Taxing Wealth Instead of Income, Part 2

As a follow-up to David Kotok’s piece last week on taxing wealth (https://www.cumber.com/cumberland-advisors-market-commentary-wealth-tax/), it may be useful to remind readers what the potential incentive effects might be when it comes to the implications of wealth tax proposals to tax wealth may have on entrepreneurs and business structures. Proponents of a wealth tax are motivated by the need to finance what is now a growing federal deficit as well as to address what is perceived to be a problem with growing wealth inequality in today’s economy.

Market Commentary - Cumberland Advisors - Taxing Wealth Instead of Income

Two of the proposals that are more easy to understand and calibrate are those put forward by Senators Bernie Sanders (https://berniesanders.com/issues/tax-extreme-wealth/) and Elizabeth Warren (https://elizabethwarren.com/plans/ultra-millionaire-tax). The Sanders proposal contains a progressive tax with a maximum of 8% on net worth over $10 billion, declining gradually to 2% for families with net worth between $50 and $250 million. The Warren proposal is less progressive, with a 2% tax for households with net worth between $50 million and $1 billion and a 3% tax on net worth above $1 billion. While the plans seem quite different, we can plot what might happen over time to the net worth of households that started with $10 billion of net worth. The chart below shows the path for net worth under both plans over the most relevant range.[1]

The Sanders’ plan would halve net worth in about 11 years while the Warren plan would halve net worth in about 23 years. It is important to recognize that these are maximum-impact cases, since the analysis ignores any investment returns or other sources of growth in the value of wealth. If the household could earn at least enough on its asset holdings to more than cover the cost of the tax, for example, then effectively the net-worth tax proposals would amount to capping net worth at whatever the current levels were. In the Sanders proposal, for example, an individual with at least $10 billion in net worth would have to earn a bit more than the marginal 8% tax rate. In Warren’s proposal, the household would only have to earn a bit more than 3%.[2] So while the proposed net-worth taxes would generate revenue to support the government, they would do little to address concerns that many have about wealth inequality which would have to depend solely on increasing the wealth of those not subject to the taxes.

Implementation of such programs could, however, have significant implications for how people manage their wealth. In a previous commentary, I noted how the composition of wealth varies over different classes of net worth. The most recent data available are from the Federal Reserve’s 2016 survey of consumer finances, shown in the following chart.

For those with net worth over $1 billion, which is really the target group for the wealth-tax proposals, I noted that “more than two thirds of the wealth of the $1-billion-dollar-net-worth cohort is composed of what are termed ‘business interests.’ The Survey of Consumer Finances divides business interests into those businesses in which the owner has an active management role and those in which the owner does not play an active role, and well over 90% of such business interests involve active management. Thus, those who wish to tax wealth rather than yearly income are, in fact, targeting mainly privately held businesses whose value is derived from the active entrepreneurial involvement of the principal and his or her family.[3] Such assets are hard to identify, since they can include loan guarantees, intellectual property, etc. Those business interests are not frequently traded and are extremely hard to value. These are the same business interests that generate employment and benefits to many others.”[4] But capping net worth effectively caps the value of household business interests, and this cap has implications for how such businesses can grow and increase their capital as well as their risk taking incentives. If the effect is to stifle growth and employment, then the unintended consequences might well be detrimental to the economy going forward. If the effect to promote excessive risk taking, then the stability of the economy may be at risk.

In Sanders’ case, it is estimated that the proposal would impact about 180,000 households, and the IRS would be tasked with the job of valuing the net worth of those households each year. This would seem to be a very difficult and costly bureaucratic process to undertake, and one can imagine the disputes over values that would accompany implementation of the wealth tax. In short, proponents of a wealth tax need to delve a bit deeper into the likely first- and second-round implications of their proposals, which may not be quite as simple as they are represented.

Robert Eisenbeis, PH.D.
Vice Chairman & Chief Monetary Economist
Email | Bio

[1] One can easily calculate from this chart how many years it would take to reduce net worth by one half, from, say, $4 billion to $2 billion, under either plan.
[2] Of course, as the marginal net-worth tax rate declined, the earnings requirement would be reduced.
[3] See for example “Changes in U.S. Family Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances,” Brian K. Bucks, Arthur B. Kennickell, Traci L. Mach, and Kevin B. Moore, revised 2009, Federal Reserve Bulletin, Vol. 95, 2009, https://www.federalreserve.gov/pubs/bulletin/2009/articles/scf/default.htm.

 


Here are links to our recent writings on the subject of Wealth Taxation.

Market Commentary - Cumberland Advisors - Wealth Taxation Series

Wealth Tax,” David Kotok, October 9, 2019
https://www.cumber.com/cumberland-advisors-market-commentary-wealth-tax/

Taxing Wealth Instead of Income?” Bob Eisenbeis, February 13, 2019
https://www.cumber.com/taxing-wealth-instead-of-income/

Taxing Wealth Instead of Income, Part 2,” Bob Eisenbeis, October 15, 2019
https://www.cumber.com/taxing-wealth-instead-of-income-2/

The Kiplinger Tax Map: Guide to State Income Taxes, State Sales Taxes, Gas Taxes, Sin Taxes,” David Kotok, October 25, 2019
https:/www.cumber.com/cumberland-advisors-market-commentary-the-kiplinger-tax-map-guide-to-state-income-taxes-state-sales-taxes-gas-taxes-sin-taxes/


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Taxing Wealth Instead of Income?

With the desire to finance both an increasing deficit and an increase in government services, politicians are searching far and wide for funds. Increasingly, proposals are surfacing to tax wealth rather than income as the means to fund pet projects. The proposals attract followers since unequal distribution of wealth is viewed as a problem that needs to be addressed. However, we really need to think through the implications of going down this road.

Market Commentary - Cumberland Advisors - Taxing Wealth Instead of Income

First, it is important to understand the distinction between income – a flow of money from work and investments – and wealth – an accumulation of assets, things that we have. We all know that we can borrow to fund our acquisition of things, which then have to be financed out of current income. Most recent proposals therefore have actually focused on taxing net worth- reflecting the difference between what we owe and what we have.

While it is easy to refer to wealth in the abstract, it is important to recognize the wide range of assets that constitute our wealth. These include our homes, cars, financial assets, clothes, vacation homes, yachts, intellectual property rights, patents, etc. Some of these are easily valued while others are more problematic. One of the most recent wealth tax proposals would tax net worth over $10 million at 2% and net worth over $1 billion at 3%.

One of the interesting points about the wealth tax is that it taxes net worth – our things – each year, whereas an income tax is based on our current year’s income. Here is an interesting thought experiment. Suppose you have $1 billion, and it is taxed 3% every year. In 10 years, assuming the principal was not invested, you would have slightly less than $750 million remaining, and in 20 years you would have about $540 million. So, in effect, the government is saying that you have too much stuff and they are going to take it. In the extreme, this is not really different from the government saying that you have too many cars or that your house is too big and therefore you must let someone use one of your cars or one or two of your rooms at your expense.

More seriously, it is interesting to look at how the composition of wealth differs over classes of different net worth. The Federal Reserve’s survey of consumer finances contains information that allows us to get a better picture of how the distribution of stuff differs across different wealth cohorts. For the lower tiers, real estate, autos, retirement funds, and liquid assets comprise the bulk of net worth. At the other extreme, for those with a net worth in excess of $1 billion, the target cohort for the net worth tax, those same assets are a minuscule portion of their net worth (See Chart, “What Assets Make Up Wealth?” at https://www.visualcapitalist.com/chart-assets-make-wealth/).

More than two thirds of the wealth of the $1-billion-dollar-net-worth cohort is composed of what is termed “business interests.” The Survey of Consumer Finances divides “business interests” into those business interests in which the owner has an active management role and those in which the owner does not play an active role and well over 90% of such business interests constitute active management. Thus those who wish to tax wealth rather than yearly income are, in fact, targeting mainly privately held business interests whose value is derived from the active entrepreneurial involvement of the principal and his or her family (1). Such assets are hard to identify, since they can include loan guarantees, intellectual property, etc. Those business interests are not frequently traded and are extremely hard to value. These are the same business interests that generate employment and benefits to many others. To implement a tax that serially requires a potential long-term expropriation of and monetization of productive businesses activities in the name of funding other social objectives requires very careful review and analysis of the costs and benefits.

The same survey also shows that one of the main determinants of wealth is education, and the returns are greatest to a college education (2). To be sure, we have recently heard about the problems of excessive student debt, and a recent Wall Street Journal article convincingly shows that students who attend but don’t finish college can be even worse off than those who don’t have a college degree (3). However, that same article also shows that unemployment rates are lower among college graduates and those with some college than for those with no college, and earnings show a similar pattern.

We need to remember that our Declaration of Independence promotes the “pursuit of happiness,” which has come to mean equal opportunity, not equal incomes or equal wealth. Given the evidence on education and wellbeing, we need to consider whether the key to dealing with the so-called problems of income and wealth inequality may be education and not government redistribution policies. Maybe we should focus on programs to raise those on the bottom while taking advantage of the often philanthropic tendencies of people with large accumulations of wealth. Perhaps we should consider policies, as just one example, that reduce inheritance taxes if a wealthy individual donated some of his or her wealth in advance of passing, provided that the gifts are to support qualified educational initiatives and keeping people in college who otherwise might be forced to drop out. This provides a carrot and opportunity for a wealthy individual to do good and avoids government expropriation with no guarantees that the funds will be used to address a social problem.

Robert Eisenbeis, PH.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


Sources:

  1. “Changes in U.S. Family Finances from 2004 to 2007: “Evidence from the Survey of Consumer Finances,” Brian K. Bucks, Arthur B. Kennickell, Traci L. Mach, and Kevin B. Moore, revised 2009, Federal Reserve Bulletin, Vol. 95, 2009, https://www.federalreserve.gov/pubs/bulletin/2009/articles/scf/default.htm.
  2.   Ibid.
  3.   https://www.wsj.com/graphics/calculating-risk-of-college/

Here are links to our recent writings on the subject of Wealth Taxation.

Market Commentary - Cumberland Advisors - Wealth Taxation Series

Wealth Tax,” David Kotok, October 9, 2019
https://www.cumber.com/cumberland-advisors-market-commentary-wealth-tax/

Taxing Wealth Instead of Income?” Bob Eisenbeis, February 13, 2019
https://www.cumber.com/taxing-wealth-instead-of-income/

Taxing Wealth Instead of Income, Part 2,” Bob Eisenbeis, October 15, 2019
https://www.cumber.com/taxing-wealth-instead-of-income-2/

The Kiplinger Tax Map: Guide to State Income Taxes, State Sales Taxes, Gas Taxes, Sin Taxes,” David Kotok, October 25, 2019
https:/www.cumber.com/cumberland-advisors-market-commentary-the-kiplinger-tax-map-guide-to-state-income-taxes-state-sales-taxes-gas-taxes-sin-taxes/


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Tax the Rich

As the political season begins to heat up for 2020, we have seen an increasing number of proposals to provide free education, free healthcare, a universal guarantee of a living wage, etc. With an historic level of public debt topping $21 trillion and a deficit of nearly $1 trillion and projected to climb even more in 2019, the logical question is how will the advocates for all those free programs pay for their suggestions, some of which have been priced out in the neighborhood of $30 trillion? The almost universal response is to raise tax rates on the wealthy so that they can “pay their fair share.” Let’s look at some facts.

Market Commentary - Cumberland Advisors - Tax the Rich

First, who is paying what? The following table is from the most recently available data from the IRS for 2015, showing federal individual shares of adjusted gross income, share of taxes paid, and average tax rates by income class. The top 1% had 20.65% of AGI and paid nearly 40% of the taxes.


Federal individual shares of adjusted gross income, share of taxes paid, and average tax rates by income class

Similarly, the top 25% earned just under 70% of the income and paid 86% of the taxes. By comparison, the bottom 50% of the income distribution earned only 11% of the income and paid 2.8% of the taxes. Data reflecting tax structure changes taking effect for 2018 is, of course, not yet available.

The argument is that it is necessary to raise the marginal tax rates on the higher-income groups so that they can pay their “fair share.” But what is a “fair share” and who gets to decide what is “fair?” Clearly, those already bearing the bulk of the tax burden are going to argue that they already are paying more than their “fair share,” while those with pet projects they want to fund will argue to increase the tax burden on the rich.

Further, would raising the marginal tax rate on the wealthy actually generate the river of additional revenue the “70 percenters” envision? Just how realistic are the proposals to raise the highest marginal tax rates to 70% or more? Historical evidence suggests that such proposals are, at best, naïve, and will not succeed. Proponents simply assume, without any understanding of history or how taxes affect behavior, that their proposals will be the magic solution. It turns out that the US has a rich history and multiple experiments with widely varying marginal tax rates, dating back to the Great Depression.

The highest marginal personal tax rate at one time was 94% in 1944, was about 91% from 1954–1963, dropped to about 70% from 1964–1980 before declining to its present rate in 1993. The highest marginal corporate tax rate was 52% in 1952 through 1963, and was only a bit higher at 54% between 1968 and 1969. (It will be 21% for 2018.) The following chart details that history, but more importantly shows the impact the variation in the highest marginal tax rates has had on tax revenues collected.


Variation in the highest marginal tax rates on tax revenues collected

Over the entire post-war history from 1944 to the present, revenues collected from all sources (including person and corporate income taxes, social insurance taxes, excise taxes and other taxes) have ranged between 14.4% and 19.6% of GDP, with an average of 17.1% and a standard deviation of about 1 percentage point. Thus, variations in the marginal tax rates have no perceptible impact on the volume of taxes collected relative to GDP. The graph of revenues collected is essentially a flat line when compared to the changes in the higher marginal tax rates and changes in the corporate tax rate. It is such a chart that in the past has led many to argue for a flat tax rather than a graduated progressive tax.

This history does not bode well for the “70 percenters” and reflects their basic lack of understanding of how individuals and markets respond when taxes begin to bite: Those impacted seek ways to avoid paying the tax by seeking tax shelters and tax-exempt returns like those on municipal securities, and by shifting income to tax havens abroad. Before any of us take the “70 percenters” seriously, they have got to explain the pattern shown in the chart, how “this time will be different,” and what criteria they are using to claim that their tax proposals are “fair.”

Robert Eisenbeis, PH.D.
Vice Chairman & Chief Monetary Economist
Email | Bio

 


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.