Does the Constitution allow a billionaire tax?

Harvard Law Professor Thomas J. Brennan explains the many hurdles, legal and practical, an effort to tax billionaires would face

Would a tax on billionaires be constitutional? How would it work in practice? And would it work at all? Harvard Law School Professor Thomas J. Brennan says the answers are complicated, and that a broad and well-structured consumption tax might be more effective and less vulnerable to legal challenges. With the recent debate on Capitol Hill about creating a billionaire tax to fund President Joe Biden’s nearly two trillion-dollar social spending bill, Harvard Law Today recently asked Brennan, a tax policy expert, to explain the constitutional hurdles such a tax would likely encounter, the arguments for and against, and whether America’s superrich might actually be made to pay.

Harvard Law Today: Can you describe some of the key elements of the most recent billionaire tax proposal?

Thomas Brennan: In broad brushstrokes, it’s targeted at very wealthy people who are, roughly speaking, billionaires. About 700 people might initially be affected by this, more or less. The idea would be to tap unrealized appreciation in their assets. When anyone owns an asset — could be your house, could be stock, could be anything else — it may go up or down in value with no tax consequences until you sell or [otherwise] dispose of it. For extremely wealthy people, this could be a lot of money. For example, much of Jeff Bezos’s, Mark Zuckerberg’s, and Elon Musk’s wealth is in stock that has unrealized appreciation. The proposal is to tax that sort of unrealized appreciation, regardless of the fact that they may not have sold and may not be going to sell.

There are two different categories of assets addressed by the proposal. The first is publicly traded assets, things like Amazon stock or Tesla stock, for example, which would be taxed currently. The second category involves private assets, including things like land. In this latter case, Congress would wait until a future date to tax it, but with an additional charge to reflect the fact that time has elapsed. So, very roughly speaking, the proposal wants to get at all the assets, but it only taxes the traded liquid items at first, and waits until later to collect with respect to other items.

HLT: What are the arguments in favor of imposing such taxes on billionaires?

Brennan: The argument in favor that probably resonates with a lot of people is based on equity — the idea that all income should be taxed in a similar way, regardless of whether you earn that income from laboring for a wage at a job, or through appreciation of stocks and other financial instruments. There is a strong intuitive case for treating economically similar increases in wealth similarly.

But it is also important to remember that our tax system already includes all kinds of exceptions to the ideal of similar treatment of all types of income. We have different rates for capital gains and ordinary income, we give various items special treatment, and so forth. We do not have a uniform one-size-fits-all system. In addition, our system taxes wealth at different stages of the process. For example, how are we to think about it when a corporation earns income and then pays corporate tax on it? A shareholder may arguably have implicitly paid some tax by virtue of owning the stock in a company which pays tax. There are questions of incidence: Who’s bearing the tax? Is it the shareholders? Or is it the customers of the corporation, via higher prices? Or perhaps the employees, via reduced wages? Even if a corporation is not currently paying much tax, perhaps future expected taxes are already impounded into the stock price, and so a shareholder may already have a reduced stock value as a result of taxes yet to be paid. It’s a complicated thing to isolate who bears what tax burden, and, in some ways, it’s really over-simplifying to say that all wealth should be taxed in the same way. Many things may make situations that appear superficially to be comparable to be in fact fundamentally different.

HLT: What are the arguments against a wealth tax?

Brennan: The biggest is the valuation problem. When you have an asset, what is its true value? How much tax should I pay on it? When a normal investor considers a stock, they think ‘I know what the value is. I can buy it. I can sell it.’ But if, for example, Jeff Bezos sold all his Amazon stock tomorrow, it seems likely that something bad might happen to the stock price. His position in Amazon is not the same as a position you or I might have as a retail investor. The same is true for other dominant shareholders. When you own a large or even controlling stake in a company, it’s a different thing than a normal investment. So, the valuation question looms large even for things like publicly traded stock when you’re talking about these huge positions. There’s also the difficulty of determining how much of a stock’s price is ephemeral, perhaps driven up by speculation. All this calls into question whether you’re taxing the right amount by using the current stock price. These concerns are reasons why the tax system typically waits until a market transaction occurs to reveal the true price and correct amount to tax.

Thomas J. Brennan

Thomas J. Brennan is the Stanley S. Surrey Professor of Law at Harvard Law School.

Another problem is liquidity. Do you have the cash on hand to pay the tax? Now, presumably these very wealthy billionaires could generate the cash. But if it’s large enough — for example, suppose it’s a 20% tax on a fortune of $100 billion; they’ve got to come up with $20 billion — maybe they will feel the need to sell some of their stock in order to fund the tax, thus altering the value of the stock being taxed. Or they could borrow against the stock, but borrowing such large amounts also is costly in itself. If they do sell some of their stock, perhaps this affects control of the company. Perhaps this also distorts the decisions that will be made in the future about the company.

HLT: I’ve read that this proposal might also have constitutional issues?

Brennan: There are two potential legal problems under the U.S. Constitution. The first has to do with whether this might be perceived as a wealth tax, or more precisely, a direct tax. Direct taxes are allowed under the Constitution, but they have to be apportioned among the 50 states according to the population as measured by the census. What does that mean? No one’s quite sure, because Congress has never levied such a tax intentionally. But it seems that Congress would have to decide how much total revenue it was going to raise and then apportion that amount across the 50 states in accordance with their populations. So, if all the billionaires live in one state, and Congress levies a tax that’s going to collect 20% of the billionaires’ wealth, all 50 states will have to pay that, rather than the one state where they live, or the billionaires themselves. The consequence would be that the billionaires would pay relatively little and the rest of the country will bear most of the burden of that tax. This is presumably not the intention of the proposal.

To avoid the constitutional problems that come with a direct tax, the proposed legislation styles itself as a tax on income, not on wealth, which is permitted under the 16th Amendment. It is not clear that this characterization is right, and it seems certain that the direct tax question would be litigated. Even if proponents of the proposal succeed on the direct tax question, there is a second legal problem, which is the question of what counts as income. In the early days of the 16th Amendment, the Supreme Court told us that income from appreciation must be “realized” before tax could be imposed This perspective is found, for example, in Eisner v. Macomber, 252 U.S. 189 (1920). Now, a lot of scholars and policymakers believe that we’ve departed substantially from that view — that 1920s viewpoint — but the case has not been overruled, and there is a possibility that there is a realization requirement under the 16th Amendment.

The biggest argument against a wealth tax is the valuation problem. When you have an asset, what is its true value? How much tax should I pay on it?

It is true that there are examples of statutes put on the books in the intervening years that impose mark to market [a method of calculating fair value of financial assets] taxation in certain situations. This lends credence to the idea that realization is not actually required.  Yet the Court has not weighed in. Good lawyers could make the argument that the existing examples are special, and that they don’t provide a sufficient basis to override the original thinking that you need the realization requirement. Lawyers on the other side could say, ‘Well, no, there’s a lot of evidence that we have moved away from Eisner v. Macomber, and there is in fact no realization requirement embedded within the meaning of the term income.’ No one knows for sure how that would come out, and it would certainly go to the Supreme Court. Everything will turn on these metaphysical questions — What is a direct tax? What is income?

HLT: Assuming the billionaires also have good lawyers, is there a worry that, even if a tax proposal like this survived the likely legal challenges, they would just find other ways to avoid paying taxes?

Brennan: Absolutely. The moment that the ink is dry on the paper, and you know what exactly the rules are, then you begin to figure out how to get around them. So, for example, suppose you’re a billionaire who has a public company that has huge value. What if you could take the company private, and then make it something that is now in the category that is taxed later, instead of taxed now? Under the law, you’re going to have to pay eventually, but eventually is not today. And who knows what a future favorable Congress might do? So, that would just be a threshold thing to do. People could potentially play more sophisticated games between the two categories of public and private. For instance, wouldn’t it be interesting if you generate losses in your publicly traded things and have offsetting gains in your private things? The complexity and multiple categories could give rise to all sorts of difficulties. I’m just making up a few things off the top of my head but I’m sure that clever lawyers will think of many more things you can do.

(In court) everything will turn on these metaphysical questions: What is a direct tax? What is income?

I would think it would be prudent to have extensive testimony and hearings and input from experts and lawyers, and particularly from people who might do this planning, to try to craft the legislation in a manner that is as robust as possible. It can never be completely avoidance proof, but it should come as close as possible to achieving its intended goal. Certainly, if it gets done over the course of two days, that’s not going to happen. So, I really worry that for the legislation to work well, it would need to be vetted much more carefully than seems possible right now.

HLT: Stepping back from the most recent proposals, have economists and tax experts coalesced on a better system for taxing billionaires’ wealth?

Brennan: I think one of the things that probably most everyone would agree with is that it’s good to tax things that aren’t highly mobile or morphable, or, you know, able to be disguised or repackaged in some way. Taxing things like financial instruments invites lots of gameplaying. So, what’s not changeable? Well, some people say consumption is a good thing to tax rather than income. Spending the wealth is the final step along the supply chain, so to speak. Taxing when the wealth is spent, rather than when it was originally created, or at some intermediate stage, might be more effective. But this too comes with challenges. For example, what if you don’t spend in the country where you earned? The more wealthy you are, the more able you might be to change jurisdictions. You could impose taxes for exiting the country — we have some of those already — but it gets complicated. Still, a lot of people think some sort of consumption tax could be a helpful thing to try to cut through all the intermediation and machinations that go on along the way.

One thing that we actually have already in the United States is the estate and gift tax. When you either give your money away during life to your heirs, or you die and leave your money to someone, a hefty tax is imposed. That in some ways is like a consumption tax because it treats the wealth transfer to your heirs as an event of consumption. For the extremely wealthy, gifts and bequests may form nearly all of their consumption. So, to the extent that that has teeth, that can be a good way to tax. Now, people may worry about setting the rate appropriately. Others may worry that you can avoid the tax by giving your money away to charity. But as long as you agree that the charities that Congress has defined by statute are good uses for the money, then at death we either tax your wealth, or we require you to give it to an acceptable alternate destination. Perhaps with some more protections to make sure that it’s not too avoidable, focusing on the estate and gift tax can be an effective way to be sure that the extremely wealthy are taxed appropriately.