Why wealth taxation may not erode capital formation (and why it’s good for immigration)

Evan Soltas and Theo Clifford were unconvinced with my call for a wealth taxation system.

Evan notes:

(1) Incentivizing individuals to shift consumption around in terms of time is inefficient; that is, a small wealth tax will create a large disincentive against saving and investment.

(2) Very little wealth is in liquid assets, and liquidation is costly.

(3) Wealth is probably easier to conceal than income, decreasing compliance or increasing enforcement costs.

(4) In the U.S., a constitutional amendment would be required.

(5) A national wealth tax of any size would create considerable global coordination problems.

Many economists favor moving in the opposite direction, such as towards a Hall-Rabushka consumption tax. Note, also, that the effective tax rate on wealth is already nonzero as a result of local property taxes, the capital gains tax, the estate tax, and the gift tax.

Theo adds:

Not only will it be very unpopular, but even if you did succeed, there’d be all sorts of exemptions and caveats. Some of these would be desirable. Many would not be. All would increase complexity and implementation costs.

Capital taxes have other weird effects. They can distort the debt-equity tradeoff. They can bias rich people against inflation if the tax is not indexed to inflation, and if the experience of the last five years has taught us anything, it’s that rich people being biased against inflation is a very bad thing. How will the tax treat declining asset values? What will the effects of the tax be on the relative demand for different risk classes of assets?

As for popularity, I don’t think April 15th is a particularly popular day, either. Evan and Theo cite standard economic theory, suggesting that a wealth tax would disincentivize saving and hence capital formation making it an “incredibly inefficient” form of taxation. However, standard economic theory would suggest that a progressive income taxation would disincentivize education, as higher incomes are usually derived from investments in human capital.

This isn’t to say economic theory is wrong, but that simply noting a single disincentive in the structure doesn’t necessarily warrant its effect. No less, I note that the tax can be implemented in a way so as to not encourage consumption:

Although IRS should aim for an average tax rate of 2.5%, it should be progressively implemented. One way to do this would be to exempt the first 50% of all wealth generated for society as a whole, and provide those exemptions on the first dollars of overall net worth, and tax everything above at 5%. This is not purely for egalitarian reasons, but to incentivize saving. If all wealth is taxed, there is an implicit subsidy of consumption, discouraging long-term savings. For example, if k was 250,000 US dollars, the only people who would face a disincentive to save are those with already high savings rates, with a low marginal propensity to consume.

I recently came across a New York Times article by Daniel Altman making the same point:

For most families, whose wealth may never reach $500,000, all disincentives to save would vanish. And families trying to accumulate a fixed amount of wealth for retirement or their children’s college fund could devote less of their incomes to saving, since in most cases the wealth tax would take a smaller bite of their interest, dividends and capital gains than the current income tax. Though the remaining minority of families subject to the wealth tax might end up saving less and spending more, this shift would also reduce inequality; the dollars they spent would be more likely to end up in the pockets of people with less wealth.

As Altman hints, Evan’s claim that wealth is de facto taxed via capital gains tax is wrong. Capital gains is income. Indeed, in my proposal, these would not be taxed at all. Therefore, any disincentive to invest in capital is further eroded by potential for increased returns. A wealth tax will, however, compel a broader ownership of such capital.

I also address Evan’s second point by recommending the opportunity to amortize the tax over a longer period of time:

Wealth, as estate, taxes are a tricky business. Especially when much of one’s net worth is in form of home equity and similarly non-liquid assets, it might be difficult to pay an immediate 2.5%. Government can introduce the option to amortize the cost over 5 to 10 years, removing the immediate burden on a family.

While it is an important point that wealth can be hidden, I don’t know whether I agree that it’s easier to hide – I certainly haven’t read any study to that effect. Indeed, it is quite easy to get paid in cash (inconvenient, but easy). It’s a lot harder to hide that cash without a formal financial institution. The argument of capital flight is also irrelevant for a country like the United States, where assets may be taxed worldwide.

Miles Kimball is also very skeptical about the long-term effects of a tax on capital:

It looks OK in the short run, but with lower investment, the capital stock gradually declines. In this spirit you would be better off taxing land a la Henry George, since the amount of land won’t decline even if you tax it. But taxing the buildings on top of the land is like taxing any other kind of capital. (However right now we tax houses very lightly compared to factories, so if it weren’t for the housing bubble’s aftermath, we would be better off taxing houses more and factories—which employ people—less.)

This is similar to Evan and Theo’s point that my proposal would hinder capital formation. However, is there any evidence that a tax on capital itself would be any more harmful than taxation on capital gains? Indeed, I think incentivizing higher returns from capital is more important than incentivizing formation of capital itself. When investors consider an investment they must focus not just on future cash flow, but speculation against fellow investors. However, focusing on capital returns isolates the consideration to future cash flow, allowing a more efficient signaling process. He also notes that a one time wealth tax won’t have a harmful effect, but I really don’t think this is subgame-perfect. If government can do it once, investors will know it can do it again. This means a single-time tax would have the benefit of only one flow of revenue, but would have the same negative effects critics of a capital tax claim it to have.

Furthermore, I agree with Evan that a progressive consumption tax is a move in the right direction:

A wealth tax would also be well-supplemented with a progressive consumption tax on carbon, sugar, cigarettes, etc. – balancing out any non-market incentives to save or consume, while at the same time ridding the country of associated external costs.

Indeed, a pure consumption based tax system can encourage oversaving, and particularly hurt those who in the short-run need to consume more than they earn. As Kimball notes, it also has a big life-cycle element to it, hurting seniors the most. While any taxation system has a life-cycle element, that associated with a wealth tax can be somewhat mitigated with a proper system of amortization.

One final point. It’s been clearly argued that there are negative effects associated with a wealth tax. I’m not fully sure that it would benefit an economy today, but I do believe it deserves consideration and a broad, full-scope study by the government, which would be able to more appropriately map incentives, signals, and future capital potential.

In light of recent debate on high-end immigration, I also believe wealth taxes are a more egalitarian solution. The income difference between the average skilled immigrant and the average American is close to, if not below, zero. However, immigrants come without any wealth. However, because of their relatively high incomes, they immediately pay more taxes than most Americans, without the ability to build an equivalent wealth.

A wealth tax would give them a chance to reach some threshold before being taxed in the same manner. This is a crucial point. Facebook made headlines in India for offering an IIT graduate a starting salary of 6 million rupees, over $115,000. This is more than Microsoft’s self-professed minimum starting salary of $100,000 and loads more than salaries India has ever seen before.

If the United States signaled that the initial starting salary for the same job in Silicon Valley now pays 25% more, it would certainly increase flow of immigration. While in the future the immigrant, now a millionaire, will have to pay more money, behavioral economics has shown that people discount future cash flow highly, and after making the move to become a US resident, it will be difficult to summon them out.

  1. Ew Pemakin said:

    In light of recent debate on high-end immigration, I also believe wealth taxes are a more egalitarian solution… However, immigrants come without any wealth. However, because of their relatively high incomes, they immediately pay more taxes than most Americans, without the ability to build an equivalent wealth.

    How is this proposal more “egalitarian”? Its only obviously more egalitarian in current time as accumulated wealth has been taxed many times over both earned income tax originally and capital gains taxes along the way over many many years. “Without the ability to build an equivalent wealth”. Surely they have plenty of ability to build equivalent wealth but building wealth always takes time.

    Most importantly, your proposal falls flat on its face on the distinction between a resident and a citizen. In the US, we tax both, but citizen are permenently taxed wherever they reside. So the US knows that they have a partial claim on all the income created by citizen’s wealth as well as all there future earned income. Presumably, the high-end immigrant under your system begins as a resident and has the potential to become a citizen down the road. If untaxed lightly on his income and heavily on his wealth, as he accumulates wealth he faces a substantial penalty to becoming a citizen since as resident he always has the option of leaving.

  2. arra95 said:

    My proposal is more egalitarian because it treats a new, but high-income, immigrant without any equity the same as it does an old wealth lawyer who’s been in the United States for generations. He already has wealth and financial security. This, tied with the nature of H-1 visas, makes it incredibly difficult for new immigrants to build real financial security. It also increases immigration because, as I said, we discount future cash flow at a pretty high rate. Knowing we would save a lot of money now versus what we would in the counterfactual is enough to spur immigration.

    Right, but your criticism of mine is iffy for the same reason: he can always drop his citizenship. Also, leaving as a resident is a lot harder than it is as a citizen, if you want to ensure future entry into to the country or path to citizenship.

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