Solving the Realization Problem with a Consumption Tax: Reconsidering Andrews' Proposal

Article excerpt


As the income gap between the rich and the poor widens, Americans have begun to demand reform.' The Occupy Wall Street movement is a recent reflection of the public's frustration.2 The lowering of the effective tax rate for the very rich to 1 8% in 2008 from 30% in 1995 is often cited as the main cause for the income gap.3 Tax experts, however, are aware that the drop in effective tax rates for the very rich over the years is only the tip of the iceberg; a much larger problem looms in the non-taxation of unrealized gains.4 Although the very rich generate a majority of their income from the appreciation of their assets like stocks, business interest, and real estate,5 the appreciation of that property can only be taxed when realized under the current law.6 Mark Zuckerberg, a co-founder and chief executive officer of the popular social networking service Facebook, is an example of this phenomenon.7 Some analysts estimated Mr. Zuckerberg's stake in Facebook to be worth as much as $28 billion before the IPO of the company.8 Mr. Zuckerberg will not be taxed on his stake in Facebook unless he disposes of his shares.9 If upon death, Mr. Zuckerberg bequeaths the shares to his heirs, his heirs will only pay tax upon sale of the stock only for the appreciation in value since Mr. Zuckerberg's death.10

Some call the realization rule '"the Achilles' heel' of the tax system, 'the root of many tax evils,' and . . . 'the most intractable problem in the income tax.'"" One explanation for the rule is the belief that unrealized gains cannot be employed for "separate use and benefit" unless realized,12 but the reality is that there are ways for the wealthy to generate cash for consumption, completely tax-free, without ever needing to dispose of their assets.13 For example, Mr. Zuckerberg can simply use his stocks as collateral to borrow against, thereby avoiding tax liability while enjoying the fruits of his enormous unrealized wealth.14 This scenario is even more likely today, when the interest rates for the very rich have plummeted to almost 1%.15 Mark Zuckerberg's ability to avoid taxes on his enormous wealth is only a very recent example of how the very rich can take advantage of "Tax Planning 101."16

Thirty-five years after its first publication, William D. Andrews' seemingly radical approach, adopting a consumption-based tax system to solve the problem with the realization rule,17 draws renewed interest. The proposal provides simple solutions to the efficiency and equity problems of the realization rule without creating new complications.18 Unlike other proposals, Andrews' forgotten approach to solving the realization rule puzzle is simple and creates few undesirable consequences.19 Part I of this Note explores the historical and legal framework of the realization rule and its relation to income. In addition, Part I discusses the equity and efficiency problems of the realization rule and provides legal background for Andrews' proposal. Part II of this Note examines the numerous proposals that have emerged since the adoption of the realization rule. Moreover, Part II uses classic tax policy analysis to explain the equity and efficiency problems of the mark-tomarket, interest-on-tax, and retrospective taxation proposals. Part III of this Note explores Andrews' proposal in detail and explains why Andrews' consumption tax system effectively solves the realization rule problem. Part III also addresses critics' concerns of the consumption tax system.


Section A of Part I takes a historical look at how the realization rule became part of the definition of income. Then, Section ? explores the equity and efficiency problems that the realization rule creates. Section C examines several of the remedial proposals that have emerged in response to the realization rule. Finally, Section D provides historical background for Andrews' consumption tax proposal and explains why Andrews' proposal becomes relevant today. …


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