How Optimal Taxation Theory Explains—and Challenges—the U.S. Exit Tax

In public finance, one of the basic ideas that gets drilled into university economics students is the theory of optimal taxation, which tells us that governments should set taxes that balance revenue, equity, and economic efficiency. Taxes should raise revenue for public goods, be fair (those with a bigger ability to pay should pay more) and hopefully not distort economic behavior too much.

A good example of this in practice would be the U.S. Exit Tax, known as the “mark-to-market” tax enacted under the Heroes Earnings Assistance and Relief Tax Act of 2008. It applies to people who expatriate themselves, by renouncing U.S. citizenship or permanent residency, and meet certain asset, income or tax-payment quotas. In 2024, it concerns those with a net worth of more than $2 million or an average annual tax bill of more than $190,000 over the preceding five years.

The Exit Tax Through the Lens of Optimal Taxation

The Exit Tax is easily shoehorned into the equity component of the optimal tax system. It is in tune with the principle of vertical equity–that is, those with more should pay more. The thinking is that these people have derived their share of benefits from American infrastructure, markets, legal protections, and public goods disproportionately—and that they should pay a “final bill” before leaving the tax base.

The Exit Tax is economically applied to unrealized capital gains as if the taxpayer had disposed of all its assets on the day before expatriation. This is to make sure affluent Americans cannot just pack up their assets and move them overseas where they will avoid all future U.S. capital gains taxes.

Economic Forces Driving the Exit Tax

Tax competition is the main driver of the Exit Tax. As more and more countries are treating the wealthy favorably with lesser tax burdens, America faces the possibility of its own high-net-worth citizens fleeing for fronts abroad. The Exit Tax is, as its name suggests, serves as a deterrent, a way to avoid these exits by making them costly.

Another factor is the increase in offshore wealth. More than $10 trillion in wealth is parked offshore, the vast majority of it belonging to people from developed countries, according to a 2022 report by the Tax Justice Network. By targeting would-be leavers, the United States is hoping to claw back tax revenues before assets begin to bleed across the borders.

Real-World Application: Eduardo Saverin

Perhaps, the most well-known case of the Exit Tax in action is the case of Eduardo Saverin, the Brazilian co-founder of Facebook, who gave up his U.S. citizenship prior to Facebook’s IPO in 2011. Although Saverin cited personal reasons, critics said he was seeking to avoid taxes, and his case drew attention to expatriation-related taxes. The Exit Tax may have cost him hundreds of millions in unrealized gains, a figure that probably still pales in comparison to what he would have had to pay by remaining an American citizen.

The Downside: Efficiency and Strategic Behavior

While the Exit Tax conforms with equity, it impairs economic efficiency and demonstrates behavior distortion—the other pillars on which Optimal Taxation Theory stands.

Planned Timing: Wealthy people could plan their exit many years ahead in order to pay as little as possible tax–sell assets far in advance, reorganize their portfolio, or move their wealth to trust structures to reduce the mark-to-market impact.

Discouraging Investment: The proposed Exit Tax liability could discourage wealthy non-citizens from moving to the U.S. or investing heavily while there. This curtails the flow of capital and entrepreneurial activity, which can potentially drag down long-term economic growth.

Administrative Complexity: Trying to calculate unrealized gains on global investments (private equity, real estate, international holdings) creates a compliance burden that can exceed the revenue collected from many expatriates.

Tax Flight Signals: High-profile departures and bad publicity could paint the U.S. as hostile toward wealth, damaging how the country is perceived and its ability to keep high-value residents.

Conclusion

From the perspective of Optimal Taxation Theory, the US Exit Tax accomplishes, in theory, it’s goal of promoting vertical equity—that is, making the wealthy pay their bill before leaving. But the tax also comes with trade-offs, encouraging complex tax planning, possibly discouraging investment, and creating enforcement problems. And as capital and talent become increasingly mobile around the world, the tension between fairness and competitiveness will only grow, compelling policymakers to rethink what “optimal” really means in an era without borders.