Biases, Inequities, and Adverse Incentives from Basing Wealth Taxes on Accounting Measures
California faces serious fiscal challenges, with structural deficits and residents departing for lower-tax states. To satisfy its appetite for more spending, California’s recent ballot initiative – the “2026 Billionaire Tax Act” – proposes a one-time 5% tax on the assets of residents with net worth exceeding $1 billion. We discuss problems and inequities associated with measuring wealth using accounting information, and briefly address perverse incentive issues that could arise.
Wealth taxes are levied on stocks of assets, rather than on flows like income (income taxes) or sales (consumption taxes). The 2026 Billionaire Tax Act (henceforth, “the Act”) would be assessed on numerous types of assets, ranging from financial investments and commodities to ownership in private firms, real estate, and artwork. The valuation of many assets is often subjective, manipulable, and subject to dispute. This creates the potential for bias, inequity, and inefficiency.
Valuing Private Firms Presents Many Problems
Many Californian billionaires found, invest in, and manage private firms. Whereas investments in shares in public companies, financial instruments, and commodities are traded in liquid markets and have observable prices, there are no quoted, arm’s-length prices for private firms. To address this, the Act would value certain private firms as follows:
The sum of the book value of the business entity according to generally accepted accounting principles [GAAP] as of the end of the tax year plus a present value multiplier of 7.5 times the annual book profits of the business entity-as averaged over the current tax year and the preceding two tax years, if available-according to GAAP. (p. 15).
The immediate problem this creates is that a large proportion of private firms do not prepare audited GAAP-compliant financial statements. Companies whose securities (shares or bonds) are traded on public exchanges are required to do so, but private firms adopt a wide variety of accounting practices based on their circumstances. A recent national survey of private firm Chief Financial Officers finds that only 68% produce financial statements based on GAAP, that of this group only 60% incur the considerable expense of undergoing formal audits, and that of those who purchase audits many are willing to accept qualified audit opinions (i.e., choose not to fully comply with GAAP).[1]
The recordkeeping of the remaining firms is often unsophisticated. For example, the survey finds that many private firms forego accrual accounting. Others use GAAP with exceptions, for example by ignoring the new leasing standard or taking advantage of the size-based modifications and practical expedients made available to private firms by the Financial Accounting Standards Board and the Private Company Council over the past fifteen years (e.g., straight-line goodwill amortization rather than annual impairment testing).[2] Such choices are prevalent among emerging technology firms that are vital to California’s economy.
As a result, many private firms owned by California billionaires will lack the standardized reporting needed to consistently apply the above valuation rule. In such cases, the Act proposes that the taxpayer will submit a “certified appraisal of all of the taxpayer’s interests in the business entity” or “compute book value and book profits using an accounting method other than GAAP if the business to be valued consistently maintains its books and records and reports income and expenses using such other method.” These provisions highlight the subjectivity inherent in valuing opaque assets and companies.
What About the GAAP Users?
Even for firms that maintain GAAP records, the Act presents complications.
First, not all expenditures are equal under GAAP. Many intangible investments are not recorded on balance sheets, yet they can be a major source of firm value. This issue is germane to California because its billionaires have generated a large share of their wealth through investments in intangibles—intellectual property, specialized human capital, and valuable brands. The Act would therefore create inequities based on tangibility. Figure 1 illustrates this point.
| Figure 1: Consider the following hypothetical private firms, both of which prepare audited GAAP-compliant financial statements. Debt financing is ignored for simplicity. Real Assets Company has invested $10 billion in manufacturing assets whose book value on its balance sheet is $10 billion because GAAP records real assets at cost. The assets earn a 10% annual return on the investment, so the annual book profit is $1 billion. The tax base for the company thus is $17.5 billion ($10 + 7.5 x $1) and the tax would be 5% of that, $875 million. The difference in tax payable by these two hypothetical companies arises entirely from GAAP treating real and intangible assets differently. This creates an inequity and (as we discuss below) it is likely to distort future investment in real versus intangible assets. |
Second, GAAP affords managers considerable flexibility in making estimates and assumptions that have significant effects on book values and earnings. Given that 40% of private firm GAAP users do not undergo audits, the extent to which the tax authority would trust the reported numbers is unclear. Substantial disputes seem likely.
Third, even setting aside these issues with GAAP, there is no single agreed-upon approach for taking a set of financial statements and estimating a valuation. Textbooks suggest a range of methodologies whose inputs can vary significantly across industries, firm sizes, and economic conditions. To illustrate, many California billionaires earned their wealth by investing in pre-profit or even pre-revenue ventures. How does one assign a valuation to such firms?
Valuing Other Illiquid Assets is Hard Too
Similar valuation challenges apply to real estate and artwork. Many real estate investments—such as those involving unique buildings, vineyards, or agriculture—lack comparables or recent transaction prices to inform valuation. Precious artwork, by definition, is one of a kind and is exchanged infrequently. Its value is more closely linked to the owner’s tastes and broader social preferences than to traditional economic fundamentals. The punchline is that the inherent opacity and illiquidity of many billionaires’ assets preclude the reliable valuation that is essential to wealth tax regimes.
Administrative Costs of Wealth Tax Regimes
Wealth taxes incur comparatively high administrative burdens (i.e., a high cost per dollar of revenue raised). They can impose significant appraisal and verification costs. Tax authorities generally lack the expertise to value and track unique assets that are common in billionaires’ portfolios. And physically tracking certain types of assets, such as art or gold, is next to impossible. This is not an economically efficient method of raising taxes.
Distorting Investment Incentives
If the proposed wealth tax could be guaranteed to be a one-off event, it would not affect future investment in California. But actual and potential billionaires may reasonably suspect that it will not be. The proposed tax reflects a political climate that is unlikely to change in the near term. California’s fiscal condition might not improve, providing a temptation to levy further wealth taxes. As Milton Friedman observed, nothing is so permanent as a temporary tax. The federal income tax originated as a temporary measure to fund the Civil War; Britain’s was to fight Napoleon.
To the extent that additional wealth taxes are expected to be levied in the future, they may induce further emigration of wealthy Californians, distort investment and employment away from real assets, and direct investment away from the most productive assets to those that are opaque, complex, and easily relocated.
We also have concerns about the unintended consequences of basing tax payments on book numbers, including increased incentives for private firms to abandon GAAP, stop obtaining audits, and distort their financial reporting, resulting in less informative financial statements for use by banks, shareholders, and managers.[3],[4]
[1] Call, A., Hendricks, B., Labro, E., and Sutherland, A. 2026. Accounting Basis and Verification: Survey Evidence from U.S. Private Firms. Working paper available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=6530720
[2] https://www.cohenco.com/knowledge-center/insights/january-2021/private-company-council-clarifies-goodwill-impairment-rules
[3] Ball, R., Kothari, S. P., & Robin, A. (2000). The effect of international institutional factors on properties of accounting earnings. Journal of Accounting and Economics, 29(1), 1-51.
[4] Hanlon, M., & Shevlin, T. (2005). Book-tax conformity for corporate income: An introduction to the issues. Tax Policy and the Economy, 19, 101-134.
