Commentary: California’s Billionaire Tax Has Another Agenda

Its financing scheme reveals a goal beyond raising revenue

By Andrew Belnap, assistant professor of accounting

At the beginning of my Introduction to Taxation course at The University of Texas at Austin, we start with a deceptively simple question: What is a tax?

One definition is “a compulsory payment to support the cost of government.” We review things that are and are not taxes. For example, a speeding ticket is compulsory, but it’s not a tax. Its purpose is punishment and deterrence, not to raise revenue to fund government.

That distinction is worth keeping in mind as California debates Proposition 40, the proposed one-time wealth tax of up to 5% on billionaires. U.S. Rep. Ro Khanna has become one of the most prominent defenders of this “Billionaire Tax.” But his recent exchange with Mark Cuban, Palmer Luckey, and others exposed a problem with the proposal: It isn’t a tax. Its defenders increasingly seem less interested in collecting revenue than in confiscating property.

The proposal has many flaws, but the most obvious one is liquidity. Many billionaires are wealthy only on paper. A founder may hold a billion dollars of equity in a private company while having nowhere near the cash necessary to pay hundreds of millions in tax. Selling shares may be difficult or impossible, and forcing a sale can affect control of the company.

Khanna acknowledges the problem, but his workaround is telling. He proposes that cash-poor founders pledge their private stock to California in exchange for a 10-year, nonrecourse government loan to cover the tax. If the founder cannot repay the note, the state takes the equity.

Consider what that concession says about the policy’s true objective. The Billionaire Tax is being advertised as a way to fund healthcare. If California urgently needs billionaire dollars to pay current government expenses, a system under which the state waits 10 years for the money (and perhaps receives private-company shares instead) doesn’t solve that problem. Khanna has inadvertently given the game away: The state doesn’t particularly care when it receives cash. It wants to establish a claim on your wealth today.

Moreover, beyond the philosophical problem lies a potentially severe tax trap. Making the loan “nonrecourse” — meaning the lender can seize the collateral only if the borrower defaults — sounds taxpayer-friendly. But under long-standing Supreme Court precedent (Commissioner v. Tufts), when you surrender collateral to erase a nonrecourse debt, it’s as if you sold the asset for the entire unpaid loan balance, even if the asset is virtually worthless.

Imagine a founder incurs a $100 million California wealth-tax bill and takes a $100 million state loan secured by founder stock with a much lower tax basis of $1 million (the basis is essentially the value of the stock when the founder bought or received the stock). During the next decade, the company struggles, and the stock’s value drops to $10 million. Unable to repay the loan, the founder walks away, letting California take the stock to cancel the debt. In the real world, the founder has suffered a catastrophe, losing the company and pocketing no cash. But under federal tax law, being relieved of a $100 million loan is treated as selling the stock for $100 million. Subtract the original $1 million basis, and the IRS sees $99 million of taxable gain. Nothing exposes how half-baked the proposal is quite like a workaround that stumbles blindly into … another tax.

Targeting extreme wealth is a legitimate subject of legislative debate. If lawmakers want the ultra-wealthy to pay more, there are straightforward ways to do it. Congress could eliminate the step-up in basis at death, treat borrowing against appreciated securities as a taxable transaction, or raise rates on realized income. We can debate the merits of those and similar proposals, but they share an important feature: They behave like taxes. They are designed to raise revenue for the government.

California’s Billionaire Tax, by contrast, would turn the state into a venture creditor and, potentially, an involuntary shareholder, not because California needs the cash today, but because it wants to guarantee that paper billionaires surrender a prescribed share of their wealth. That is a very different objective.

The views expressed in this commentary do not necessarily reflect the views of the McCombs School of Business or The University of Texas at Austin.