President Joe Biden’s latest budget proposal includes a $5 trillion tax hike, which would introduce a 25% annual minimum tax on unrealized capital gains for individuals with incomes and assets over $100 million. This plan would increase the top marginal rate on long-term gains and dividends to 44.6%, the highest in U.S. history. While it’s uncertain if this policy will be approved by a divided Congress, it is important to understand the potential implications of such a drastic tax increase.
Taxing unrealized capital gains, or gains on assets that have not been sold, is unprecedented and flawed. Under Biden’s plan, individuals would owe taxes on gains that exist only on paper, leading to financial burdens without actual economic benefit. This policy could disrupt investment behavior, particularly in small caps, startups, and early-stage companies, slowing innovation and productivity growth.
Americans overwhelmingly oppose the taxation of unrealized gains, with a 2021 study showing a rejection of this policy by a three-to-one margin, including 76% of independent voters. The resistance to such tax measures is rooted in beliefs of economic liberty and fairness, where a gain is not considered realized until it is sold. High taxes can also drive demographic shifts, with individuals and capital migrating to states with more favorable fiscal climates, as seen in the Census Bureau data.
Rising Treasury yields and inflation concerns have created challenges for small-cap stocks, which are more sensitive to economic shifts due to higher debt loads and smaller financial cushions. The inverse relationship between the 10-year yield and the Russell 2000 stock index indicates that small caps may face obstacles if rates remain inflated. However, this challenging environment could present buying opportunities for investors as small caps are trading at their lowest levels since the dotcom bubble.
The taxation of unrealized gains could have sweeping unintended consequences for the U.S. economy, personal liberty, and the foundation of American innovation. Influential figures in the investment community, such as Anthony Pompliano and Scott Melker, have expressed concerns that wealthy investors may find ways to minimize the impact of this additional tax burden, potentially distorting investment behavior and hindering economic growth. It is essential for individuals to be aware of the potential ramifications of such tax policies and the broader implications for the economy and society at large.
