Better living through public service:

I know what's on everyone's mind these days: Incoming Treasury Secretary Henry Paulson. Specifically, why would a CEO of Goldman Sachs want to be (1) Treasury Secretary, (2) in the last two years of an administration (3) that doesn't have the coziest relationship with the Treasury Department?

My colleague Marty Ginsburg has two possible explanations: (1) perhaps he's public-spirited?, and (2) section 1043.

Here's what §1043 of the Internal Revenue Code (26 U.S.C. §1043) says (my translation into English):

Suppose you take a position in the Executive Branch. To comply with federal conflict of interest rules, you have to get rid of some of your property — say, stock in companies that do business with the Treasury. Normally, you would have to sell the offending property — and pay tax on your capital gain. This could come out to a hefty chunk of change for people who have a lot of their wealth tied up in unrealized capital gains (i.e., assets that have gained a lot in value since they acquired them). But thanks to §1043, you get to instead use your capital gain to buy new, non-conflicting property, for instance a diversified fund approved by the Office of Government Ethics, tax-free!

Section 1043 was passed in 1989, in the days of Bush, Sr., apparently to make wealthy people more willing to go into government. Now I know what you're thinking: Can I, too, save by becoming Treasury Secretary? To answer your question, let's work through an example. Suppose you bought (or got as compensation) stock for $100 million. We law types call $100 million your "basis." Now it's worth $500 million. If you sell the stock, you realize a capital gain of $400 million. Normally, when you sell the stock, the gain is also "recognized," i.e., taxed. Section 1043 allows you to avoid recognition if you buy $400 million of other stuff.

The tax code is clever, though. Your $400 million unrecognized gain sticks around, and goes to reduce your basis on your new property. Even though you bought your $400 million of stock at a price of $400 million, your basis is now considered to be $0. One day, if you sell your new stock, you'll still have to pay tax on that $400 million (plus whatever extra gains you've had since then). So the recognition of your capital gain has only been delayed, not avoided.

Bottom line: Suppose you're perfectly happy with your portfolio, and (rather than holding it until you die, when you'll get some beneficial tax treatment) plan to sell some day in the future. If you become Treasury Secretary, you can rejuggle your portfolio, but when you sell in the end, you haven't saved any money. So what's the point? I suspect that, if you're the CEO of Goldman Sachs, you're not perfectly happy with your portfolio. In particular, you're heavily invested in Goldman Sachs stock, and would prefer to diversify. Even if you think Goldman Sachs will do fine, you're risk averse and would rather not have too many eggs in one basket. But to diversify is to sell, and to sell is to pay tax. So if you're in that sort of position, becoming Treasury Secretary lets you do what you'd like to do — diversify — without getting penalized.

More seriously, talking about §1043 allows us to talk about the "lock-in" effect of capital gains taxation generally — i.e., why do we have a system that taxes transactions, and thus discourages efficient portfolio reshuffling and diversification, rather than taxing capital gains as they happen? See, e.g., George R. Zodrow, Economic Analyses of Capital Gains Taxation: Realizations, Revenues, Efficiency and Equity, 48 Tax L. Rev. 419, 467 (1993). Why can't we all be Henry Paulson? But that more serious discussion is a topic for another post.

Thanks, Marty! (Cross-posted on Georgetown Law Faculty Blog. See also this New York Times article, Paul Caron's discussion on TaxProf Blog, and this Bruce Bartlett op-ed.)

UPDATE: Preliminary notes on the serious question at the end of the main body of this post -- why not tax capital gains as they happen? (This is called "marking to market.") The main reasons we have a "realization rule" are administrability -- once you sell, you know how much you've made -- and liquidity -- once you sell, you definitely have the cash to pay the tax. Check out the excellent comment by commenter nc3274, going into more detail on potential problems with "mark to market."