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.
So under the wealth taxation plan of Chen et al. society would take some money away from these rich kids and one-hit wonders and give it to the Elon Musks and Warren Buffetts of the world — people who have the ability to turn it into more money, by investing in growing companies. Essentially, if you have money, you would have to use it or lose it.
Now, there are two obvious problems with the scheme. The first is that it could hurt old people, who often live off of their investments. The second is that it could exacerbate inequality — after all, what do you expect from giving more to the Musks and Buffetts of the world?
Fortunately, these problems are not too hard to solve. If the wealth tax comes in the form of an estate tax, old people don’t get hurt. Exempting low-income old people from wealth taxes is another easy fix. As for inequality, it would only increase among the rich — is it really so bad if spoiled heirs have less and creative entrepreneurs have more? Also, the money collected from the wealth tax could be used for welfare programs, public housing, or even government programs to help poor people start their own businesses. Meanwhile, the productivity gain from switching from capital taxation to wealth taxation would increase the size of the economic pie, allowing more to be redistributed without hurting growth.
More to the point, the Chen et al. idea just seems a lot fairer. As economist Greg Mankiw has written, many people instinctively feel that vast fortunes are OK as long as the people who hold them did something to earn them. Relatively few people resent Mark Zuckerberg or Steve Jobs for being rich. But when people become billionaires through luck of birth or luck in the markets, it just doesn’t feel quite as justifiable. The use-it-or-lose-it principle that motivates Chen et al.’s model could reduce inequality while making people less upset about whatever inequality remains.
Wealth taxation has been on economists’ minds a lot in recent years. Chen and her coauthors give us one more reason to take the idea seriously.