A wealth tax is preferable to an income tax – it efficiently allocates resources to productive businesses

The well-documented rise in wealth inequality in the United States since the 1980s has sparked debate on wealth taxes as a tool to raise revenue and reduce wealth disparities. Contributing to this debate, a new working paper finds that wealth taxes are preferable to capital income taxes because a wealth tax shifts the tax burden from productive to unproductive entrepreneurs and reallocates capital to the more productive ones. The optimal wealth tax in the model the authors study increases aggregate productivity and reduces consumption inequality relative to the status quo, thus delivering large and broad-based welfare gains.

A wealth tax is a tax on a household’s wealth, or the value of its assets less its debts, whereas a capital income tax is based on the income generated by wealth. Federal, state, and local governments in the United States tax wealth through property taxes; income taxes on interest, dividends, and capital gains; and corporate taxes, but they do not use wealth taxes.

In their paper, economists Fatih Guvenen and Sergio Ocampo Diaz of the University of Minnesota, Gueorgui Kambourov and Burhan Kuruscu of the University of Toronto, and Daphne Chen of Econ One compare wealth taxes and capital income taxes and find that the optimal wealth tax yields gains for rich and poor families alike.

The five co-authors find that wealth taxes increase aggregative productivity and output through two main channels. The first is what the authors term the “use-it-or-lose-it” channel. Under a wealth tax, individuals who own the same amount of wealth pay equal taxes, regardless of how much income their wealth generates. You use your wealth productively or you lose it. This shifts the tax burden toward unproductive entrepreneurs. Second, a wealth tax reduces the after-tax returns of high-return entrepreneurs less than low-return ones, which raises the savings rate of productive entrepreneurs.

The paper highlights how differences in the rates of return on capital—return heterogeneity, in economic parlance—have important implications on how policymakers should think about taxing capital. Wealth taxation and capital income taxation are equivalent when the rate of return to wealth is equal across individuals. Indeed, much of the existing literature on capital taxes assumes that everyone earns the same return on their wealth. Yet there is a growing body of research that documents significant differences in rates of return across individuals, even after adjusting for risk, both in the United States and overseas. Further, economic models that account for return heterogeneity more effectively generate the extreme concentration of wealth, or the so-called thick Pareto tail, that many models of inequality have failed to do.