Taxing the Wealthy: The Fine Printby gene steuerle
gene steuerle, a former deputy assistant secretary of the U.S. Treasury, is cofounder of the Tax Policy Center and Richard Fisher Chair Urban Institute. This is a modified version of commentary that first appeared in the Tax Policy Center’s TaxVox blog and Gene’s own blog, The Government We Deserve.
Published February 24, 2020
The current debate over wealth taxes mostly focuses on whether the very rich are undertaxed and pays little attention to the most efficient and fairest ways to tax their assets or the capital income earned on those assets. Now, a cynic might argue there’s no point to a deep dive into the details of a concept that faces such daunting political hurdles, especially when the details suggest that designing a fair and efficient wealth tax would not be a walk in the park. If a wealth tax is ever to be taken seriously, though, advocates surely need to flesh out the concept and expose it to critical analysis. And here, I raise three, largely ignored issues that any practical effort would need to account for.
Double — or Even Triple — Taxation
Depending on what their wealth consists of, the wealthy already may be subject to corporate income taxes, individual income taxes and estate taxes. Yet few believe these taxes combine efficiently to raise revenue or that the burdens are distributed fairly. Some individuals are paying all of these taxes on their capital income; some pay none. And these double tax — really, multiple tax — issues would be magnified should a new wealth tax simply be grafted onto the existing federal tax code.
Consider how the corporate tax can combine with the individual income tax to create a double tax. (For now, I’m ignoring the estate tax.) Imagine the position of the owner of shares in a corporation that pays tax on its current income and then pays out its after-tax income in the form of dividends. With a 21 percent corporate income tax rate on the books and a potential individual income tax rate of 23.8 percent (the 20 percent tax on qualified dividends plus the 3.8 percent net investment income tax), our shareowner pays a combined rate of nearly 40 percent. Let’s further assume that the return on capital owned by the wealthy is 6 percent, implying that a 2 percent wealth tax (the ballpark for most of the proposals floating around) is roughly equivalent to a 33 percent income tax rate on capital income on top of the other taxes. This unhappy shareowner could end up paying a total tax rate on income over 70 percent.
By contrast, the owner of real estate through a partnership who uses interest and other cost deductions to completely offset rent revenues while earning a 6 percent net return entirely in the form of capital gains on the property, owes no corporate or individual income tax. He or she would simply pay the 2 percent wealth tax.
One could argue that this wealth tax would do its job by taking a nice piece of change from savvy real estate investors who currently get off scot-free. But it would also leave owners of corporations that realize substantial income and pay substantial dividends (not typical these days, but that’s another story) in a tax bracket that most American would consider unfair — and, as important, give the owners huge incentives to duck the levy by investing in other ways.
Multiple-tax problems aren’t new by any means. What ought to be done about them depends on the context. But at very high levels of tax assessment, this issue becomes a lot more important. And, as far as I can tell, almost none of the proponents of a wealth tax has even discussed it.
It may be better for society to collect tax on the accumulated unrealized gains at death rather than taxing them during life and reducing the entrepreneur’s wealth accumulation.
Taxing Capital at Death
Among the issues that arise in assessing higher taxes on the wealthy is whether Congress should continue to forgive income taxes on gains accrued but not yet taxed at the time of the owner’s death. Put it another way: getting rid of this tax preference would function as a new (and very significant) tax on wealth that would certainly be efficient because it would have little impact on incentives and would probably seem fair to most people who have paid tax on their income.
Contrast the holder of a regular IRA retirement account containing unrealized capital gains with a holder of corporate stock outside a retirement account. At death, the heirs of the IRA face income tax liability, but the heirs of the stock are forgiven the liability on the capital gain; the heir’s tax basis in the asset is “stepped up” to the value at the time of the deceased’s death. In fact, the contrast has just grown more stark because the retirement reform package just passed by Congress requires the heirs of an IRA to accelerate the pace at which they pay the tax.
Now, I recognize that the two cases are not exactly equivalent because IRA owners do enjoy an extra tax break during their lives in the form of deferral of taxes on contributions to IRAs. But this is a distinction often without a difference. Much wealth derives from returns to labor and entrepreneurship for which tax was also deferred. Why not create greater parity between households with IRAs and more wealthy households that accrue their untaxed capital income outside of retirement accounts?
Timing of Taxation on Returns from Wealth
Regardless of the rate of tax assessed on the wealthy, when to tax them raises very important efficiency issues. (See my earlier two-part discussion here and here.) Successful entrepreneurs become wealthy mainly by earning a very high rate of return on their business assets and human capital, then saving most of those returns within their businesses. Because the societal returns to most great entrepreneurial ideas dissipate as the new idea ages and because the skills of the entrepreneurs often don’t pass on to their children, capital held by rich heirs tends to generate lower rates of return for society than their entrepreneurial forebears.
Thus, it may be better for society to collect tax on the accumulated unrealized gains at death rather than taxing them during life and reducing the entrepreneur’s wealth accumulation. As Winston Churchill put it, “The process of creation of new wealth is beneficial to the whole community. The process of squatting on old wealth, though valuable is a far less lively agent.”
Again, this is a problem that existed before the current enthusiasm among some Americans for a wealth tax. But it raises the ante: the higher the total tax on wealth, the greater the potentially negative impact on the productivity of capital if we only think about how much but not how well to collect those tax dollars.