The idle rich, no longer

Debate about wealth taxation is inescapable these days, at least in media coverage of the U.S. presidential race. But for most economists, the story is simple: Taxing wealth is mathematically equivalent to taxing the capital income that wealth generates. That’s exactly what the U.S. tax code already does—the IRS taxes business profits, rents, royalties, dividends, and interest. Economists have studied the practice exhaustively. Case closed.

But Minneapolis Fed economist Fatih Guvenen and his colleagues have revisited the subject in recent research, noting that this conventional wisdom neglects an obvious fact: People vary widely in their ability to use capital productively. Recent research in Norway, Sweden, and the United States documents wide individual and business variation in rates of return; casual observation lends additional credibility. Some of us are born entrepreneurs, but not most.

When this distinction is taken into account, the economists find that wealth taxation has implications very different from those of capital income taxation. In fact, their analysis suggests that wealth taxation is far preferable, delivering higher output, productivity, wages, and income. Consumption levels would rise. And unlike most tax policies that promise greater efficiency, there is no equity trade-off. The poor would benefit, not sacrifice. “Wealth taxes can yield both efficiency and distributional gains,” write Guvenen and his colleagues.

The economists are careful to emphasize that gains arise only if capital income taxes are eliminated when wealth taxes are implemented. Adding a wealth tax on top of existing capital income taxes would likely be calamitous.

Gains would come from reducing the tax burden currently faced by those who use wealth productively and shifting it to those who don’t. Capital would be used productively as it’s siphoned away from the idle rich; thus, “Use It or Lose It”—the title of the research paper.

Changing taxes and capital flows

By definition, the more productive an entrepreneur is, the more capital income she or he generates from a given amount of wealth. If capital income is taxed (as in the United States) productive entrepreneurs face higher tax burdens than the less productive—the tax is a disincentive to production. But if wealth is taxed—rather than the income it generates—every person at a given wealth level would face a similar tax rate, regardless of her or his productivity. Highly productive people would no longer be discouraged from being so, and their wealth levels would rise as the unproductive would have their wealth taxed away. Another important element in the economists’ theory is a borrowing constraint. A wealth tax that encourages saving and capital stock growth will lead to higher output, wages, incomes, and consumption. But this is particularly true when productivity rises because capital flows freely to the most-productive people, some of whom may have insufficient capital of their own. A bond market allows wealth exchange from low- to high-productivity individuals. Those with wealth but an inability to invest it productively lend to those with profitable business plans but too little capital.

Testing the theory

What would this look like in the real world (or, at least, in this model world)? The economists study a simple hypothetical reform: Replace the current U.S. capital income tax system with a wealth tax that raises an equal amount of revenue, and don’t change taxes on labor income and consumption. This reform would raise average welfare by as much as 8 percent of consumption per person per year and generate a host of other changes in the macroeconomy. With a wealth tax rate of 1.13 percent to provide a revenue-equal impact, capital levels jump 19 percent, productivity rises 4.6 percent, and both output and consumption increase 10 percent. Overall, note the economists, the reform delivers “a reduction in the misallocation of capital, yielding higher average wages, consumption, and welfare.”

Welfare gains are fairly evenly distributed, with people at all levels of entrepreneurial ability benefiting in a wealth-tax economy. The gains diminish with age, however, and are negative for older age groups, especially the wealthy old. Incorporating pensions that are allowed to rise along with average wages would address this for the not-wealthy old, lowering average gains but spreading them “to the vast majority.”

Adjusting take-home pay

But this first scenario compares only capital income versus wealth taxes. What is the optimal policy if policymakers adjust taxes on labor income as well? The economists look at two versions of this hypothetical: an optimal capital income tax (OCIT) and an optimal wealth tax (OWT), both of which are revenue-neutral and incorporate labor income taxation. Curiously, the OCIT would actually subsidize capital income (a negative tax) and increase the labor income tax; the OWT would tax wealth at 3 percent and lower labor income taxes from present levels. Both policies raise average welfare relative to current U.S. levels.

The distributional implications, however, are far different. OCIT “shift[s] the tax burden from the wealthy to wage earners, delivering efficiency gains at the expense of large distributional losses.” By contrast, an OWT raises after-tax wages by lowering the labor tax rate. That leads to more hours worked and greater aggregate output. “The OWT system shifts the overall tax burden … from labor to capital—and further shifts the capital tax burden from high-productivity entrepreneurs to low-productivity ones.”

Who, specifically, are these low-productivity wealthy? In a separate comment, Guvenen writes, “These can include wealthy entrepreneurs whose best years are behind them, some children who inherit large fortunes but have no interest or ability to growth the wealth, one-hit wonders, etc.” In essence, wealth taxation rewards the wealthy who put that wealth to work and penalizes those who don’t.

The bottom line

The economists are careful to note that numerical estimates are highly dependent on how the model is calibrated and subject to change. Guvenen and his colleagues perform robustness and sensitivity tests, study a number of extensions, including a wealth tax exemption level, and analyze the transition from the current economy to a wealth tax world. These experiments confirm that the qualitative results are very robust even if the numbers change with policy variations. In a side note, Guvenen also points out that the wealth tax should be levied on a firm’s book value, not its market value, an accounting distinction that includes the entrepreneur’s productivity and would undo the benefits of a wealth tax.

But the bottom line is clear: Switching from capital income taxation to wealth taxation has the potential to raise overall productivity and output substantially and lower inequality, thereby benefiting virtually all population groups (again, not adding wealth taxes to capital income taxes, but replacing the latter with the former). Wealth taxation is controversial in the United States, but has been widely accepted in Europe. Although less common in recent decades, wealth taxes are still imposed in France, Spain, Netherlands, Switzerland, and Norway. And while predicting how wealth taxation will fare in the political future is a fool’s errand, economists are—as a result of this study—quite likely to renew their exploration.