Standard economic theory says that taxation reduces productivity. If you tax income, you reduce the incentive to work. If you tax capital gains, you reduce the incentive to invest, and so on. When you discourage useful economic activity, the economy becomes less efficient.
But what if it were possible to impose taxes in a way that also increased productivity? That’s the promise of a clever new theory by economists Daphne Chen, Fatih Guvenen, Gueorgui Kambourov and Burhanettin Kuruscu.
The basic idea is startlingly simple. Lots of people have wealth but aren’t able to use it effectively — they pick bad investments, or use it to start failing businesses. The U.S. tax system accommodates these people with a variety of breaks; if they lose on their investments, they get capital gains tax write-offs, while if their businesses are unprofitable those companies pay no tax. Meanwhile, the people who put wealth to good use — the savvy entrepreneurs and wise investors of the world — get taxed on their profits and capital gains. The net effect of this system is to allocate more of society’s capital to the people who are least able to put it to good use.
But if the U.S. replaced capital taxation with a tax on wealth itself, as Chen et al. suggest, the effect is reversed. Rich people who don’t earn good returns on their investments would see their net worth shrink, while those whose returns are high would prosper. Eventually, the distribution of wealth shifts toward society’s most productive entrepreneurs and investors, and growth goes up as a result.
Who loses as a result of this policy? Heirs and heiresses. It’s well known that business and investing skill isn’t perfectly inherited — there are plenty of rich kids who fritter away their fortunes or lose them on bad stock picks and harebrained business schemes. The Williams Group consulting firm estimates that 70 percent of rich families lose their fortunes by the second generation, and 90 percent by the third. The old saying “shirtsleeves to shirtsleeves in three generations” is no myth.
The lucky rich would also lose. Some investors make a killing on a single big score, but underperform thereafter. Some entrepreneurs have middling business skill but are in the right place at the right time. Wealth taxation would erode the fortunes of those who can’t repeat, while rewarding those whose success was no fluke.