Long-term wealth tax hurts inequality – lack of savings reduces economic productivity and wages

National conversations about wealth inequality in the United States have led to proposals for a wealth tax. The motivation is to tax concentrated wealth to raise revenues for public programs and redistribution.

Combining insights from macroeconomic models, James Feigenbaum and Austin Brooksby examine the effects of different wealth tax proposals on wealth inequality. The two models of the economy that they consider are infinite-horizon model and the overlapping-generations model. Infinite-horizon models assume that households never leave the economy and exist forever. The overlapping-generations model assumes that households move in and out of the economy in the same way that generations of people do. Generations share time together in the economy as a new generation enters and the older generation begins to die off.

Both infinite-horizon models and the overlapping-generation models are commonly used by economists, but a persistent question is how to reconcile these models when their predictions differ. In the case of wealth taxes, the overlapping-generations model suggests that social welfare rises with a wealth tax while the infinite-horizon model suggests that social welfare falls when a wealth tax is implemented.

The authors’ solution to this conflict is to combine the two models into a hybrid, called a segregated-economy model. This model treats wealthy households as infinite as they pass along sufficient wealth to their children that makes their household effectively infinite. In contrast, poor households are finite because their children do not inherit comparable wealth.

This hybrid model suggests that wealth taxes can significantly reduce social welfare even at low rates of two or three percent. This is because a wealth tax encourages wealthy households to consume rather than save. This reduction in savings translates into a lower level of funds available for investment and economic growth.

The paper estimates that a wealth tax of two percent a year would be sufficient to turn all wealthy households into poor households. This means that households reduce their savings and choose to consume more instead. The lack of savings reduces the stock of economic capital (productive machinery and factories) by 20 percent. In turn, this reduction in capital reduces the economy’s overall productivity. Output and wages both fall by roughly seven percent. This equals nearly twice the reduction in output that occurred, albeit only temporarily, during the Great Recession.

In the segregated-economy model, wealth taxes ultimately harm social welfare by reducing wages. Yet the model suggests that it may be possible to reduce wealth inequality by paying off the public debt by utilizing wealth taxes with a short-term sunset provision. The model shows that paying down the public debt can reduce wealth inequality. That is because paying down debt, unlike a wealth tax, does not encourage the wealthy to consume instead of saving. So the economy remains productive, wages do not fall. Yet the level of taxation needed to finance public spending and debt payments falls. That allows poorer households to retain more of their wealth.

As the economy continues its recovery from the COVID-19 pandemic, the relevant question is how governments should pay for the economic recovery. In the short run, these expenditures will be financed by borrowing. Eventually, the bill must come due. This research suggests that a permanent wealth tax would harm the economy. However, history suggests that the wealthy will recover from the recession sooner than the rest of the population. The author finds that this would justify raising taxes on the wealthy in the short term to help pay down the public debt, but also recommends that increased taxes should be temporary to avoid long-term negative impacts on economic growth.