#AI #ChatGPT #Grok: If in good times taxing unrealized capital gains, will there be less to tax in bad times

I asked: "If in good times, when you least need it, you tax unrealized capital gains, does that not mean that in bad times, when you most need it, since you can deduct capital gains already taxed, there will be less realized capital gains to tax? Or can capital gains be taxed twice?"

ChatGPT answered:

Your logic is mostly sound, and you're highlighting a real and important issue in how capital gains taxation interacts with economic cycles and investor behavior.

Let’s unpack the mechanics and implications:

1. Unrealized vs. Realized Capital Gains Taxation

Current norm: Capital gains are taxed when realized—that is, when an asset is sold for a profit.

Proposal (e.g., under some wealth tax or mark-to-market systems): Tax unrealized gains annually, whether or not the asset is sold.

2. The Deductibility Issue: Can gains be taxed twice?

Generally: No, capital gains are not taxed twice.

If unrealized gains were taxed under a new regime, those same gains would not be taxed again upon realization. That would be double taxation, which is typically avoided via mechanisms like:

A cost basis adjustment (your “purchase price” is reset to the value at which the unrealized gain was taxed).

Or a credit for previously paid unrealized gain taxes when you sell.

3. Your Core Point: Pro-cyclicality

In good times, when you least need it, unrealized gains are taxed, but in bad times, when you'd most need revenue, there are fewer gains left to realize or tax.

Yes. This exposes a pro-cyclical fiscal risk:

Boom times:Asset values rise → more unrealized gains → higher tax receipts.

But this is when governments often least need the extra revenue.

Downturns:Asset values fall → previously taxed unrealized gains evaporate → fewer realized gains to tax.

Plus, investors may claim losses or credits on prior taxed gains.

Governments may face refunds or lower receipts, just when stimulus spending is most needed.

So paradoxically, pre-taxing gains when things are going well may reduce your ability to tax when things go badly. That’s exactly your insight.

4. Policy Implication

A system that taxes unrealized gains needs very carefully crafted rules:

To avoid over-taxing on paper gains that later vanish.

To ensure the system doesn’t create volatility in tax revenue, especially during downturns.

To maintain inter-temporal fairness and economic stability.

Conclusion

Yes, taxing unrealized capital gains in good times may mean fewer realized gains—and less tax revenue—available in bad times. While gains aren’t usually taxed twice (due to basis adjustments or credits), this design introduces real fiscal timing risks. Your concern reflects a key reason why such proposals are controversial among economists and tax experts.

Grok answered:

Taxing unrealized capital gains in good times would likely reduce the pool of realized capital gains available to tax in bad times, assuming deductions are allowed for previously taxed unrealized gains. 

Here's why:

Unrealized Gains Taxed in Good Times: If you tax unrealized capital gains (gains on assets not yet sold), taxpayers pay on the increased value of their assets during economic booms. This generates revenue upfront but marks those gains as "taxed."

Deductions in Bad Times: If the tax system allows deductions or credits for unrealized gains that were previously taxed, then when assets are sold (realizing gains), taxpayers could offset the tax on realized gains with those deductions. This reduces the taxable realized gains in bad times, when asset values may have dropped or sales occur at lower gains, leading to less tax revenue from realized gains.

Double Taxation?: Capital gains are not typically taxed twice in a well-designed system. If unrealized gains are taxed, a mechanism (like a deduction, credit, or basis adjustment) is usually proposed to prevent taxing the same gains again when realized. For example, if you tax $100 of unrealized gain on a stock, and later the stock is sold, the tax system would adjust to ensure only new gains (if any) are taxed, not the $100 already taxed. Without such a mechanism, double taxation could occur, but this would be highly controversial and likely avoided in policy design.

Impact in Bad Times: In economic downturns, asset values often decline, leading to fewer or smaller realized gains. If deductions for previously taxed unrealized gains are allowed, this further reduces taxable realized gains, potentially starving the government of revenue when it’s most needed. Even without deductions, the drop in asset values would naturally reduce realized gains, but the unrealized tax system could exacerbate this by shifting tax revenue to good times.

In short, taxing unrealized gains front-loads tax revenue in good times but could reduce realized gains tax revenue in bad times, especially if deductions are allowed to prevent double taxation. The system’s design (e.g., deduction rules, basis adjustments) would determine the exact impact, but revenue volatility is a key concern. Double taxation is unlikely in a rational policy but could happen if the system lacks proper safeguards.