Thursday, January 9, 2020

Wealth and Taxes, Part IV

(This is Part IV of a series. Part III, and Part V. which has the punchline.  See the overview for a summary.)

The Wealth Tax.

So, if arguing about the ill-defined and ill-measured distribution of wealth lies in service of the wealth tax, what is the question to which the wealth tax is an answer?

Revenue and Redistribution -- good and bad taxes

Preamble: Economists have no real professional expertise to object to redistribution, or argue for it. Swallow hard, you may not like it for political, moral or other reasons -- or you may be all for it for those reasons -- but admit economists economists have no special insights to the right amount of redistribution. Economics has one analysis to offer the world: incentives. (OK, and equilibrium.) If it were possible to take money from A and give it to B without creating any adverse incentives, we have no special standing to cheer or to object. Economics can tell us something about tax rates, but not much about taxes. 

Thus the theory of optimal taxation is straightforward: how can the government raise a given tax revenue while generating the least perverse disincentives? The theory of optimal redistribution offers an additional wrinkle: how can the government give money away while generating the least perverse disincentives to recipients as well as payers?

Disincentives include evasion -- What legal or accounting moves will people make to  avoid taxes?  -- and changes in economic behavior -- To what extent will people move away, stop working, invest less, choose different careers, etc. in response to taxes? The former lose revenue and employ a lot of lawyers and accountants. The real damage to the economy comes from the latter.

This isn't the place to review this theory, but one thing is clear: the wealth tax does not answer these questions. It is a very inefficient way to raise money, for expenditure or for redistribution. It generates a swarm of avoidance, and it does a lot of economic damage per dollar raised. That's why most of Europe has abandoned substantial wealth taxes.

Let's list some disincentives.

On a most basic level, "don't tax rates of return" is a pretty solid conclusion of optimal tax theory.  People react to a tax on rates of return by saving less and consuming more. They can do this a lot, resulting in a lot less investment capital.

Like any other famous result in economics, of course, this one attracts a beehive of theorists looking for ways to unseat it, but in my view it's pretty solid. It stems essentially from the principle tax inelastic things and don't tax elastic things.

A tax on rates of return taxes when you consume not your level of consumption overall. You have some money. Consume all today, or invest it and consume tomorrow? If there is a strong tax on rates of return, you consume more today and less tomorrow to avoid the tax. It's like taxing groceries at whole foods but not at Safeway. Well, go shop at Safeway. A non-distortionary tax wants to tax consumption at both dates, and not distort which date you choose to consume.

Put a third way, remember the wealth tax like a rate of return tax taxes money that has already been taxed. Earn money, pay taxes on it, invest it, and they pay taxes again. We should only tax it once. (This is the source of the great canard that the rich pay lower taxes than us. It's a canard because it counts only second-round tax on interest, not the first-round tax on the income that produced the investment.)

So a substantial wealth tax screams incentives: don't keep your wealth saved. Consume it, now! Take that private-jet round-the-world tour! Give it away to political candidates quick before the government takes it. (I mention the latter because so much of the wealth tax is designed to reduce their political influence. The incentive effect of a wealth tax is exactly the opposite.)

A substantial wealth tax screams, don't get wealthy in the first place. They'll just take it away from you.

A progressive wealth tax, like the progressive income tax, strongly discourages risk taking.  This part is much less analyzed, and I think more would be a good idea. Most optimal tax models assume the future is known and all assets earn the same interest rate. The world is all about risk.

Suppose you have $20 million, and a choice between a Silicon Valley moonshot startup with a 1 in 4 chance of making $100 million, or the quiet safety of government bonds. The wealth tax says, invest in the government bonds. If you're choosing careers between entrepreneur and tax lawyer, become a tax lawyer.

Underlying this analysis are the two distinctive features of modern economics: Decisions are made intertemporally, subject to risk, and respond to incentives. I think most popular opinion (and too much economic opinion) treats decisions as static. Wealth is just there. Capital "income" is just a source of money, not an intertemporal price or a reward for risk taking.

The progressive wealth tax has another singular disincentive. You may answer, sure, make that investment, take that risk, you can accumulate up to $50 million before the tax hits. Your disincentive is not that big. (It is, actually -- the chance of finding another Google is a larger part of the average return of early stage venture capital investments. But that's not the point here.) But a wealth tax, which lowers the rate of return for any investment made by a billionaire by six percentage points, singles out billionaires not to make any more investments. 

So who is most likely to find the next immensely valuable company? The progressive wealth tax says that the people who made the last successful investments are the least likely to make the next one. They should take that round the world tour, give it away, but heavens don't invest it. The rest of the world thinks the opposite -- people who have been very successful at starting companies in the past actually have some skill at this, and are precisely the ones we want to keep hard at work starting new companies.

Again, let me preview the political counterargument. If you think all current billionaires are just lucky, no more likely than the average DMV employee to find the next great invention; or if you think all great wealth in the US comes only from stealing from the government or impoverishing the little people, then you don't worry about putting billionaires out to pasture.  I think you're living on another planet but we'll get there in the next part.

Of course, the other delicious result of optimal taxation theory is that a wealth tax can be the perfect tax. If the government confiscates wealth completely unexpectedly, and promises credibly never to do it again, the government gets all the revenue and none of the distortion. People have no choice but to go back to work and save and build that wealth up again. I've been criticizing taxes on rates of return. This "capital levy" is a true tax on wealth without taxing rates of return.

The catch: unexpectedly, completely, and once. Swoop in in the middle of the night and never come again. If people see it coming, they scramble to get out of the way. If it's a slow drip like 6% per year, ditto. And if having been impoverished once they wonder if maybe the government might do it again, then they refuse to work, save, and build up wealth that might be taken again. "Just this once" is what addicts say. People know that. "Capital levies" are therefore something governments can do only in extremely rare, visible, once-per-century crises, with some strong pre-commitment never to do it again. That's not the proposed wealth tax.

This fact gives you some insight into the deep tensions and arguments about government finance and much other policy. Any time wealth is there, there is a temptation to grab it, or transfer it, as it's too late for the disincentives of wealth creation to kick in, and those take a long time. The same temptation is there for rent control. Transfer the value of apartment buildings to today's tenants. The landlords can't move the apartments out of state after all. Exempt new buildings, in an effort to persuade landlords it won't happen again and they should build. Alas, they're too savvy for that -- they ask what stops you from passing a new rent control after we've built the buildings? The same temptation is there for drug prices. Force the drug companies to sell cheap. The drug is already developed. The damage that they won't develop new drugs takes a long time.

The trick is to tax the rich without taxing the incentive to get rich. The proposed wealth tax has a bit of capital levy in it -- it's mostly aimed at taking away wealth from people who have it as of November 6 2020. But it also taxes away the incentive to get rich. In standard economics that's a bad thing, since people get rich by inventing new and better products, starting new companies, or increasing efficiency and lowering prices. (In my next post we'll get to the political argument, which I think is the one its advocates really have in mind.)  

Another good rule of thumb from the theory of taxation is that the economic damage of a tax is proportional to the square of the tax rate. Roughly, the damage equals the price distortion times the quantity distortion. The quantity is proportional to the price, so damage is price squr.

Now you might say, 2% or even 6%, that's not so bad. But one should compare the two or six percent to the rate of return, not the principal. Take a fixed-income investment, which in part I we found out gives an average interest income of 1% per year. We currently tax that interest income at federal, state, and local levels. If you pay a 50% income tax, then you get 0.5% return after taxes. The 50% income tax is the same as a 0.5% wealth tax. And a 6% wealth tax is effectively a 600% capital income tax rate.

Hank Adler and Madison Spach in the WSJ make another good point. To pay the wealth tax, you have to sell assets. If you sell assets, you have to pay federal and state capital gains tax all before you pay the wealth tax. This multiplies the tax.
Consider a hypothetical founder of a California company who has to pay a 6% tax on wealth in excess of $1 billion. The founder is exclusive owner of a company with a fair market value of $6 billion... The founder’s wealth in excess of $1 billion [i.e. $5 billion] would initially trigger a $300 million wealth tax. To raise the $300 million, he would need to sell $1.053 billion (17.6%) of the company to pay Ms. Warren’s 58.2% federal capital-gains tax, California’s 13.3% income tax, and the 6% wealth tax. (The $1.053 billion sale price minus $613 million in federal capital-gains taxes, minus $140 million of California income taxes leaves $300 million.) 
Including the wealth tax on the first billion dollars, at the end of five years, sales of roughly $3.69 billion of the company would be required. The founder would have paid 61% of his net worth in taxes, losing most of the business.
As they point out, this is only the beginning. Most businesses also borrow money, and if you sell part of the business you have to repay debt before you do anything else. If, for example, the company is half financed with debt, then you have to sell $2 of assets, pay back $1 of debt, and then start paying taxes.

And remember most "wealth" is some accountant's idea of the present value of the income from a partnership or privately held business. Just who do you sell half of a small business to?

This too may be a feature not a bug. We're working up to my point, that the wealth tax is not at all a sensible answer to raising revenue for the government. Yet the people advocating it are smart and know this. So there must be a different question to which the wealth tax is the answer. As I'll document next time, for many people the actual purpose of the wealth tax is to eliminate billionaires without the ugliness of guillotines. If you want to get rid of billionaires and their businesses, the wealth tax is a dandy way to do it. If you want to durably raise revenue, for programs or for transfers, without destroying the economy, the wealth tax is a rotten way to do it.

An obvious reaction to a wealth tax will be for wealth people to make sure their wealth is in multiple small private companies with no easy to observe value. This is an important economic distortion as well as an evasion issue. Large public companies are more efficient than small private companies whose organization and finance are geared around tax avoidance. The disclosure and transparency that listing alone requires is beneficial. See WeWork. A lot of European companies stay small, private and inefficient for other reasons including labor laws.


The wealth tax is extraordinarily open to evasion, which is a second reason most countries that had it abandoned it. There is nothing like the prospect of an annual 6% tax to focus the mind of a billionaire, his or her tax lawyers and accountants and lobbyists. (People with billions, and businesses that hire lots of voters, can get special provisions of the tax code too.)

Like all tax evasion it creeps up and gets worse and worse over time. It takes time to set up businesses and investments to avoid taxes like this. The parable of capital levy or rent control should ring.

We have a wealth tax, the estate tax. There is also nothing like 40% tax once a generation to focus the mind of billionaires and their tax lawyers, accountants and lobbyists. And it's a rotten mess. Wealthy families structure their businesses with the estate tax in mind from the day a grandchild is conceived.

How do you avoid wealth and estate taxes? First, take businesses private or invest in only private businesses that don't have clear market values. Real estate is especially good, because of the complex tax treatment and difficulty of valuing large investments. Then create complex share structure to spread ownership of the businesses around, staying ever one step ahead of the IRS' valuation rules. For example set up two classes of shares. Each share gets $1000 dividend per year. But class A shares have the right to buy class B shares for $2000. Thus, class B shares are only worth $2000. But the class B shares never get around to exercising that right. Outside investors or family members with less than $1 billion in wealth hold all IRS-valued "wealth" and inside investors get all the benefits. Add multiple interlocking LLCs and Cayman Islands special entities and nobody will figure it out. The New York Times' various exposes of President Trump's tax dealings from the 1990s are, I think, wonderful examples of just how wealthy dynastic families today get around income taxes, estate taxes and even sales taxes. This is just going to get worse.

Saez and Zucman's "How would a progressive wealth tax work?" anticipates some of these objections
"The greatest risk to enforcement comes from base erosion due to the exemption of specific assets, such as business assets and unlisted corporate equity. .. International experience shows that base erosion tends to occur when specific constituencies (such as business owners) lobby to become exempt."
In the good old USA, surely farmers, "constituencies such as business owners," "small" businesses (one person can own many), startups, businesses that employ many of a given congressperson's voters, businesses who now get all sorts of tax breaks for investing here and there, and so forth wouldn't lobby successfully for ways to avoid a wealth tax, especially by subterfuge -- special valuation rules for factories producing solar panels in rustbelt cities and so on... (that was a satirical paragraph in case you didn't get it.)
Wealthy individuals can try to hide assets abroad to evade income and wealth taxes. ...Wealth concealment is a serious enforcement concern. However, just like for legal avoidance, illegal evasion depends on policies and can be reduced through proper enforcement...
But why is enforcement "improper" now? On the big question, how do you value assets
Other countries such as Switzerland have successfully taxed equity in private businesses by using simple formulas based on the book value of business assets and multiples of profits. The IRS already collects data about the assets and profits of private businesses for business and corporate income tax purposes, so it would be straightforward to apply similar formulas in the United States.   
I think this misses the point. These are taxes on small businesses. The uber-wealthy don't own businesses. They own complex claims on businesses, claims that are going to get insanely more complicated as soon as the wealth tax is passed. As above, good luck valuing 4 or 5 classes of shares, combined with debt that includes various options, funneled through various interlocking partenerships....
Valuing real estate..Local governments have a cadaster of real estate property for the administration of local property taxes. Such property taxes are based on assessed value. In most states, assessed values closely follow market value...
Two words: Donald Trump. As with businesses, wealthy people don't own real estate in their own names for goodness sake! They own shares of complex entities that eventually own real estate, all of it designed for tax avoidance. Like most of this article, they are taking the evidence that you and I pay property tax to infer that Trump enterprises will do so. That's silly.

They address this issue:
Some assets are held through intermediaries such as trusts, holding companies, partnerships, etc. To prevent avoidance, all the assets of intermediaries should be included in the tax base of their ultimate owner (granter or grantee, in the case of a trust) at their market values, without any valuation discount. Formulaic rules can be set to divide the ownership of jointly-held assets for wealth tax purposes.
Just how are we to untangle who actually owes what, especially when the structures are going to be designed to hide that fact? In a revealing footnote:
Estate tax revenue collected in 2017 from wealthy individuals who died in 2016 was only $20 billion. This is only about 0.13% of the $15 trillion net worth that the top 0.1% wealthiest families owned in 2016. This demonstrates quantitatively that the estate fails to take much of a bite on the wealthiest (in spite of a reasonably high 40% nominal tax rate above the $5 million exemption threshold, set to increase to $10 million in 2018). The main factor driving such low tax revenue is tax avoidance.
So people reacted to estate taxes predictably by forming complex asset structures, which destroyed the revenue from those taxes. Just how are you going to avoid exactly this result from the wealth tax? The paper does not say. 

The the overall answer strikes me as a reiteration of a classic liberal conceit. Oh yes, it's all terrible now, but it's just been done badly.  Put smart people like us in charge, and we'll somehow be immune to political pressure and we'll really put the screws on. 

Even the New York Times concedes "Name a tax and there’s a way to reduce it, delay it or not pay it. Financial advisers say a wealth tax would be no different."

Optimal taxes

So, if the question is how do we raise revenue with minimal economic distortion, the wealth tax is an awful idea.

(New readers might wonder, what is the answer? The standard answer to this question is a consumption tax, which can be levied either directly or from income minus savings. This taxes consumption overall, and you can't squish out of it by consuming earlier.   Get the rich at the Porsche dealer. Give them incentives to leave it invested. For income-based redistribution, either make a progressive consumption tax or use a high consumption tax to write people checks. )

Seeing this simple fact by experience, our tax code like those around the world has slowly reduced taxes on rates of return both directly - lower rates on dividends and capital gains than ordinary income -- and via a plethora of complex 401(k), 526(b), IRA, and other programs. (In the US, we always do things the most complex way possible, perhaps to raise taxes mostly from people who don't take the time and effort to avoid them, or perhaps to keep lawyers and lobbyists in business, but there you have it.)

This is not controversial. Every undergraduate knows this.  As I prepared for this essay, I found that every article even in the New York Times and New Yorker admits all these points. Despite the above rather vain effort to rebut it, Saez and Zucman admit it isn't about raising revenue.

So why are we arguing?

Well, if the wealth tax is the answer, raising government revenue or transferring income with minimum economic distortion is not the question, and all of this is a complete waste of time.

What is the question then? It's not hard to find. Stay tuned for Part V


  1. I would like to see John Cochran someday do a fully fleshed-out, long post on all the economic misallocation and retardation that accompanies wage taxes.

  2. A lot about incentives. I'm interested in hearing your response to the Banerjee and Esther Duflo piece in the NYT that insists incentive effects are overstated and largely irrelevant apropos a wealth tax. My opinion is that they've cherry picked studies.

  3. "for many people the actual purpose of the wealth tax is to eliminate billionaires without the ugliness of guillotines"

    AOC has actually said explicitly that she thinks it's immoral for billionaires to exist.

    "The trick is to tax the rich without taxing the incentive to get rich."

    One point on incidence. Many people understand that one can't tax a seller of a good without taxing the buyer. Doesn't the same apply to taxes on rates of return? One can't tax the rich lender without simultaneously taxing the poor borrower, who must pay a higher pre-tax rate of return to convince the rich lender to lend rather than consume immediately. A wealth tax doesn't just disincent entrepreneurs by reducing their future payoff should they become successful. The tax also makes it more difficult for currently cash-poor entrepreneurs to convince the wealthy to back them instead of buying an extra yacht. For every saver that would be hit by a wealth tax, there is a corresponding borrower that would like to make use of that saving.

  4. One big disagreement the left has with you are the magnitudes of the deleterious effects of high distortionary taxes. Whatever disincentives this has on capital formmation(including human capital) are small. They point to Scandinavia as an example.

    Well, I don't live in Scandinavia but I am curious about those who do/did. How much did distortionary taxes affect those countries.

    But then I remember, I live and grew up in the Bay Area, which in some ways is even more distortionary than any other country. Between sky high sales taxes, income taxes, rent control, prop 13, and zoning laws on top of the health care cross subsidy mess... I wouldn't be surprised if the effective tax rates of a Bay Area citizen are the worst in the world. So what do I observe? There is indeed a lot of destruction one observes and does not observe. My list:

    1) Bay Area homelessness
    2) absurd house prices
    3) migration of in state residents
    4) punitive costs for raising children or affording services
    5) high prices in general.

    So why do I stay? At the moment inertia and a desire not to leave a place I grew up. But at some point, inertia gets overwhelmed. I'm curious to others who live in the Bay Area or coastal California cities...what have you observed?

    1. James, just for the record, Sweden (Scandinavia is not a country) has one of the highest rates of billionares in the world and it is also one of the world’s most unequal countries in terms of the distribution of wealth.

      The inheritance tax was abolish there in 2005 and the wealth tax in 2007.

      There are many myths in this "tax the ultrarich" religion. "Scandinavia" is one of them

  5. This is a great discussion of a wealth tax.

    One nit: consumption taxes have problems of their own. It is easy to know that a dinner out or air travel are consumption and tax them as such, but not all cases are so easy. The business lunch or the purchase of a house are not as easily classified. These aren't fatal problems, but an explicit consumption tax has issues of its own that remain to be discovered in the way that issues associated with an income tax have arisen and been dealt with (often adding complexity).

  6. I would like for you to flesh out a bit how consumption taxation would work. It seems possible to circumvent, particularly for the very wealthy. The owners of capital could earn their income, but just avoid living or consuming in the united states. How do you address the international dimension? It seems a lot like your whole foods vs safeway example. I believe that your explanation makes sense for a closed economy or if there is a worldwide consumption tax, but otherwise it seems like it would also distort by pushing consumption outside of the borders, and I'm not sure the practical arrangements that prevent those distortions.

  7. Good series of posts, especially on the technical critiques. On evasion: Cochrane is pretty convincing that the uber-rich will be able to escape the brunt of the tax, while the less wealthy will have to pay--but isn't that exactly Saez and Zucman's underlying complaint, that billionaires have an unfair advantage? Maybe a wealth tax is inefficient at limiting that advantage, but it doesn't seem consistent to argue 1) we should be at worst indifferent to how billionaires spend their money and 2) even if we wanted to take it we couldn't because the laws do not apply to them.

  8. "To pay the wealth tax, you have to sell assets. If you sell assets, you have to pay federal and state capital gains tax all before you pay the wealth tax. This multiplies the tax." Not to mention the effect of PRICE IMPACT... The combined effort of investors to sell assets (at time t+1) worth billions of dollars to pay for the wealth tax (set at time t) will not generate a downward pressure on prices only if the market is free from liquidity frictions. However, this kind of market may be somewhat unrealistic, even though it is difficult to assess exactly what could be the extent of the price impact. In any case, investors will probably be forced to rely more on active managers and liquidity providers in the attempt to minimize the effect of price impact, meaning that the cost of managing financial assets will increase. Moreover, reading this debate I realized that there is something extremely ironic about the wealth tax. This proposition is often advanced by people who do not believe in the efficiency of the markets. In other word they do not believe in the ability of the market of properly set prices, and yet the ability to levy this tax strongly depends on the availability of reliable market values... I find this quite fascinating...

  9. John, this analysis is unnecessarily complicated.

    Let's simply take our "measures of success" which would be something like, measures of reported happiness, crime rates, poverty rates across different states, and see how they vary with levels of consumption, income and wealth (property) taxes. There's no substitute for data.

    Let's examine a flat wealth tax as a replacement for income tax. Change the laws so it all makes sense, and then see how it would affect incentives. Obviously, there wouldn't be requirement to sell illiquid assets every year, just that you'd have to report it and pay interest.

    Avoidance is the most obvious flaw with a wealth tax currently. Because other nations don't have a wealth tax, it would be easy to store wealth abroad. As a result, the only wealth tax that would currently be practical would be a national property or land tax. No avoidance, no evasion, easy (easier than income) to collect and assess.

    There's a reason why just about every municipality in the world uses property / land taxes instead of income taxes. Why should the same dynamics be different on the national level?


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