Does the current structure of capital gains taxes provide interest-free loans?

By Tyler Cowen.

"Dylan Matthews and a few others were saying this on Twitter, so I thought I should cover the question.  Perhaps we are all understanding terms differently, but my answer is a simple “no.”  At least not apart from the step-up basis being revalued at death, which I (like many others) would change.  Even that is not a direct gain for you.

First, I define a zero interest loan as when you can increase your consumption today by “k,” and later pay back only k, rather than paying back the higher sum of k modified by the relevant exponential relationship.

Second, let us say you are a wealthy person who owns a start-up now worth $100 million, under the current tax regime.  But you are illiquid, and also you do not want to sell for a number of reasons, one being to avoid an immediate capital gains tax liability.

So you borrow — let us say $50 million — collateralized by the stock.  Of course that does help you consume more today.

But is it a zero-interest loan?  No, you have to pay the real rate of borrowing to raise that $50 million.  I do not see where the zero-interest loan is supposed to come from.  (Of course, real interest rates might have been zero to begin with, but that is a matter aside from how the capital gains rate is structured.)

It is true you postpone paying the government.  But the wealthy person, to consume more now, still equates impatience with the real rate of interest in standard fashion.  And let’s say you don’t own any capital value at all.  You still have the option of borrowing (if you can), consuming more today, and not paying the government anything extra!  That is built into the nature of borrowing, and how it interacts with our current tax system, which tends not to tax consumption very much.  Like that or not, don’t blame it on the ownership of capital assets.  The main example people are citing is not much different than this example of the poor person borrowing and consuming more, except we gave the subject an extra $100 million in side holdings, so this somehow feels more outrageous.

If someone wants to limit or tax that borrowing, I would consider that suggestion, if only to avoid far worse policies.  But what is going on in this scenario does not seem so sinister to me — “I borrowed more to become more liquid” is an age-old story, which surfaces in a wide variety of settings.  So I would not myself limit or tax that borrowing.

Another relevant factor is that the capital gains rate is not indexed to inflation.  So if you just hold the asset and borrow against it for say twenty years, the tax system treats your twenty years of nominal gains as if they were real gains, and taxes you accordingly.  Ouch!  That in my view is bad, and also unfair.  It also limits the extent to which wealthy people, or for that matter poorer people, will pursue this strategy.

And again, the government could avoid these problems all the more by shifting its taxation focus from capital income to consumption, in progressive fashion if need be.  And that is not utopian, it is in fact what so many of the wealthier countries in the world have done.

If you feel this part of the debate might be semantic, perhaps that is correct.  But that judgment also means that the concept of “zero interest loan” is not some kind of extra argument for taxing unrealized capital gains.  It is, however, an argument for shifting the tax system toward a greater taxation of consumption."