Are unrealized capital gains income?

Here are three possible answers to this question:

1. No, they are not income and should not be taxed.
2. Yes, they are income and should be taxed.
3. Yes, they are income, but they should not be taxed. We should tax consumption, not income.

I favor the third view.

People often say that you haven’t really earned income on an appreciating asset until the asset is sold.  I understand their intuition, but I think they are conflating two issues, income and consumption.

Consider two investors that have identical big gains on Nvidia stock.  One holds onto the stock, and the other sells the stock and then buys it all back just one minute later at roughly the same price.  One guy has no income tax liability while the other faces a huge capital gains tax bill.  But their underlying financial situations are essentially identical.

I suspect that the intuitive belief that income is only real when the asset has been sold is based on the perception that until it is sold there is a risk that the price goes back down.  But if you sell an asset and put the money into a different investment, that new investment also might go back down. Even cash is slightly risky due to inflation.  The only way of being 100% sure that you’ve realized your gain is by spending the profits on consumption.

To an economist, the person that holds the Nvidia stock has earned income every bit as much as the person who sells it and puts the funds into an alternative asset.  Both hold portfolios that have appreciated.  Both hold portfolios that might go back down.

And yet I understand why people are reflexively hostile to the idea of paying taxes on assets that haven’t yet been sold.  The real problem is that basic tax theory suggests that taxes should apply to consumption, not income.   Under a consumption tax, it makes no difference whether you hold the asset or sell it and buy an alternative investment.  There’s no tax until the funds are spent on consumption.  This reduces lock in effect of capital gains taxes.  

Of course the real world is very complex, and it’s possible to argue for the taxation of capital as a second best policy.  In my view the real problem is not which capital gains to tax, rather it is the entire concept of income.  It is very difficult to define income in a way that is both logical and useful for real world tax systems.  You either give up on logic and consistency, or you impose a true income tax system (including unrealized gains) that many people will think makes no sense.

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