We are resuming our weekly entries. Sorry for any inconvenience we caused.
The Occupy Wall Street movement has not expressed clear goals, but it does want higher taxes on the “rich”. President Obama agreed in his State of the Union address, and proposed that the rich-in his case, anyone with an annual income of at least $1 million- pay no less than 30% of their income in federal taxes. Others have proposed to add annual taxes on household wealth, in addition to taxes on income. The fact is that Obama’s tax goal is already being met by the complicated American tax code, while even a small wealth tax would discourage savings and create other problems.
According to a 2010 study by the Congressional Budget Office, the effective federal tax rate on the top 1 percent of households has already been about 30%. This might seem to be a misprint since very wealthy persons like Warren Buffet and Mitt Romney report that they pay only about 15% of their income in taxes. However, much of their incomes come from investments that are first taxed at the corporate tax rate of 35%, and then the after-corporate tax income is taxed again when paid out as corporate dividends, or when capital gains are realized.
According to the same CBO study, federal taxes on the middle classes comprise on average only about 15% of their incomes, This disparity in tax rates indicates that the American tax system is already quite progressive when corporate income taxes are combined with personal income and capital gains taxes. To be sure, it is inefficient to have such high tax rates on corporate incomes. Eliminating the corporate income tax, and then taxing personal incomes, capital gains, and dividends at the same rate would go a long way to both simplifying the tax code and to improving its efficiency.
Better still would be to scrap entirely the income tax, and substitute a consumption (i.e. sales or value added) tax instead (see the more extended discussion of a general consumption tax in my post on 8/29/11). Even if consumption of the poor were taxed at lower rates, the current bloated level of federal spending could be financed with a consumption tax on the great majority of households of no more than 25%. The effective tax rate does not have to be high because a generally flat consumption tax would be far more efficient, in particular, it would be more encouraging to investments, than the present complicated personal and corporate income tax system.
An income tax is an indirect tax on wealth because it lowers the value of the assets that produced the taxable income. Nevertheless, support has recently emerged for a direct tax on wealth to go along with taxes on incomes. Some forms of wealth are already directly taxed, such as property taxes levied by most local governments, and taxes on estates of deceased individuals. Henry George in his book Progress and Poverty (1879) made a famous proposal for a wealth tax in the form of a 100% tax on increases in the value of land. This single tax, he believed, could replace all other taxes. George argued that a land tax was a good tax because, so he claimed erroneously, the value of land did not depend on what landowners did, but rather depended only on forces like population growth that were beyond their control.
Current proposals for a wealth tax go beyond taxes on particular assets, like land or housing, and envisage a much broader tax that includes financial wealth, like stocks and bonds. I only say “broader” since a viable wealth tax would still exclude wealth in the form of human capital, the most important form of capital in modern economies, and the source of wage and salary incomes. Since the richest one percent of households on average get about half their incomes from wages and salaries (the remaining 99% get almost all their income from human capital), much of the true wealth of the rich would escape a wealth tax.
Another major problem with even a small tax rate on wealth is that it implies a very high tax rate on savings. Consider a constant 2 percent tax on wealth, and suppose that a household saves $10,000 out of its income to raise its future wealth. A one year 5% return on these savings would increase its before tax wealth next period by $10,500. Since a 2 % wealth tax on $10,500 would leave an after-tax value of just $10, 290, such a wealth tax would reduce the after-tax return form 5% to only 3%, a 40% reduction.
So what seems like a small tax on wealth of only 2% is the equivalent of an income tax on savings of 40%. Presumably, this would discourage savings and increase consumption, whereas sustained higher long-term growth in GDP requires greater, not lesser, savings. As I mentioned earlier, the discouragement to savings of an income (or wealth) tax is a major reason why consumption taxes are better.
Wealth taxes have several other serious problems in addition to their negative effects on savings. It is almost impossible to value accurately many sources of tangible wealth, such as the value of privately owned businesses, so that an actual wealth tax would be rather narrow. Moreover, forms of wealth that can be most easily valued because they have good asset markets, such as stocks and bonds, can be moved across countries, and hidden through complex arrangements of assets.
Therefore, I conclude that a general tax on wealth is undesirable because it is both inefficient and ineffective. A feasible wealth tax is dominated by consumption taxes, including even progressive consumption taxes, and by inclusive income taxes.