Return-to-Basis Taxation

• In Event: Realization

Abstract

A realization-based tax at a flat rate τ may be viewed as an interest-free loan from the taxpayer to the government, with principal equal to τ times the invested tax basis and repayment at the time of realization. Under ideal market assumptions, this is equivalent to an alternative “return-to-basis” tax in which the government does not wait for realization and instead periodically collects a fraction τ of the basis multiplied by the economic rate of return to the asset in the period. Equivalence is preserved if any other market rate of return, including the risk-free rate, is substituted for the rate of return on the asset.

Return-to-basis can be better than realization-based alternative when idealized assumptions fail. If tax rates change, it mitigates the problem of concentrated gain realization when rates are low. If there are transactions costs for the government in smoothing irregular revenue cashflows, it helps by naturally spreading revenue over time, including by eliminating concentrated outlays for depreciation and expensing. Return-to-basis also allows for taxation of difficult-to-measure imputed income derived from an investment, such as a home. It may provide a politically practical path for achieving certain policy goals, such as the effective repeal of step-up in basis at death under §1014. On the other hand, in some cases the usual system is better. For example, it provides a channel for implicit government investment in illiquid assets with unobservable periodic returns. We discuss these and other applications and limitations of return-to-basis taxation.

Authors

• Thomas J. Brennan, Harvard Law School

• Daniel Halperin, Harvard Law School