for lenient grading.

Start with the fact that investors “get as much time as they need” to pay tax on their accrued gains. Investment gains are taxed, not as they accrue, but only when they are “realized”—by, for example, selling the asset. This is a tax advantage because the unpaid tax stays on the taxpayer’s balance sheet and continues to earn income.

The lock-in argument then comes back for more: given that gains aren’t taxed until realized, it says, realized gains should be taxed at lower rates. Because investors can delay the tax until they sell the asset, they’ll be tempted to delay selling for an inordinate amount of time. That’s inefficient because better investments might crop up in the meantime. Keeping rates low reduces this tax-borne inertia.

Might it not be time to “call the Dean” about taxing only upon realization? Camp’s proposal—though it applies only to derivatives—is a strong prod to pick up the phone.

Proponents of the lock-in argument offer two main reasons to take the realization advantage as given. Camp’s proposal implicitly challenges both.

First, they say it’s just too hard to determine the market value of investments at year-end. That argument has always been suspect when it comes to publicly-traded securities for which prices are readily available with the click of a mouse.

But Camp now calls for marking to market derivatives whose underlying asset values are neither widely published nor even publicly traded. A derivative is merely a financial instrument, like an option or forward contract, whose value is tied to some underlying asset. One has to wonder: If it’s feasible to value the derivative, how can it not be feasible to value the underlying asset to which the derivative’s price is linked?

Second, proponents of the lock-in argument raise the specter of inconsistent treatment across assets. Sure, they say, some assets, like publicly traded stock, are easily valued and can be precisely marked-to-market. But others, like uniquely situated land, cannot be. Won’t that distort investment decisions and open up tax arbitrage opportunities?

In the context of a tax code full of partway measures, this too has always been a dubious argument. But it is even more suspect in light of Camp’s proposal.

He’d mark-to-market most derivatives but none of the assets from which they are derived. If disparate tax treatment distorts investment decisions between land and stock, would it not distort investment decisions between derivatives and their underlying assets? If tax arbitrage is a danger between stock and land, surely it is a danger between a derivative and its underlying assets. The arbitrage seems readymade.

Camp’s proposal is more than food for thought regarding derivatives. It’s a four-course meal for fundamentally rethinking how we tax investment gains.