Realization and Progressivity

Abstract

The realization requirement is the income tax’s original sin. Although longstanding, it is widely considered the main source of tax complexity, inequity, and economic distortion. Despite these problems, realization is also considered a fundamental element of modern income tax regimes. It is explained early in most federal income tax courses as necessitated by problems of asset valuation and taxpayer liquidity. To the dismay of certain professors, this explanation usually generates little class discussion. More worrisome, it is also widely accepted outside the classroom— prompting few political objections or normative academic inquiries. The goal of this article is to provide a normative framework that allows policymakers to better understand the role of the realization requirement. It makes two related arguments. First, with respect to certain emotionally non-fungible (personal) assets, the realization requirement is normatively justified because the market price is not a good indication of the assets’ value to their owners. Second, contrary to the traditional view of realization as a regressive element, taxing only these personal assets upon realization would promote income tax progressivity. This article’s normative approach provides a basis for developing a more effective and coherent redistributive income tax policy. This analysis contributes to the broader tax reform debate and opens a novel theoretical inquiry with respect to the distributive impact of different types of errors. * Associate Professor Hebrew University. LL.B. Hebrew University of Jerusalem, LL.M. University College London, LL.M. & J.S.D. Yale Law School. We are thankful to the following people for all of their comments and suggestions along the way: Reuven Avi-Yonah, Edna Benshalom, Gadi Benshalom, Tom Brennan, Assaf Hamdani, Sharon Hannes, Stephanie Hoffer, Susan Morse, David Pozen, and Edward Zelinsky. We would also like to thank participants of the University of Toronto Faculty of Law Tax Policy Workshop for their very helpful comments. We would like to extend special thanks to Ben Alarie, Avital Benshalom, David Enoch, Lee Fennell, Alon Harel, Sarah Lawsky, Debra Lefler, Daphna Lewinsohn-Zamir, Jacob Nussim, Diane Ring, and Eyal Zamir for their detailed comments. Most of all, we would like to thank Avihay Dorfman and David Gamage for their invaluable framing and substantive comments. ** J.D. Northwestern University School of Law. I would like to thank Ryan Sniatecki, Scott Lerner, and Jonathan Conon for their thoughtful comments. 44 COLUMBIA JOURNAL OF TAX LAW [Vol.3:43 INTRODUCTION 45 I. THE REALIZATION REQUIREMENT—COSTS AND ENDURANCES OF AN ACHILLES’ HEEL 49 A. The Function and Social Costs of the Realization Requirement 49 B. Technical in Nature—The Valuation Liquidity Consensus 53 II. WITH IT OR WITHOUT IT? EXISTING APPROACHES TO REALIZATION.... 55 A. Without It: A Less Realization-Based Income Tax Regime 55 B. With It: Some Hidden Justifications for Realization 57 C. The Policy Costs of a Theoretical Debate 60 III. A NORMATIVE DEFENSE FOR REALIZATION—PROMOTING INCOME TAX PROGRESSIVITY 61 A. Tax and Redistribution: At the Crossroads of Philosophy and Public Finance... 62 B. Market Price, Personal Assets, and Interpersonal Comparisons 63 C. Realization as a Progressively Distributed Tax Benefit 69 D. Advantages and Limitations of the Proposal 72 IV. THE ROAD AHEAD—PRELIMINARY POLICY IMPLICATIONS 78 A. Taking the First Step: A Modest Real-World Reform Proposal 79 B. Future Avenues of Research 81 CONCLUSIONS 84 2011] REALIZATION AND PROGRESSIVITY 45