Please Stop Trying to Tax Book Numbers, Even if Produced by Billionaires
There is a proposal to tax the wealth of billionaires in California. At first glance, it seems simple enough: take the net worth of the wealthy, multiply it by the tax rate (in this case 5 percent), and send a tax bill. But this simplicity masks a fundamental question. What exactly is that net worth? What number, precisely, is being taxed?
In many cases, the tax base is the value of publicly traded shares. That is fairly straight forward (although it does leave a lot of questions). But, billionaires own many other types of assets, some odd ones which are hard to value, including the value of private companies. How to value these private companies?
We have been down this path before. Beginning with Senator Elizabeth Warren’s “Real Corporate Profits Tax,” evolving through President Biden’s campaign platform promise to tax book income, becoming part of the Build Back Better proposal, and ultimately emerging as the corporate alternative minimum tax (CAMT) enacted in the Inflation Reduction Act of 2022, policymakers looked to book income as a tax base when other bases are less certain. The argument was straightforward. If Congress has so eroded the tax base as defined in the Internal Revenue Code, why not tax a seemingly cleaner and more transparent number, book numbers as reported for financial accounting purposes?
This approach was adopted despite warnings from experts in financial accounting, who argued that taxing book income would be far more complex than proponents assumed, would create perverse incentives, and would raise less revenue than expected. Nonetheless, the corporate alternative minimum tax was enacted. Those concerns have since been validated. What was billed as a simple reform has expanded into more than 600 pages of Treasury regulations, with additional guidance still forthcoming. The tax has raised far less revenue than anticipated. It has proven highly complex, described as a “compliance nightmare” by one corporate tax director, with one Big 4 partner joking that it has added to GDP simply through the hours billed by Big 4 accounting firms. At the same time, it has done little to curb tax planning. By most accounts, it has failed.
The California billionaire wealth tax is heading down the same path. According to the law, billionaires will report “The book value of the business entity as of the end of the tax year, determined according to generally accepted accounting principles”, and “The book profits of the business entity in the tax year according to generally accepted accounting principles.” These values go into computations that are considered when forming the tax base.
The underlying issue is that book numbers were never designed to be taxed. Financial accounting is governed by a principle of conservatism, which systematically biases reported values downward. This is precisely the opposite of what one would want in a tax base. Billionaires, particularly those with significant holdings in nonpublic assets, will have considerable discretion in determining reported values under Generally Accepted Accounting Principles. For many of these assets, this discretion is substantial. As a result, reported values are likely to be significantly lower than proponents of the wealth tax assume. This is leaving aside those assets valued using the appraisal method, which will also subject to substantial discretion.
Importantly, the leading revenue estimates for the California billionaire wealth tax is based on publicly available measures of wealth, such as those published by Forbes. These estimates are not necessarily based on GAAP financial statements, nor are they subject to audit. The incentives underlying Forbes valuations differ sharply from those embedded in financial accounting. When assets are instead valued under GAAP with reporting incentives mean to bias downward, reported amounts are likely to be considerably lower. As with the corporate alternative minimum tax, relying on book values as the tax base for a component of the Billionaire Wealth Tax will almost certainly lead to disappointing revenue outcomes.
