A wealth tax disincentivizes saving and capital investment – That crushes economic growth, reducing the overall GDP by 5% and causes a loss of revenue in the long run

How to Tax Capital There are two basic things people do with their earnings: consume and save. Saving is abstaining from current consumption. Savings are channeled back into the economy and used to support investments by business enterprises. To grow, economies need pools of savings—that is, pools of capital or wealth. Senator Warren and other policymakers are concerned that wealth is “concentrated.” But the wealth of the wealthy is mainly dispersed across the economy in productive business assets. Looking at the top 0.1 percent of the wealthiest Americans, 73 percent of their wealth is equity in private or public companies, while just 5 percent is the value of their homes.78 Looking just at billionaires, only 2 percent of their wealth is accounted for by their homes and personal assets, such as yachts, airplanes, cars, jewelry, and artwork.79 The great majority of their wealth is in productive business assets, which generate output for the broader economy. Nonetheless, many policymakers and pundits believe that people with substantial wealth should be targets of heavy taxation. They think that raising taxes on people owning capital would lighten the burden on labor and that taxing wealth would benefit the nonwealthy. However, imposing heavy taxes on wealth would reduce living standards for everyone because it would reduce the overall size of the economy. Under certain assumptions, a basic finding from economic theory is that everybody should want taxes on capital to be low or even zero—including wage earners, who have no capital income.80 Economist Greg Mankiw describes a simple economy with two groups: workers and capitalists.81 The capitalists save and earn capital income, while the workers earn wages and do not save. The workers are in the democratic majority and can set tax policy anyway they want. Should they tax wages, capital income, or both? It turns out that—acting in their own interest—the workers should tax wages only, not capital income. The reason is that the supply of capital is elastic or responsive to taxation, and so setting the tax rate to zero would generate increased saving and investment. In turn, that would create rising worker productivity and wages—worker efforts are more valuable when they have more and better machines to work with. In the long run, the after‐​tax wages of workers would be higher under this policy than under a policy of imposing taxes on capital. This result assumes that the supply of capital is perfectly elastic or responsive. While that is not fully realistic, capital has become more responsive in today’s global economy. In another paper, Mankiw and coauthors noted that the zero capital tax prescription “is strengthened in the modern economy by the increasing globalization of capital markets, which can lead to highly elastic responses of capital flows to tax changes even in the short run.”82 They conclude that the “logic for low capital taxes is powerful: the supply of capital is highly elastic, capital taxes yield large distortions to intertemporal consumption plans and discourage saving, and capital accumulation is central to the aggregate output of the economy.”83 From an average worker’s point of view, it is beneficial for the wealthy to maximize their savings and reduce consumption. Capital and labor are complements in the economy—workers are more productive and better paid when they are supported by more capital generated by savers. The Council of Economic Advisers has summarized the empirical evidence in support of low taxes on capital.84 The basic idea goes back at least to Adam Smith, writing in The Wealth of Nations. He described how heavy taxes on mobile “stock” or capital would cause losses to workers: Stock cultivates land; stock employs labour. A tax which tended to drive away stock from any particular country, would so far tend to dry up every source of revenue, both to the sovereign and to the society. Not only the profits of stock, but the rent of land and the wages of labour, would necessarily be more or less diminished by its removal.85 This insight on the importance of savings also underlays opposition to the federal estate tax, which is a wealth tax imposed at death. From a liberal perspective, law professor Edward McCaffery has long made the case for abolishing the estate tax, arguing, “The rich person who passes on wealth is doing good things for society—continuing to work and save, keeping money in the capital stock.”86 McCaffery notes that a weird thing about the estate tax is that it is a “virtue tax,” or the opposite of a sin tax.87 Sin taxes discourage vices, but estate taxes and other wealth taxes discourage the virtuous behavior of saving. Greg Mankiw has made similar points: When a family saves for future generations, it provides resources to finance capital investments, like the start‐​up of new businesses and the expansion of old ones. Greater capital, in turn, affects the earnings of both existing capital and workers. Because capital is subject to diminishing returns, an increase in its supply causes each unit of capital to earn less. And because increased capital raises labor productivity, workers enjoy higher wages. In other words, by saving rather than spending, those who leave an estate to their heirs induce an unintended redistribution of income from other owners of capital toward workers. The bottom line is that inherited wealth is not an economic threat. Those who have earned extraordinary incomes naturally want to share their good fortune with their descendants. Those of us not lucky enough to be born into one of these families benefit as well, as their accumulation of capital raises our productivity, wages and living standards.88 All of this raises what appears to be a policy dilemma. How can we have a tax system that does not penalize beneficial wealth accumulation but also distributes the tax burden equitably? How do we ensure that the rich pay a fair share of taxes while not discouraging saving? The answer is consumption‐​based taxation. Consumption‐​based taxes can be taxes on transactions, such as retail sales taxes and value‐​added taxes. Or they can be taxes assessed on individuals and businesses, such as the “flat tax” designed by economists Robert Hall and Alvin Rabushka and the “X‑Tax” designed by economist David Bradford.89 Both income and consumption‐​based taxes tax income from labor and capital. But unlike income taxes, consumption‐​based taxes exempt the “normal” return to capital, which removes the bias against saving and investment. The normal return is usually thought of as the yield on a riskless investment, which represents the time value of money. Both income and consumption‐​based taxes tax the “above‐​normal” returns to capital. Those include the returns, or profits, attributable to market power, innovations, windfalls, and various rents available to certain businesses and investors.90 Economist Glenn Hubbard notes that wealthier households receive a larger portion of their capital income from these items, so consumption‐​based systems can be quite progressive.91 Bradford agrees that “sources of great wealth,” such as monopolies and highly profitable technology firms, are taxed under both income and consumption‐​based systems.92 However, by exempting the normal returns, the latter system is more conducive to growth. Bradford also long argued that consumption‐​based tax systems allow for much simpler administration and compliance.93 Consumption‐​based systems are also better at equalizing taxes on capital across activities and industries, and they capture some activities that escape taxation under the income tax. As one example, the “buy‐​borrow‐​die” strategy in real estate investment can allow individuals to go years without paying income tax if they borrow against appreciating properties to fund their consumption.94 That is the sort of loophole that angers the public about wealthy people, and it would be closed under a consumption‐​based system. Theoretical models suggest that consumption‐​based taxes are superior to income taxes on both efficiency and distributional grounds.95 The key is that income taxes distort both work effort and savings, but consumption‐​based taxes just distort work effort. Consumption‐​based taxes are superior on efficiency because you can raise a given amount of revenue with fewer distortions than under income taxation. Regarding distribution, you can design a consumption‐​based tax to match the progressivity of an income tax, but which collects revenue with fewer distortions. Tax law professors Joseph Bankman and David Weisbach conclude that “everyone is equally well off or better off under a properly designed consumption tax,” as compared to an income tax.96 They note that consumption‐​based taxes would tax the “idle rich,” which is often the motivation for taxes on the wealthy.97 Economists Kevin Hassett and Alan Auerbach agree that consumption taxes would target wealth, noting that “consumption taxes reduce the value of wealth, just as wealth taxes do” and “if the disproportionate political power of the wealthy is the concern, a consumption tax is potentially a more powerful tool.”98 Wealth taxes are an inefficient method for taxing the rich because they treat profits in the opposite way as consumption‐​based taxes. Wealth taxes exempt some above‐​normal returns to savings and tax the normal returns, which would distort savings and investment.99 In its report on wealth taxes, the OECD pointed to this problem: “The taxation of normal returns is likely to distort the timing of consumption and ultimately the decision to save, as the normal return is what compensates for delays in consumption.”100 Auerbach and Hassett come to similar conclusions: a consumption tax differs from a capital income tax in its treatment of capital income only by its exemption of the safe rate of return on investment. Thus, consumption taxes hit wealth without interfering with the incentive to save associated with the intertemporal terms of trade. Wealth taxes, on the other hand, effectively tax the safe rate of return on investment because they do not depend on actual rates of return, thereby incurring the intertemporal distortion but forgoing tax on other components of the rate of return.101 Bill Gates sort of captured the idea of consumption‐​based taxation when he said: “Think about the three wealthy people I described earlier: One investing in companies, one in philanthropy, and one in a lavish lifestyle. There’s nothing wrong with the last guy, but I think he should pay more taxes than the others.”102 A better framing would be to say that the last guy, who spends lavishly, is favored under income and wealth taxes, while the first guy, who saves, is penalized. Consumption‐​based taxation would fix that problem by taxing income and wealth only if consumed. Because wealth taxes suppress savings and investment, they undermine economic growth. A 2010 study by Asa Hansson examined the relationship between wealth taxes and economic growth across 20 OECD countries from 1980 to 1999. She found “fairly robust support for the popular contention that wealth taxes dampen economic growth,” although the magnitude of the measured effect was modest.103 The Tax Foundation simulated an annual net wealth tax of 1 percent above $1.3 million and 2 percent above $6.5 million.104 They estimated that such a tax would reduce the U.S. capital stock in the long run by 13 percent, which in turn would reduce GDP by 4.9 percent and reduce wages by 4.2 percent. The government would raise about $20 billion a year from such a wealth tax, but in the long run GDP would be reduced by hundreds of billions of dollars a year. Germany’s Ifo Institute recently simulated a wealth tax for that nation.105 The study assumed a tax rate of 0.8 percent on individual net wealth above 1 million euros. Such a wealth tax would reduce employment by 2 percent and GDP by 5 percent in the long run. The government would raise about 15 billion euros a year from the tax, but because growth was undermined the government would lose 46 billion euros in other revenues, resulting in a net revenue loss of 31 billion euros. The study concluded, “the burden of the wealth tax is practically borne by every citizen, even if the wealth tax is designed to target only the wealthiest individuals in society.”106