Wealth managers continue to seek sophisticated paths to tax avoidance for their clients -- most recently as the "tax-aware long-short" strategy has gained more popularity among Wall Street types. Though this form of tax-loss harvesting has been around for many decades, it's now more widely accessible as an increasing number of wealth management firms offer it to their clients.
The darker side of more palatable taxation of investors' capital income is an expected $1.56 trillion in tax expenditures that will emerge between tax years 2023 and 2033. To stem this trend, eliminating capital gains taxation by absorbing it under the income tax would resolve any inequities caused by tax-loss harvesting -- but this solution is extreme. Two other possibilities would involve more nuanced reform: taxing unrealized gains or drastically reducing capital gains rates.
Designed to offset capital gains through carefully planned or engineered capital losses, the tax-aware long-short strategy allows money managers to legally shrink investor tax liabilities, often by exploiting market propensity for short-term losses and long-term gains. But as wealthy investors reduce their tax contributions, the tax burden shifts to average taxpayers and revenue diverts from essential public funding.
The tax-aware long-short strategy leverages disparities in capital gains tax treatment in somewhat of a balancing act. An investor holds one stock likely to grow in value, while investing in another stock they expect to lose value in the short term.
When the short-term loss occurs, the investor sells it and offsets some of the long-term gain. The net result is less taxable income and a smaller tax bill. High-net-worth individuals are more able to use such strategies because they have more wealth and flexibility.
Treating long-term capital gains under a separate tax structure rather than taxing them as ordinary income was Congress's deliberate choice over a century ago -- and a costly one.
On top of this policy choice, sophisticated tax avoidance strategies further reduce tax revenue. The complexity and costs often make these strategies inaccessible to average taxpayers, leading to a push-pull dynamic with efforts to make the tax code progressive.
This only exacerbates inequities inherent in a tax policy that already favors investment income over ordinary income such as salaries and wages. The top capital gain rate is 20%, while the top income tax bracket is 37%.
When money managers and investors spend significant time and money to avoid tax compliance even with this relatively generous treatment, it suggests systemic failure in tax policy. Equitable tax policy aims to fairly and efficiently distribute resources but must not unnecessarily consume them in the process.
Each time a wealthy investor hires a money manager, spending $10 to avoid a $20 tax bill, the public loses nearly $20 in potential tax revenue. This reduces funds for essential services and represents a broader opportunity cost. Skilled professionals are pulled into work that primarily exists to sidestep taxes, rather than creating value that benefits society.
At a certain point, the more equitable policy would be one that generates less tax revenue on paper but results in the collection of that revenue -- that is, with less lost to complex planning.
Taxing gains at the same rate as wages or salaries would eliminate the incentive to structure income as capital gains and manipulate capital losses to offset those gains. Such a policy shift would increase vertical equity and lead to an influx of much of the $1.56 trillion in tax revenue -- which could at least partially be used for public services.
This would simplify the tax system, but it likely would have a devastating effect on investment, reducing tax revenue in the long term. The complete inability to offset gains with losses would shift the risk of investments entirely on investors' shoulders, potentially making markets more volatile and deterring long-term commitments of capital.
Taxing unrealized gains -- levying taxes on the increased value of investments without waiting for the investor to realize the gains through sale -- is a more feasible solution. Similar to how mark-to-market accounting works, unrealized gains would be deemed realized at specific intervals.
For tax purposes, it would be as though the investor who holds $100 million in Company X with a basis of $10 million sold their shares and realized the $90 million gain, despite them having done nothing but hold the appreciated asset. The investment's value would be taxed without a sale being necessary, just as the value of real property is taxed in a property tax system.
In the same way investors currently use realized losses to offset realized gains, unrealized losses could offset unrealized gains at each deemed realization event. Investors would still be able to take deductions for their losses, but the effect of complex strategies such as the long-short would be blunted.
Such strategies rely on an investor's ability to bet on a given stock price going down in the short term but up in the long-term. Under an unrealized gains tax, gains and losses would be recognized each deemed realization period, reducing the value of timing-based tax maneuvers.
On the opposite end of the policy spectrum, lowering capital gains rates across the board could decrease the financial motivation to engage in tax planning. Investors retain expensive advisers and engage in complex schemes to reduce their tax liabilities because the former costs less than the latter. If total tax liabilities were significantly reduced, some investors would simply pay the taxes they owe without turning to complex planning techniques.
Incentivizing avoidance of rules that encourage equitable distribution can be more wasteful than misallocating resources. By focusing on policies that both capture revenue on paper and reduce the opportunity for expensive planning and loopholes, legislators can build a tax system that better supports economic productivity and social equity.