Unrealized Capital Gains Taxes Will Trickle Down to the Middle Class

Unrealized capital gains taxes may start by targeting the ultra-rich, but they will eventually target you.

The Harris campaign has recently revived the Democrat talking point of taxing unrealized capital gains. In simple terms, an unrealized capital gains tax would tax owners of stocks when those stocks appreciate in value, even if the stocks have not been sold.

The policy is strange. When someone sells his stocks, he is subject to a tax for the income he receives on the sale. Before he sells the stock, he has not realized any “gain” in value because if the stock market falls the next day, all of those supposed gains would disappear.

Typically, supporters of this policy resort to red herring arguments when fighting detractors. For example, one major argument used to silence opponents of the policy is the claim that “it will only affect billionaires, so you shouldn’t care about it anyways!”

There are lots of problems with this argument. First, if something is unjust, you shouldn’t only oppose it when it happens to you. Second, something can be economically deleterious without being directly targeted at you. You could very well be harmed by the repercussions of a policy aimed at the ultra-rich.

However, I’m not going to focus on either of these reasons. Instead, I want to make the case against an unrealized capital gains tax that will appeal to people on narrowly selfish grounds. The case is simple. Unrealized capital gains taxes may start by targeting the ultra-rich, but they will eventually target you.

Trickle-Down Taxes

Why would I claim this? Well, historically this is exactly how many tax policies in the US have worked. Let’s start with the income tax.

In 1913, the income tax as we know it was codified by the Revenue Act of 1913. Let’s look at whom this act targeted.

Here are the tax rates by income when the initial income tax was passed. We should note that the deduction was $3,000 for single filers and $4,000 for married filers.

To interpret this chart, we need to understand what wages were in 1913. Research shows that in 1914, daily wages in manufacturing were a little less than $2.10 per day. In other words, even if workers in manufacturing worked every day of the year, they wouldn’t even get near the $3,000 deduction.

Adjusting for inflation, $20,000 in 1913 would have been equivalent to around $642,000 in 2024. In other words, only the very rich were paying anything more than 1 percent. Furthermore, $3,000 in 1913 equates to around $96,000. That means that if we had the 1913 structure today, you wouldn’t pay a penny as a single person if you made less than $96,000 (or $128,000 if you were married) due to the standard deduction.

The US National Archives claims that the result of this structure was that “generous exemptions and deductions [led to] less than 1 percent of the population [paying] income taxes at the rate of only 1 percent of net income.” In short, income taxes were only paid by a fraction of the top 1 percent of income earners.

According to a 1917 IRS publication, the median American who filed for income taxes (so this already excludes those with incomes low enough that they did not bother filing) earned between $2,000 and $2,500 that year. Assuming that this was true three years prior, this would mean that the median American paid $0 in income taxes. Indeed, in 1916, the same publication reports $0 received from those making between $2,000 and $3,000.

In other words, before 1917, the median American was not paying income taxes. Income taxes were truly a policy targeted toward the rich.

In 1917, however, the standard deduction was reduced by $2,000, bringing millions of Americans into the realm paying income taxes.

History tells us that taxes, even those aimed at the very rich, have a tendency to trickle down. Maybe unrealized capital gains will start at the One Percent, but, incrementally, it’s quite likely that they’ll work their way into the 401k plans of middle-class Americans.

Trickle-Down and Ratchet-Up

So we’ve seen historically that taxes targeting the rich trickle their way down to the middle class. Why does this happen? First, we can take a page from the standard economic analysis of the government.

If we view the government as being composed of benevolent agents of the people, it may be difficult to explain why tax policies which were promised to be directed at the rich trickled down to the middle class. However, politicians are not angels. They are normal people. Normal people are subject to the influence of money.

In order for a politician to survive in politics, he or she must get re-elected. Getting re-elected costs money. Thus, many politicians will succeed by (knowingly or unknowingly) catering to special-interest groups. The few wealthy members of society have sufficient resources to have access to politicians. Average working Americans have more limited access, and it will be costly for such a large group to organize.

Because of this, politicians may be able to benefit by catering to rich, organized special-interest groups contrary to the interests of large disorganized groups (like average working Americans). This logic of special interests leads to a nasty conclusion. Tax policies ostensibly made to target the super wealthy will be crafted based on the desires of that group.

As such, we expect, on the margin, it will be beneficial to shift some of the burden from the wealthy to the middle class. This doesn’t mean that the wealthy won’t still pay the majority of taxes (in fact they do), but it does mean that politicians will benefit from shifting the burden from them in some cases.

Oftentimes, these changes come during times of crisis. While not as organized, the precursor to the 1913 income tax was instituted in 1861 to pay for the Civil War. The 1913 tax was increased significantly in 1918 to finance World War I.

Tax policies are often introduced during crises, and, following the crises, things remain at a higher tax state permanently. This is an example of what Dr. Robert Higgs calls the “Ratchet Effect.” Throughout history, several of these emergencies (financial, military, or otherwise) have led to permanently higher spending and taxes.

This ratcheting-up can’t be limited to the rich only, as the higher rates incentivize the rich to fight the tax system even harder. As a result, the tax trickles down to the middle class.

So it may be true that a particular tax proposal by Harris or Democrats generally will target the unrealized gains of the rich today, but after a few wars and pandemics that tax threshold will work its way down to ordinary Americans. Once the policy itself has been passed, it becomes relatively cheap to lower the threshold. One might say that it’s a slippery slope.

In any case, don’t let yourself be fooled. Fighting against an unrealized capital gains tax isn’t just about defending millionaires and billionaires (even though that may be justified on its own terms). Fighting new taxes is ultimately about fighting the inevitable trickling-down of taxes to the middle class.