Elon Musk and California’s Income Tax

The tax lesson illustrated by the Elon Musk saga is not what you might think.

By David Gamage and Darien Shanske

Elon Musk has left California, or so he says.[1] And so cue the gnashing of teeth about California’s relatively high top personal income tax rates.

The funny thing about this is that the real tax-related story about Musk’s potential leaving is that California’s taxes are not high enough — or, to be more precise, do not apply broadly enough, to enough income.

The notion that Elon Musk could not afford California’s taxes or high cost of living is, of course, not credible. That said, California’s tax system does give Musk a big (and perverse) incentive to leave the state because of how California (and all other states with income taxes) treat unrealized gains in capital assets, such as Musk’s share in Tesla.

The structure of our existing income taxes — both at the federal level and in every state — make it so that taxpayers only owe tax when they sell appreciated assets. This is so even when a taxpayer’s assets have gone massively up in value and even when taxpayers borrow against that appreciation to fund lavish lifestyles.

Thus, even as Musk built Tesla in California, benefitting from the services provided by California and its workforce, and even as the value of his shares in Tesla grew and grew, he did not pay tax on this accumulation of wealth (sometimes called unrealized income or economic income). Now, all Musk has to do to escape ever paying California tax on this economic income — this wealth built up and accumulated in California — is to leave before he sells any of these shares.

Put another way, the story of Elon Musk is a story of how California, by not taxing the value of wealth as it accumulates, perversely provides incentive to taxpayers like Musk to leave the state before selling their shares and other appreciated assets.

California — and all states with income taxes — should change this. Specifically, the currently untaxed accrued gains of billionaires and mega-millionaires should be deemed realized and taxed either immediately over a period of a few years.

Along with a number of co-collaborators, we have drafted a proposed reform along these lines for NY State (a 100% annual-deemed realization mark-to-market reform that would apply only to billionaires), and we have been in discussions about the potential for this sort of reform for other states. Also, we previously published an essay proposing a one-time fifty percent deemed realization reform as an emergency revenue-raising response to pandemic-created budget crises.

We are in the process of both drafting further such reforms and writing scholarship further elaborating the merits of such reforms and the best options for designing and implementing such reforms. For now, consider a relatively simple and (we think) attractive version of this sort of accrual income tax reform. As a middle ground between either leaving all unrealized gains fully untaxed (the current policy in every state), or fully taxing all unrealized gains annually (as the proposed NY State reform would do for billionaires), a reform could tax a specified percentage of unrealized gains annually above a high threshold. For instance, a reform might annually tax 25% of all unrealized gains above a twenty-million-dollar exemption threshold. This would effectively exempt twenty million dollars of unrealized gains per tax household and then subject the remainder to realization over a period of a few years.

Of course, further implementation details are needed beyond what we can explain here, including transition rules and provisions to deal with taxpayers who enter the state with gains built up in other states. But hopefully this short discussion suffices to explain the basic idea.

A reform of this sort would help in no small way to close states’ current budget holes. Plus, basic fairness demands that mega-millionaires and billionaires not be able to escape tax on most of their economic income, as they currently can.

But, your might ask, won’t such tax reforms themselves encourage migration out of state? There are two answers to this. First of all, the evidence on taxpayer mobility indicates that the taxpayer response, certain high-profile movers notwithstanding, would not be that great. Second, we think the mobility concern is overblown. If certain taxpayers would prefer to live in a lower tax, lower service state, then that is how fiscal federalism is supposed to work. A few taxpayers at the margin should not dictate the ability of a state to have a truly progressive tax system capable of financing a set of services and investments that its citizens want and that best serves the interests of the overwhelming majority of state residents.

[1] We note that there is some history of billionaires saying that they will leave for states without an income tax, and then either not actually doing so or soon moving back to their original state.