Sen. Warren’s Wealth Tax Is Problematic

By Nicole Kaeding & Kyle Pomerleau of The Tax Foundation.

"Today, Senator Elizabeth Warren (D-MA), Democratic presidential hopeful for 2020, announced plans for a wealth tax on high-net-worth individuals, a type of tax that is flawed economically and administratively. (There are also constitutional questions about assessing a wealth tax.)

According to The Washington Post, Senator Warren’s proposal would assess a 2 percent annual wealth tax on individuals with more than $50 million in net worth, increasing to 3 percent on those with more than $1 billion in wealth.

Wealth taxes are not a new idea—they date back hundreds of years—but have been used less and less frequently. In 1990, 12 member countries of the Organisation for Economic Co-Operation and Development imposed a wealth tax; today, only four do. Countries have dropped the taxes due to the challenges they pose.

First, these taxes are difficult to administer. The uber wealthy tend to have very hard-to-value assets. They own more than publicly-traded stock, such as real estate holdings, trusts, and business ownership interests. It is difficult to value these assets on an ongoing basis. Imagine a large privately-held company—its value could change almost daily. How would the tax handle these fluctuations?

This is a challenge currently facing the Internal Revenue Service (IRS) when administering the estate tax, but one faced only once by an individual. Here, the problems would multiply as the tax would be assessed annually on a much larger share of individuals.

Second, these are poorly targeted taxes on capital. Usually when designing a tax on capital or capital income (these are ultimately the same) you want to target what are called super-normal returns—returns over and above the amount needed to compensate someone for saving and delaying their consumption. At the same time you want to exempt, or lightly tax, normal returns to investment.

Normal returns are effectively the returns to waiting; that is, the rate of return an individual requires to make it worthwhile to save their money and delay consumption. The taxation of normal returns can ultimately impact an individual’s investment decisions. This is why economists generally favor exempting these returns from taxation.

In contrast, super-normal returns can include highly successful business ventures, economic rents, returns to patents, and luck. This is the type of capital income a system should target for taxation, because it is believed to be less sensitive to tax. Taxation of super-normal returns doesn’t necessarily distort investment decisions.

Imagine a saver who expects a normal return and makes an investment. Her decision was based on the after-tax return. But suddenly, the investor receives a super-normal return, which, in her case, would be unexpected. Getting taxed on those surprise super-normal returns doesn’t have much of an impact on her decision to save.

Exempting normal returns, while taxing super-normal returns, is the principle underlying why expensing of capital investment for businesses is such a good idea. It preserves the tax on capital but targets it at a less sensitive tax base.

Unfortunately, a wealth tax does a poor job targeting this type of income. In fact, it gets it exactly backwards: a wealth tax lightly taxes super-normal returns while heavily taxing normal returns.

You can think of a 1 percent wealth tax as a 1 percent subtraction from annual returns. If we earn a return of 5 percent, but there is an annual wealth tax of 1 percent, our return is really 4 percent. This low-return asset is hit hard—a 20 percent(!) tax on its returns. In contrast, an asset earning 20 percent gets reduced to a return of 19 percent. That’s only a 5 percent tax on those returns.

And these issues matter for more than just the wealthy individuals directly impacted by the tax. The capital owned by these high-net-worth individuals is used to employ others, to make products consumed by other individuals, or to generate returns for pensions and retirement accounts owned by others. While the legal incidence of the tax would be on the wealthy individuals, the economic impacts (incidence) would be much more dispersed.

This is another example of why policymakers, when discussing issues such as income inequality, should consider the limitations and negative consequences created by using the tax code as a fix."