This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: untapped resources.

The taxation of the superrich has long been a focus of a number of tax policy scholars. There are many features of the tax code that those with large fortunes can exploit to allow their wealth to grow while avoiding tax on the gains.

Today, we're taking a look at one of these loopholes and a proposal on how to close it.

Here to talk more about this is Tax Notes contributing editor Robert Goulder. Bob, welcome back to the podcast.

Robert Goulder: Thanks for having me, Dave. It's great to be back.

David D. Stewart: Now I understand you recently talked to someone about this topic. Who did you talk to?

Robert Goulder: I spoke with professor Edward Fox with the University of Michigan Law School and with professor Zachary Liscow with Yale Law School.

David D. Stewart: What sort of things did you talk about?

Robert Goulder: We discussed their Tax Notes article in which they outline an interesting tax reform proposal, one that targets certain high-net-worth individuals. As you know, there are these wealth tax proposals in circulation around Washington, D.C., and they're controversial for one reason or another.

This proposal is fundamentally different. In fact, I'm hesitant to even call it a wealth tax. It's not concerned with the taxpayer's accrued wealth, per se. Instead, it's narrowly targeted on the extent to which millionaires and billionaires borrow against their amassed fortunes to finance an opulent lifestyle. It's really more of a tax on borrowing than on wealth.

David D. Stewart: All right, let's go to that interview.

Robert Goulder: We are joined by professors Ed Fox and Zach Liscow. Thank you for joining us. Now you've written this article for Tax Notes. It came out in January, and it's been circulating for a while now. It's gotten some real positive feedback. Even on social media, people are praising your ingenuity.

Just to review, the piece is titled "No More Tax-Free Lunch for Billionaires: Closing the Borrowing Loophole." My very first thought on reading your piece was that the headline was a nice little nod to the noted economist Milton Friedman, who once famously said, "There is no such thing as a free lunch."

And well, with all due respect to Mr. Friedman, he obviously didn't spend enough time reading the Internal Revenue Code, because our tax laws do create some metaphorical free lunches for certain taxpayers, as we're about to learn. Let's take our time, back up, and review your proposals step by step.

First, now you open your article talking about Larry Ellison, the co-founder of Oracle, and he has income — he pays tax every year. But if we're honest, he is proportionally undertaxed when you take his wealth into consideration. Part of that is due to this borrowing loophole. Right out of the gate, let's just define what it is. Can you tell us what is this loophole?

Zachary Liscow: Yeah. Great. This is Zach here. Delighted to be here. Thanks so much for the invitation. What Larry Ellison and many other very well-off people do is they own an asset — in the case of Larry Ellison, Oracle stock. It increases in value, they get rich, and then they want to spend some of that money.

One thing that they could do is sell stock and buy things. In that case though, they would have to pay tax on the gains. In the case of Oracle for Larry Ellison, those would be large gains. Another thing though that they can do and is totally allowed under the current income tax code is to borrow against those gains. When folks borrow like Larry Ellison, they do not pay any tax at all.

There can be a variety of opinions around the idea of taxing gains that have not been sold. Some think that there are good reasons to tax that; other reasons think that's problematic. But people who think that's problematic tend to think that the reason that it's problematic is that those gains have not actually become cash. They're not real in some sense.

However, when you have those gains and then you borrow against them and get cash from that borrowing and then buy things with that, that argument no longer holds. You have, in effect, turned those gains into cash, and we think that it is thus fair to be taxed on those gains, in effect, to have a realized income.

Robert Goulder: Ed, anything to add to that?

Edward G. Fox: The problem is particularly profound when it comes to borrowing that's held over until death. Ed McCaffery, a tax scholar at [the University of Southern California], has coined the term "Buy, borrow, die," for the strategy that Zach was just describing, except that instead of ever selling to pay, you say, back your borrowing, or to buy other things, you keep rolling over that debt until your death.

At that point, the current treatment is that your heirs will receive what's known as a stepped-up basis in their assets equal to the fair market value at the time of the decedent's death. What, in effect, that's going to do is for income tax purposes, that erases all of that built-in gain that, say, Larry Ellison had on his Oracle stock, and his kids can repay his borrowing, selling that stock having no gain because the basis has been stepped up.

At that point, Ellison is able to consume large amounts of his gains without ever having paid any tax. That you might just be wondering, well if you borrow, the other shoe's going to drop at some point. But in the presence of [section] 1014 and the step-up in basis, that's not necessarily true.

Robert Goulder: In the broadest terms, can you describe what is the problem that your proposal is trying to resolve?

Zachary Liscow: What we have is a situation in which someone borrows a large amount of money, turns it into cash. Effectively turns those unrealized gains into cash and does not pay any tax on it. We propose this tax to address that problem.

The nontaxation of the things that we spend our money on, unlike wages where you get your wage, you do pay tax on that. Most of us when — Things we spend money on, we have paid tax previously on that money.

Suppose you've got your billionaire, and he borrows $10 billion, and suppose he has underlying assets that he originally bought for $1 billion. What that's going to mean is that our billionaire has to pay tax on $9 billion: the $10 billion worth of borrowing minus the $1 billion worth of basis. That is, in effect, a deemed realization on those $9 billion worth of gains.

Robert Goulder: OK. It looks like the real problem then is that our tax code has a concept of realization, which requires what? A disposal sale or exchange of an asset, but it excludes the act of borrowing against that asset. How do you propose to fix that?

Zachary Liscow: We want to treat borrowing as a realization of underlying assets. Ellison borrows $10 billion; it means he has realized $10 billion worth of income. We estimate that this would raise about $100 billion at the higher tax rates in the proposed Biden budget. At existing tax rates, it would raise less.

Importantly, we propose imposing this on both future borrowing as well as borrowing that exists today. People have borrowed; they've benefited; they've consumed. We think that they should be taxed on that. When we estimate the revenue, a little over half the income comes from the existing borrowing. We think that that's an important and, we think, fair part of the tax proposal.

Robert Goulder: OK. You're looking at the act of borrowing against an asset as a form of constructive realization. When I read that, I was thinking, "OK, if I wanted to game this system — if we actually had this tax in place and I wanted to game it — what if I only used as collateral the assets that I held that had a real high basis, or would you have gaming of that type?"

What I liked about your proposal, as I understand it and correct me if I'm wrong, it's not a tax on collateral per se because this is all recourse debt. You actually don't have a strict requirement in your proposal that any particular assets be pledged as collateral. Is that correct, and can you work us through how that works?

Edward G. Fox: Sure. The basic idea here is exactly as you were saying, Bob. If we limited the proposal to just secured borrowing, Mark Zuckerberg, Larry Ellison, people who are very wealthy, a bank would feel pretty comfortable taking out lending on a recourse basis, knowing that they have billions and billions of dollars' worth of net worth. There'd have to be a totally radical shift in their economic circumstances and their borrowing behavior before they were really at risk of not being paid back.

And so the easiest way to avoid this tax, if it was limited simply to security interests on recourse debt, is just not to use security interest. Or if you have to use security interest, precisely as you said, to order it in a way where you're going to borrow against your highest-basis assets first.

One of the things we think of as artificial about looking only to a security interest, even in terms of debt that is secured, is that with recourse debt, the lender always has recourse to all of your assets. When you go into the bank, regardless of what security interest you pledge, you're always, in some senses, pledging that all of your assets will be available if you don't pay and if the security interest is not sufficient to satisfy the loan.

For that reason, suppose Ellison goes in and borrows $10 billion. Whether he uses a security interest or not, we propose that instead, what will happen is that his gain, the amount realized under [section] 1001a here, is still going to be $10 billion no matter what, but that his basis will be calculated not based on the basis of whatever he either does or does not use as a security interest, but instead using what we call just a simplifying assumption: first-in, first-out, or FIFO. We're going to use his basis in his oldest assets.

We had considered other proposals for dealing with how to think about what assets are implicitly realized by borrowing. But we think this has a nice combination of being relatively difficult to evade or avoid, and also being relatively straightforward in terms of the cost of administration. We don't want to require Ellison to value all of his assets. He has hundreds of billions of dollars' worth of assets. When he's borrowed only $10 billion, we don't want to require the administrative apparatus to value a $100 billion worth of assets. We really only want him to have to value $10 billion worth.

Robert Goulder: OK, so that's very clever. If I understand it, you're saying the tax base isn't the collateral. The tax base is the borrowing, but the amount of the gain has to look to the collateral. Because you are looking at assets and taking them first-in, first-out as you said?

Edward G. Fox: Yes. Although, but it's still just, I would emphasize it's not the collateral here. It is just [that] his pool of assets is, in some senses, is where we're looking for his basis. And we're using this first-in, first-out assumption to decide, in essence, what assets should be assigned.

We're not going to say, "Larry, you get to pick your own basis, in essence, by choosing your collateral," but instead to say, "We're going to take just arguably an arbitrary but a relatively straightforward assumption of first-in, first-out."

Robert Goulder: Valuation issues. If we're talking about a publicly traded security, it's really easy to look up a price quote and figure out what these assets are worth. Maybe a little bit less easy if you're talking about a privately held security. If you get into works of art or real estate, then it gets really murky. Are there limitations on the types of assets that you'd look at? Major assets? I think you use the term major assets?

Zachary Liscow: Yeah. We spent a while thinking through how to make this thing as low compliance cost as possible, while still being true to the goals of the tax. Suppose we have Larry Ellison, he has this $10 billion loan. What we do is we look to firstin, first-out, FIFO assets. But we focus on the major assets, and we define that as large holdings of easier-to-value things.

As you're going through the assets, by the time that our billionaire, Ellison, purchased them, you skip over the art. You skip over the hard-to-value home. It is the case that most wealthy, they have publicly traded assets. Some of them, though, do not.

Some of them are a little harder to value. Coke Enterprise, not publicly traded on stock markets but, we think, fairly easy to value, at least relative to your Picasso. We think that if we limit it to these types of what we're calling major assets, the valuation issue will be relatively easy.

Furthermore, it is worth noting when you're talking about the estate tax and you're a taxpayer, there are really big reasons to try to undervalue something. Because if you say, "Oh yeah, it's only worth half as much as it actually is," let's say, you pay half as much in tax.

That is not what happens under our tax because if your asset is actually worth half as much, well that just means you go on to the next asset. Yes, the basis will be higher as a share of the value of the asset. But in the end, you're still going to go on to the next asset and pay a decent amount of tax. So that the games that taxpayers are going to play here are likely substantially lower. They have an incentive to play games much less than they would under taxes that we're otherwise familiar with, like the estate tax.

Edward G. Fox: Yeah. I just wanted to add to that. First of all, we're intimately familiar with both the difficulties and the feasibility of valuing things like private companies under the estate tax. But we do have some estimates in terms of the compliance costs both on the side of the IRS, but also importantly on the side of taxpayers coming out of the estate tax.

There's a relatively widely cited article by Greg Leiserson on that question. We estimate extrapolating from that, that basically taxpayer compliance costs here would be less than half of 1 percent of the total revenue raised, which for tax that we think is relatively equitable is, I think, not a bad ratio in terms of compliance costs.

Robert Goulder: Now I have to ask about double taxation. I assume there's going to be an adjustment in basis once this tax applies. Because if you didn't, then you would effectively be taxing the person twice when it's eventually disposed of, if it's disposed of, if there isn't a step-up at death or something like that.

Edward G. Fox: Yeah, exactly. In the same way that whenever else there is a constructive realization and you have to pay tax, even if you didn't get cash, your basis is adjusted upwards for the fact you pay tax on that gain. It's just the same as if you'd sold it to yourself in some senses, and if you did that and you pay tax on the gain, your basis would adjust upwards.

Robert Goulder: Excellent. OK. Who is a covered taxpayer? What kind of households are we talking about here?

Zachary Liscow: We begin with households that have $100 million of wealth, and that household would actually pay 0 percent tax. We phase it in from $100 million to $200 million. So $200 million households would pay the full tax rate, and $150 million would pay half the tax rate. We'd phase it in linearly like that.

If you have that amount of wealth, then you're in. And if you borrow, you pay tax subject to some thresholds. One million dollars of borrowing at the outset are exempt; $200,000 annually are exempt. Again, we're trying to reduce the compliance costs, while still having an equitable distribution of the tax and still maintaining the revenue-raising aspect of it. Above $100 million pays, up to $200 million, subject to these thresholds.

Robert Goulder: Well, that still leaves a lot of borrowing out there. I mean, the loopholes are not going away if you can go up to a $100 million in debt and not pay the tax. And even between $100 million and $200 million, you're just phasing it in. And then you've got an annual allowance, and you have a lifetime allowance. It seems very balanced.

Edward G. Fox: Yeah. I do want to just correct one thing there, which is it's for $100 million worth of wealth, but that does leave obviously people who are tremendously wealthy. If you have $99 million of wealth, you're tremendously wealthy, but you are not covered by our tax.

We're trying to trade off, in essence, making sure that we are hitting the area where the problem is, we think, most severe, and reducing compliance costs by virtue of reducing the covered portion of taxpayers to this relatively small segment of the population. We're dealing with only around 40,000 households, which we think is going to help also lower compliance costs and, in our view, make it more equitable.

In some sense, you've just got to draw the line somewhere. There's no particular reason to think that the arguments that make us think that somebody who has $101 million should be at least partially taxed under this doesn't apply to somebody with $99 [million].

Zachary Liscow: The one thing I would add is, look, $100 million is a nice, round number. It's also the number that was used in the billionaire minimum income tax in the president's budget. Look, you could start higher. You could start lower. We would not start any higher than $100 million, but $50 million could be possibly reasonable.

We were keying off of the political choice that the White House made on this. If Congress were to take it up, they could choose a different number and lower it. It'll raise more revenue, but also it affects more taxpayers and vice versa.

Robert Goulder: Now, one thing that's interesting is you are not creating a whole new tax regime, right? I mean, there are some proposals out there for a federal wealth tax. And they envision basically a whole new framework, a whole new structure, something based on a mark-to-market mechanism, which raises all sorts of legal issues and constitutional issues, and there's a liquidity concern.

You don't have any of that, right? You don't have the liquidity concern. There's this case out there before the Supreme Court, Moore v. United States, about the realization requirement and all of the background with Eisner v. Macomber and so forth. You don't get into any of that, right?

Edward G. Fox: We think the answer is no. We think that our proposal is constitutional. We think that for a couple of reasons. Actually, I think the most obvious reason is actually that it is an excise tax on borrowing. The Supreme Court, during the era of Pollock before the 16th Amendment, when the Supreme Court had previously held that income taxes were unconstitutional as direct taxes that were not apportioned, nevertheless upheld both the estate tax and the corporate income tax as excises, respectively, on the privilege of passing wealth at the time of death and of doing business as a corporation.

Again, the idea here is this is an excise on borrowing. Whereas with, say, the corporate income tax, the Court said, is an excise on the privilege of doing business as a corporation. The measure of the tax, though, is income. Similarly here, the excise is on the privilege of borrowing with the measure being unrealized income at the time.

In addition, I think Zach and I both think that the correct outcome in Moore is that realization is not constitutionally required. The Court has said both in Helvering v. Bruun and in Cottage Savings that the realization requirement is simply a matter of administrative convenience.

But even if the Court were to hold in Moore that the realization is constitutionally required, we think that this tax should meet, is in essence, a constitutional realization. Now it's not a realization under the current code, but that doesn't mean that Congress has exerted its full taxing power in terms of realization.

What's going on here in Eisner v. Macomber, the case you just mentioned, [is the] Supreme Court held that a stock dividend was not constitutionally income. One of the things that it emphasized was that there had been no severing of the gain and, in particular, that Ms. Macomber got no cash out of this stock dividend, got nothing separate for her own personal use. That is obviously contrasted with a situation in which you borrow against gains implicitly or explicitly and you get cash.

That is exactly the situation, in some senses, that the Macomber Court was concerned about. What they found — I think incorrectly in my view, but that's what they found — was constitutionally required in some form or fashion, but we have it here.

Zachary Liscow: Just an add-on in terms of the policy arguments as well, apart from the constitutional bit: Compared to a wealth tax or a mark-to-market tax, there are upsides and downsides as a policy matter. One downside of ours is that the scope for revenue-raising is much, much lower than with the mark-to-market tax or wealth tax, for the simple reason that people just don't borrow all that much. These folks borrow 1 to 2 percent of their wealth, which is a much, much smaller base than wealth. It is 99 to 98 percent less than the wealth tax, so it's a smaller base than mark-to-market, but it does have these upsides that you point to.

Liquidity is less of an issue. You have borrowed money, so you should be able to pay it. You may have to borrow a little more to pay the tax, but you are engaging in borrowing. Based on a survey that Ed and I did a couple of years ago, of a representative sample of Americans, we think that this is likely to be viewed more favorably versus a pure mark-to-market tax.

As you alluded to at the very beginning, there's actually surprising opposition to even taxing quite rich people mark-to-market because of the intuition that it's not real. But if you borrow against it and turn it into real cash, we find that there's 90 percentage points' greater support for taxing it, taxing if it's borrowed versus taxing it to just all mark-to-market. We think that this might fit with public's intuitions more in terms of what should be taxed.

Robert Goulder: Yeah, and that complies with my own thinking about your proposal. When I read it, I thought this is a better federal wealth tax. Maybe not as robust for the reasons you mentioned, but it just seems cleaner and more precise, and it doesn't have all these mark-to-market problems or constitutional issues.

You mentioned as a excise tax, I suppose, under the Article I excise tax power, it would only be subject to the uniformity requirement, and that's a very low, low hurdle. But even then, I mean, you have a realization event. The idea that the borrowing is a constructive disposition of the asset just seems very, very clear to me, so I don't think you'd have any of those headaches. Hopefully if it ever comes to pass, I don't know, I don't think it would be that litigious, although in this day and age, everything is litigious.

But let me ask you this final question. We live in an era of global mobility where people pick up and leave. We've been talking about Larry Ellison. Let's say he really didn't like this tax. He really hated it, and he said, "I'm going to move to Singapore." It applies, what, on the basis of residence and citizenship because it's part of the income tax, right? It's the same rules as you'd have for the regular income tax. Your thoughts on that? Expatriation, how does that affect this?

Zachary Liscow: Yeah. I mean, so this is a slightly higher tax rate on capital for U.S. citizens and residents. It's worth noting, a lot of the revenue that, like I said, over half of the revenue is borrowing in the past rather than forward-looking.

One, people are not borrowing all that much, 1 to 2 percent of wealth. It's just not all that much more money, and of what's raised, a lot of it's in the past and is not even forward-looking. A good reason to think that this would not do much to deter people from being U.S. citizens.

It's worth emphasizing that is what it would take to avoid paying this tax. You'd have to say you are no longer a U.S. citizen and do all that's involved. And that [is] a good reason to think that Larry Ellison is not going to leave over a tax of this size.

Edward G. Fox: Yeah. I think that's right, and I think expatriation is highly salient but relatively rare. There also is, and obviously as you probably know, an exit tax that would require Ellison to end up paying quite a lot of tax if he wanted to expatriate to Singapore.

I think this is unlikely to be the straw that breaks the camel's back on that. As Zach said, on the one hand, obviously there's some tension to our argument. We want to say there's real revenue potential here, but it's not so much that Larry Ellison and other covered taxpayers would not wake up in a radically different tax system. They wake up in pretty much the same tax system, with what we view as one loophole that's been closed.

Robert Goulder: Yeah, I completely agree. I think the exit tax under [section] 877A with the deemed sale when you expatriate, I think he'd actually pay more tax if he left than if he stayed and remained subject to this.

OK, and just one final thing I wanted to review is your revenue estimate. You said it comes in around what, $102 billion? That's over 10 years, and that's making what kind of an assumption about tax rates? You're following the Biden administration's proposal. That revenue estimate, just to be clear, it would be a little bit less if tax rates remain the way they are today. Correct?

Zachary Liscow: Yes. We're assuming a tax rate of 44.6 percent, which is what when you add up all the Biden proposals, add up to. So the revenue would be about half of what is about $100 billion at existing, current rates.

Robert Goulder: Yeah. To review that, the 44.6 percent effective tax rate, that's top marginal rate of 39.6 [percent] plus the net investment income tax that would increase from 3 percent to 5 percent. There you have it. The authors of the piece are professor Ed Fox and Zach Liscow. The name of the piece again is "No More Tax-Free Lunch for Billionaires: Closing the Borrowing Loophole." Professors, thank you so much for joining us.

Edward G. Fox: Thank you.

Zachary Liscow: Thanks for having us.

David D. Stewart: And now, coming attractions. Each week, we highlight new and interesting commentary in our magazines. Joining me now is Senior Executive Editor for Commentary Jasper Smith. Jasper, what will you have for us?

Jasper B. Smith: Thanks, Dave. In Tax Notes Federal, Tom Greenaway explains self-help options for handling tax mistakes in different contexts. Reuven Avi-Yonah considers which provisions of the TCJA should be retained and which should be allowed to expire.

In Tax Notes State, David Uri Ben Carmel considers non-litigated resolutions to tax disputes. Ronald Fisher analyzes low-tax states and their status in the economy.

In Tax Notes International, three King & Spalding practitioners explain how investment treaties may help companies preserve tax incentives designed to encourage foreign direct investment. Matias Milet breaks down Husky Energy v. The King, explaining the potential effect on Canadian tax treaties and cross-border securities lending transactions.

Finally, in Featured Analysis, Marie Sapirie discusses lawmakers' frustrations with their proposed regulations implementing the Inflation Reduction Act's electric vehicle credits.

David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W, and be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. As always, if you like what we're doing here, please leave a rating or a review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.

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