Around the world, governments in recent decades have sought to lighten the burden on capital by reducing taxes on dividends, capital gains, corporate profits and wealth. The motivation is straightforward: more capital means more investment, higher productivity and faster growing wages. Capital is also highly mobile: Tax it too much, and it will go elsewhere, undermining growth.
Massachusetts senator and Democratic presidential contender Elizabeth Warren has broken with that consensus by proposing a tax of 2% on net worth above $50 million and 3% above $1 billion. It may never be enacted; yet in spirit it marks a historic pivot in the focus of capital taxation, from growth to inequality.
While there is no “right” level of inequality, it stands near historic highs and Democrats are unified in wanting to reduce it. Taxing wealth is an immensely appealing, nearly surgical strike at its most glaring manifestation. Yet it may not be an efficient response.
Income consists of money received each year in the form of wages, benefits, interest, dividends, capital gains and government transfers. Wealth consists of income you’ve saved over your lifetime or inherited, then invested in assets such as cash, bonds, stocks, property and stakes in a business, minus debts.
Wealth has always been more skewed than income and the imbalance has grown since the financial crisis. The median U.S. family’s income, adjusted for inflation, fell 4% between 2007 and 2016, while its wealth plummeted 20%, according to Federal Reserve figures. For the richest 10% of families, median income rose 9% while wealth leapt 27%. More than 80% of American households had less wealth in 2016 than on the eve of the last recession, in great part because their homes, the principal asset for most families, were below their precrisis values whereas stocks, whose ownership is concentrated among the rich, have roughly doubled since 2007.
Two broader economic forces have accentuated the trend: low interest rates, which boost property and stock prices; and unusually high profits. Treasury estimates that 52% of all investment income this year will flow to the richest 1% of families by income. The richest 0.1% of families are expected to earn nearly $1.5 trillion, of which 60% will be from investments.
This poses a number of challenges. For the middle class, stagnant wealth limits their ability to buy a home, pay for college or respond to a financial emergency. Wealth imbalances may also undercut economic growth because assets, which typically rise in response to interest rate cuts, are concentrated among people who are less inclined to spend.
For policy makers who want to tax the rich more, this limits the reach of income and consumption taxes. Shielding capital income leaves a big chunk of the richest families’ incomes untouched by taxes, says Greg Leiserson, director of tax policy at the Washington Center for Equitable Growth, a left-of-center think tank.
While property and some estates are already taxed, a wealth tax would hit every form of wealth. It can also be quite selective: Ms. Warren estimates only 75,000 families would pay her tax, yet it would raise $2.75 trillion over 10 years.
This would create administrative headaches such as how to precisely define wealth to limit avoidance. It also would raise economic issues. It was barely a year ago that Republicans slashed the U.S. corporate tax rate to closer to international levels in hopes of juicing growth. A wealth tax would go in the opposite direction. For example, on an investment in a company averaging 8% annual returns, a shareholder may expect her holdings to grow 8% per year. A 3% wealth tax on that increase represents, on average, an implicit 37.5% income tax, on top of the corporate taxes. And unlike the corporate tax, it would have to be paid even if the company made no money that year.
Mr. Leiserson predicts the effects on investment and growth would be small, and offset by public investments financed with the tax.
Denmark abolished its wealth tax, borne by the wealthiest 2% of families, between 1989 and 1997. In the subsequent eight years, the wealthiest families’ net worth rose 30%, according to a study by Katrine Jakobsen and three co-authors distributed last year by the National Bureau of Economic Research. The authors attribute most of this to increased saving.
Alan Auerbach, an economist at the University of California at Berkeley, thinks this shows a U.S. wealth tax would reduce wealth and saving by enough to hurt investment and economic growth. This might be offset if the U.S. turns to foreign savings to finance an investment. This, however, means foreigners would take a bigger share of U.S. income.
There may be more effective ways to tax wealth. A large chunk of capital gains are never taxed because shareholders bequeath shares to their heirs without selling them. President Barack Obama proposed in one of his budgets taxing unrealized capital gains at death. Adam Looney, a Brookings Institution economist who worked on the proposal, says it would have raised roughly $200 billion over a decade. Mr. Auerbach says taxation at death seems to have less effect on the saving of the wealthy than taxation during life.
An even better response would be to attack the concentration of economic power that results in monopoly-like profits by reducing barriers to competition. Competition policy, unlike tax policy, faces no tradeoff between equality and growth.