Issues 2020: What’s Wrong with a Wealth Tax

The Narrative

"[My wealth tax will] raise an estimated $4.35 trillion over the next decade and cut the wealth of billionaires in half over 15 years, which would substantially break up the concentration of wealth and power of this small privileged class." — Bernie Sanders [1]   "I’m fighting for big changes like universal child care, investing in public schools, and free public college. We can do all of that with a #TwoCentWealthTax." — Elizabeth Warren [2]   "The tax, if effectively enforced, would eat fortunes." — NPR [3]

Reality

In the coming months, Americans can expect calls to tax the wealth of the richest citizens. There are four oft-cited justifications for such a measure: inequality is rising, and there is a need to restore fairness; more revenue is necessary to bring exploding deficits under control, and taxing the wealthy is the least harmful way to do so; extreme wealth disparities harm economic growth; and the rich use their wealth to rig the political system, so democracy requires leveling the playing field.

Wealth inequality is indeed increasing, the country does need more tax revenue, and special interests can get government favors. But none of these reasons justifies a wealth tax, which could damage the economy while raising little revenue. Instead, a better solution for raising additional revenue would be to remove the many existing distortions in the tax system.

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1. Wealth inequality has increased but is not exploding.

• The share of domestic wealth held by the wealthiest 0.1% of Americans rose from 7% to 14% over the past four decades, 1978–2016.[4] That increase is significant, but it is only half as large as the estimates that proponents of a wealth tax frequently cite.
• The richest Americans tend to be self-made entrepreneurs: 67% of the Forbes 400 richest Americans are self-made, and eight of the top 10 all got to where they are by creating successful businesses. 
• There is no evidence that reducing wealth inequality will increase economic growth. It may even harm growth because it discourages saving and investment. 

2. Of all the possible types of ways to collect revenue, wealth taxes are the least desirable.

• Wealth taxes are inefficient and ineffective because wealth is inherently more difficult to measure. Privately held companies, for example, are not traded in public markets, which means that there are no stock prices by which one can objectively gauge their value. Also, financial assets can be hidden or moved abroad with the click of a mouse or converted into other assets that are hard to value.
• A dozen European countries had a wealth tax in 1990, but most abandoned them because they were ineffective and expensive to administer. In part, the taxes failed to raise much revenue because wealthy individuals easily moved their assets across borders to avoid taxation. Today, only Switzerland, Norway, Belgium, and Spain still have wealth taxes, but the rates—0.3%–1%, 0.85%, 0.15%, and 0.2%–2.5%, respectively—are much lower than the 2%–6% proposed by advocates such as Senator Elizabeth Warren for the United States. With a small enough rate, there is much less incentive to evade the tax, but far less revenue is raised. Switzerland collects the most from its wealth tax; and it only brings in about 3% of its tax revenue.[5]
• Wealth taxes distort behavior in a way that is harmful to economic growth and national prosperity. By taking a fraction of people’s wealth each year, the tax reduces the return to investing and discourages saving. This can reduce growth because investing and capital accumulation are critical to innovation.

On the Record "'Tax the rich' has become a rallying cry for the left, unfortunately it’s an idea that would both fail to accomplish the goal of effectively raising new revenue and also deliver a devastating blow to domestic growth and prosperity." —Allison Schrager, senior fellow, Manhattan Institute & Beth Akers, senior fellow, Manhattan Institute

While the federal government taxes income, it does not tax wealth. The IRS does not keep data on citizens’ individual wealth, and it is very difficult to assign an objective value to many forms of wealth, such as family businesses and art collections. This makes it difficult to measure wealth inequality. Nevertheless, economists Emmanuel Saez and Gabriel Zucman[6] attempted to do so by using individuals’ reported capital income—such as interest and dividends—that is reported on their income-tax filings. Assuming that wealthy individuals earned a percentage return on par with the prevailing return on capital in the market, the filer’s wealth (i.e., the value of the assets that generated the capital income) can be roughly estimated by simple arithmetic.

But the critical assumption of the Saez and Zucman study—that the wealthy earn the average market return on their assets—is problematic. More likely, the wealthy have assets yielding higher than average returns, which is how they became wealthy in the first place. If this is true, it has major implications for estimates of Americans’ wealth.

Recently, economists Matthew Smith, Owen Zidar, and Eric Zwick reestimated wealth inequality and accounted for the fact that the wealthy tend to own higher-yielding assets and have more of their wealth in their own businesses.[7] For example, their study assumed, consistent with the data, that wealthy Americans hold fixed-income assets that earn a higher return than average—because they are more likely to own high-yield debt and municipal bonds. The fixed-income assets owned by poorer Americans tend to be things like bank accounts. When you allow for a higher rate of return, the estimates of asset values (and the wealth of their owners)—are lower. Accounting for different rates of return, their study estimated that the amount of wealth held by the top 0.1% was half of what was estimated by Saez and Zucman, whose study has been trumpeted by proponents of a wealth tax such as Elizabeth Warren.[8]

Yet even the more recent and accurate estimates by Smith, Zidar, and Zwick make strong assumptions about asset returns and sources of asset income. The most appropriate takeaway from this line of research is that we don’t know very much about the distribution of wealth; using wealth taxation to reduce inequality is thus difficult to justify or monitor. 

There is no clear evidence that rising inequality of wealth has harmed economic growth. Traditionally, economists thought that there was a trade-off between growth and equality. More growth necessarily meant that some people became very rich as the result of starting very productive companies, fashioning new technologies, synthesizing drugs, or devising new and popular products. Reaping the rewards meant that they earned far more than others, although their income (and wealth) did not come at the expense of everyone else. Conversely, taxing wealth and redistributing it enhanced economic equality, but it also reduced incentives to invest and innovate. Tolerating inequality was considered a worthwhile trade-off because a wealthier, albeit more unequal, economy has the potential to make everyone better off from rising living standards. And with appropriate redistributive policies, some of the wealth could fund social insurance while still rewarding successful entrepreneurs. However, Saez and Zucman[9] claim that entrepreneurs don’t require outsize rewards to take risks and innovate and that reducing inequality, for its own sake, can increase growth.

One argument that inequality may depress growth is that the wealthy distort the political process, lobbying to rig the game through laws and regulations that benefit them at everyone else’s expense. To be sure, this kind of lobbying has long been all too common. Nevertheless, as economist Larry Summers points out, distorting the political process does not take billions of dollars; even a few million can influence politics.[10] In any event, the election of Donald Trump, whom many big political donors did not like, suggests that billionaires and millionaires may not have overweening political power.

Another argument for reducing inequality: low-income people spend more—and more consumption fuels growth, so taking money out of the hands of the wealthy, who save more, will grow the economy.[11] In the depths of a recession, when people are reluctant to spend, it may be true that focusing stimulus on middle- and lower-income households will generate consumption and growth. But normally, saving, not spending, is what drives growth because it provides capital that firms use to innovate and invest. Government efforts to take wealth out of markets and put it into the hands of spenders can undermine long-term growth.

Wealth taxes would also force the owners of private companies to sell their companies earlier than they normally would in order to pay the taxes they owe. Many successful entrepreneurs own companies that are not publicly traded, especially in the critical early growth years. A significant wealth tax would stick them with a large tax liability based on a notional estimate of their wealth that is based on a notional estimate of their company’s value, which is, by definition, illiquid. Paying this liability would force some to sell equity earlier, often to private equity investors who may be more short-term-oriented. This dilutes their control, ownership, and investment in their firm. To the extent that entrepreneurial talent is important to success, a wealth tax can damage innovation and job creation.

The U.S. faces historic deficits, and the federal government’s debt-to-GDP ratio is predicted to exceed 100% next year. This most likely means that, eventually, taxes must increase to pay some of the debt, especially if interest rates increase. Wealth taxes, however, are not a good way to raise revenue.

All taxes alter people’s behavior, and the distortions they create can be harmful. Capital does not go toward its more productive uses; and distorting the returns from risk often yields unintended consequences. Income- and consumption-tax rates have to be quite high in order to discourage work or spending because it is hard to avoid these taxes.[12] Wealth taxes, however, are considered to introduce more distortions than any others. Even at low rates, they discourage saving and investment because they lower the return on these activities.[13]

A 2% wealth tax may sound small. Senator Warren points out that it is only 2 cents on every dollar of wealth.[14] But it will be levied each year, so it is more instructive to think of it as a tax on capital income. And when you put the tax in income terms, 2% can be enormous. For example, if your assets return 4%, a 2% wealth tax is equivalent to a 50% tax on capital income! Thus, it is not surprising that wealth taxes increase the incentive to move assets abroad, as European nations have experienced. Unlike income, wealth is relatively easy to move and its value is relatively easy to manipulate.

We already see significant distortions that exist in the taxation of estates. Quirks in the tax code that determine how tax liabilities are valued on estates lead to delays in when people sell assets, changes in how they value assets, and even changes to when people die. One paper[15] estimates that death rates changed slightly around the time when there were changes in the tax code that would affect tax liability, though some of the effects may come from when deaths are reported.

Another, more common, distortion, is the stepped-up basis. It means that tax liability is based on capital appreciation from when the assets were bequeathed to when they were sold. Normally, capital-gains taxes are based on the growth in value from when an asset was originally purchased. Estate-tax rules encourage some to hold assets until their death that they would otherwise have sold earlier. Holding these assets will reduce the intergenerational tax burden.[16] This distorts asset markets, and the estate tax is only a one-time tax levied after death.

An annual tax would create more distortions that could even worsen inequality. A wealth tax creates an incentive to keep companies private and not sell shares on the stock market, because that makes wealth easier to underreport, which lowers the tax burden. There are numerous examples of private wealth being unreliable and difficult to value. Take the Forbes list of richest Americans,[17] which, according to one study, is completely out of step with estate-tax data.[18] One example was the great fanfare around the report that Kylie Jenner, a reality-show and makeup mogul, was a billionaire and appeared on the Forbes list. Later it was revealed that she was indeed very wealthy but not a billionaire.[19] Her case demonstrates how easy it is to misstate wealth when a company’s shares are not sold on the open market. A wealth tax creates an incentive for entrepreneurs not to take their companies public—which means that the American public cannot share in the growth of the most productive firms. This reduces wealth creation within the broader economy.

1. “Tax on Extreme Wealth,” Berniesanders.com.
2. Rachel Sandler, “Billionaire Leon Cooperman to Elizabeth Warren: ‘Your Vilification of the Rich Is Misguided,’ ” Forbes, Oct. 31, 2019.
3. Greg Rosalsky, “Wealth Tax Showdown,” NPR.org, Oct. 1, 2019.
4. “Wealth Gaps Are Smaller than Previous Estimates Suggest, and Capital Isn’t Entirely to Blame for Rising Inequality,” Princeton Economics, Apr. 29, 2020.
5. Joseph Zeballos-Roig, “4 European Countries Still Have a Wealth Tax. Here’s How Much Success They’ve Each Had,” Business Insider, Nov. 7, 2019.
6. Emmanuel Saez and Gabriel Zucman, “Wealth Inequality in the United States Since 1913: Evidence from Capitalized Income Tax Data,” Quarterly Journal of Economics 131, no. 2 (2016): 519–78.
7. Matthew Smith, Owen Zidar, and Eric Zwick, “Top Wealth in America: New Estimates and Implications for Taxing the Rich,” Working Papers 264, Princeton University, Department of Economics, Center for Economic Policy Studies, 2020.
8. Elizabeth Warren, “Tax the Ultra-Rich.”
9. Emmanuel Saez and Gabriel Zucman, “How Would a Progressive Wealth Tax Work? Evidence from the Economics Literature,” Feb. 5, 2019.
10. “Would a ‘Wealth Tax’ Help Combat Inequality?” debate with Emmanuel Saez, Larry Summers, and Greg Mankiw at the Peterson Institute for International Economics conference “Combating Inequality: Rethinking Policies to Reduce Inequality in Advanced Economies.”Oct. 18, 2019.
11. Heather Boushey, Unbound: How Inequality Constricts Our Economy and What We Can Do About It (Cambridge, Mass.: Harvard University Press, 2019).
12. Congressional Budget Office, “Effective Marginal Tax Rates for Low- and Moderate-Income Workers in 2016,” Nov. 19, 2015.
13. Wojciech Kopczuk, “Comment on “Progressive Wealth Taxation,” by Saez and Zucman, prepared for the fall 2019 issue of Brookings Papers on Economic Activity; John Cochrane, “Wealth and Taxes,” Cato Institute, Tax and Budget Bulletin No. 86, Feb. 25, 2020.
14. Elizabeth Warren, “Ultra-Millionaire (2 Cent) Tax,” 2020elizabethwarren.com.
15. Wojciech Kopczuk and Joel Slemrod, “Dying to Save Taxes: Evidence from Estate Tax Returns on the Death Elasticity,” NBER Working Paper No. 8158, March 2001, also in Review of Economics and Statistics 85, no. 2 (2003): 256–65.
16. James M. Poterba and Scott. J. Weisbenner, “The Distributional Burden of Taxing Estates and Unrealized Capital Gains at the Time of Death,” NBER Working Paper No. 7811, July 2000, also in William G. Gale, James R. Hines, and Joel Slemrod, eds., Rethinking Estate and Gift Taxation (Washington, D.C.: Brookings Institution, 2001), pp. 422–49.
17. Kerry A. Dolan, Chase Peterson-Withorn, and Jennifer Wang, eds., “The Forbes 400: The Definitive Ranking of the Wealthiest Americans in 2020,” forbes.com.
18. Brian Raub, Barry Johnson, and Joseph Newcomb, “A Comparison of Wealth Estimates for America’s Wealthiest Decedents Using Tax Data and Data from the Forbes 400,” NBER Conference Paper, 2010.
19. Chase Peterson-Withorn and Madeline Berg,“ Inside Kylie Jenner’s Web of Lies—and Why She’s No Longer a Billionaire,” Forbes, May 29, 2020.