A Positive Account of the Realization Rule

There is a widespread belief that a realization rule is either a normative or an administratively necessary feature of an income tax. There is a strong consensus in the literature that a normative income tax would tax changes in wealth as they accrue rather than as realized, but a realization requirement is nevertheless necessary due to the liquidity and valuation constraints of accrual taxation. Because a pure realization system (with full loss offsets) is unworkable due to strategic trading, and the realization rule produces distortions and inequity, steps to limit its reach and to bring the system closer to accrual taxation are desirable. The article evaluates this consensus. It offers a positive account; it makes no attempt to build a normative case for the rule. The article first considers the two traditional explanations for the realization rule. Many commentators accept without questioning that accrual taxation is impossible because the problems with valuing all assets annually are insurmountable and annual taxation would create an untenable liquidity burden. This argument merits closer attention. The article concludes that the liquidity argument does not stand up to scrutiny and that measures less distortive than the realization rule could address cash flow concerns. The article also concludes that while the valuation concern has some explanatory power, it alone does not explain the durability of the realization standard. Rather, a richer positive account of the realization rule can be developed by focusing on the political impossibility of repeal, particularly the popular conception that paper gains do not constitute income. Doing so explains the durability of a hybrid tax-a realization-based income tax. Such an account, however, would lead to a pure realization-based tax and thus a positive analysis also must take into account the reality that the realization rule threatens the very existence of our hybrid tax. The rule is easily manipulable, making it possible for the well-advised and wealthy taxpayer to avoid tax on capital income. Thus, a pure realization rule is indefensible in a system intended to impose a tax on capital. Efficiency and equity concerns explain the extraordinarily complex array of fiscal defenses erected to prevent escalation down the slippery slope to a consumption tax.