Thursday, September 19, 2019

Analysis: The Implicatons of a Wealth Tax in the U.S.

Public Finance, Inequality, Cash Flow

Empirically, broad wealth inequality has a potentially negative effect on economic growth. Countries where gaps between income and wealth narrow have much greater overall economic growth than countries with widening income gaps. The OECD finds that the large disparities in income can be associated with 10% reduced growth in Mexico and New Zealand, and up to 9% in the U.S. This is generally caused by the reduced educational outcome from the bottom 40% of earners, which we already knew.

Calls to address inequality have created discourse surrounding the economic implications of a wealth tax. Proponents of a wealth tax concede that it's not a pro-growth policy. Instead, they contend that reducing inequality and redistributing the benefits will be better for growth in the long run. While this may be somewhat true when factoring in other policy decisions, many arguments for a wealth tax are inconsistent with tax and public finance literature. In fact, it would be better and more attractive to abandon a wealth tax and favor taxing capital income and/or consumption. 

In the paper linked below, "a tax of t on wealth is revenue-equivalent to a tax of τ = (1+r )t/r imposed on capital income rW." (With a two percent rate of return, a 2 percent wealth tax is a 102 percent tax on capital income) If we want to analyze the analytical implications of a wealth tax, we can break down the rate of return and see what the literature suggests each tax on said return will do. 
r = normal rate of return + risk + rents

When most people think about inequality and power imbalances in society, they think about rents. They think about corporations deriving supernormal profits/extraordinary returns from extensive market power, rent-seeking, government protection of an industry, or a misrepresentation of income which one could view as unethical. The literature suggests that "a uniform capital income tax collects revenue at a high rate, (1+r)/r times higher than a wealth tax, from all these components." A wealth tax can produce the same amount of revenue, but it would be done so through taxing the principal. What does this mean? Choosing to use wealth relieves rents which are exactly what we're trying to tax, extraordinary returns. If you want to be less distortionary and focus on supernormal profits, you should favor a 20 percent capital income tax over a 2 percent wealth tax.

There are many ways we can utilize the current tax code to expose us to supernormal profits, but still be consistent with sound tax literature. For instance, you can deduct the investment from capital gains(thus reducing the burden on "savings") and then tax the return. This gives the IRS some exposure to supernormal returns while maintaining that the code is conducive towards investment, placing weight on the correct tax element, correcting the base, and not relieving pressure on rents. 

Does this tax logic sound attractive? It should! And you can apply this to the tax base in general. On the intensive margin, the tax base reduces normal returns. Lower after-tax returns reduce investment, productivity, wages, and economic growth. To address this, we want to exempt the normal return and focus on taxing cash flows and consumption. On the extensive margin, we focus on entrepreneurship, long-run dynamism, and tax competition.  What we want to do is minimize marginal tax rates on capital and limit average effective rates(tax burden) from rising above international norms and factor in incentives such as relations to the labor supply.

No comments:

Post a Comment