Many of the wealthiest people on earth hold their wealth in the form of a financial asset, like stock in a succesful company. When it comes to capital gains, there is a choice to be made between a tax on “wealth,” which seeks to estimate the value of these gains whether or not the assets have been sold, and an “income” tax that imposes taxes on capital gains only when they are sold (or “realized”). Florian Scheuer makes the case for the second approach in “Taxing capital, but right: Why realized gains, not asset values, should guide tax policy (UBS Center Policy Brief 1, 2025).
Scheuer focuses on the fact that movements in stock prices are often closely linked to interest rates. After all, the price of a stock is determined by the future stream of profits the firm is expected to produce, but the interest rate determines the “present v value” that an investor will put on that stream of future profits. Lower interest rates will tend to boost stock prices, because it means that future profits have a higher present value; conversely, higher interest rates tend to push down stock prices, because future profits will have a lower value in the present. Scheuer offers this example:
Take a stock that pays a constant dividend of $100 per year forever, and suppose the interest rate is 10%. Then the stock price, which reflects the present-discounted value of the flow of dividends, must equal $1,000. Now suppose the interest rate falls to 5%. As a result, the stock is now worth $2,000: The stock price doubles, a massive capital
gain. But notice that the dividends paid by the stock have not changed at all: They
are still $100 per year. Therefore, the income and lifetime consumption possibilities
for someone who does not sell have not gone up. The capital gains of $1,000 are a pure “paper gain.” Of course, an investor who sells the stock can cash in on the gains, resulting in an increase in consumption. Conversely, an investor buying the stock loses: She needs to pay twice the amount for the same fl ow of future dividends. In sum, sellers gain, buyers lose and those who hold the stock are una ffected. This is why a tax on realized gains is aligned with who gains and loses from asset price fluctuations. By contrast, a tax on unrealized gains (or a wealth tax) would fully tax the “paper gains” of those who neither buy nor sell even though they do not benefit from their capital gains.
Scheuer also points out that paying capital gains tax whenever a sale occurs will tend to lock investors into their existing investments–because they would owe income tax if they decided to sell one stock and buy another. Scheuer argues that sell-and-immediately-reinvest should not be taxed. The result of such a transaction is again a paper gain, rather than actually realized income. And it’s generally a good thing for investors to be able to reallocate their portfolios.
So far, those who would prefer to see a wealth tax or greater taxation of capital gains presumably don’t like what they are hearing from Scheuer, at least as I have described it so far. But Scheuer also argues that perhaps the biggest loophole in capital gains taxation should be closed. I refer here to “step-up in basis at death,” which basically means that if someone dies and passes an asset along to their heirs, the capital gains of that asset are never taxed. Scheuer argues that passing along assets at time of death should be treated like a “realization” of gains.
The capital gains tax systems in the U.S. and many other advanced economies feature a particularity referred to as step-up in basis at death for inherited assets. This tax rule eliminates the taxable capital gain that occurred between the original purchase of the asset and the time of inheritance, thereby reducing the heir’s tax liability. Effectively, it completely exempts from taxation all capital gains accrued during the original holder’s lifetime if she never realizes the gains but passes them along at death. This is considered a major tax loophole, and indeed comparisons between capital gain realizations reported on income tax returns with historical stock market gains suggest that a large share of all capital gains on corporate stock was never taxed purely because of this provision. Our findings imply that this tax rule should be abolished in favor of a “carryover basis” approach, which makes the heirs subject to a tax on the full gains going back to the original purchase price, and which is already used by a number of countries including Germany, Italy, and Japan.
Relatedly, a tax avoidance strategy of wealthy families known as “buy, borrow, die” has received attention in recent years. The idea is to borrow against appreciating assets rather than selling them and then taking advantage of the stepped-up basis at death, thereby avoiding capital gains taxes altogether. Eliminating the stepped-up
basis loophole would also close the door for this avoidance strategy.Changing the “step-up in basis at death” can be done in two ways. In the version Scheuer describes, the value of capital gains is taxed on those who receive the inheritance. An alternative method would be to tax the estate of the decedent, as if that person had realized the gains at time of death. According to estimates from the Congressional Budget Office, either approach would raise tens of billions of dollar per year. However, a tax on capital gains nominally paid by the decedent raises more revenue that a tax on capital gains paid by the heirs, because the income received by heirs is broken up into smaller chunks and taxed at lower rates.
