The Libertarian Podcast: The 3 Percent Solution | Richard Epstein | Hoover Institution

>> Tom Church: This is the libertarian podcast from the Hoover Institution. I'm your host, Tom Church, and I'm joined by the libertarian professor Richard Epstein. Richard is the Peter and Kirsten Bedford senior fellow here at the Hoover Institution. He's the Lawrence A Tisch professor of law at NYU and is a senior lecturer at the University of Chicago.

Richard, this week I would like to talk to you about your column, because when I read wealth tax and when I read states are considering this, I think, well, let's get into this. We're not gonna get a national wealth tax Richard, Republicans hold the house right now, and that just won't pass anywhere there.

But you mentioned there's, what, seven states toying around the idea right now?

>> Richard Epstein: That's right. Well, first, on the first point, the Republicans hold the House now. Lord knows what will happen in 2024. But I think if you were to ask the question as to whether you could find uniform domestic democratic support for a wealth tax of one form or another.

I think the support for has actually grown, not diminished in the last several years at the state level. It's clear that it's all taking different forms and shapes in different places, some more aggressive than others. Each of these states is going to evolve in some fashion, but essentially the focus of all of these inquiries is at threefold, whatever the rates are on the top, we have to make the scale more progressive.

That's probably the most modest of the forms. And then the second reform is what we have to do is the tax income before it is realized. That is, before the appreciation in a share of stock or a piece of land is converted into cash or some other marketable security by sale.

And the third thing says is, we don't care whether you're earning or not earning. We just wanna take a piece of the total wealth pie that you have. And there's a question as to whether that is off a base which is marketable securities, easy to value but incomplete, or whether it's on an entire wealth base, which is much harder to value but much more complete.

There's a question as to whether or not there are any territorial limitations on this. So as you can see, you put the permutations together. They're all moving in one direction, but they're not moving in lockstep.

>> Tom Church: Is it accurate to say that there's almost a fourth set, you mentioned an exit tax, which would maybe be different, if I'm reading that right, we know you have this much money in assets, liquid or illiquid, we'll take a portion of that.

What if I look at the state and say, I'm out of here, I'm leaving. I'm leaving next year, how does an exit tax work?

>> Richard Epstein: Well, an exit tax is essentially saying, if you wish to pull out of this particular state, we are going to tax you an amount which roughly approximates the amount of tax that you would have paid if you had stayed in this state.

I actually wrote about this some years ago, in 1999, when I worked on a case which had to do with the wind insurance in Florida. It seems as though it's a disparate subject, but in fact, it's exactly the same thing. Wind insurance is a fancy way for talking about hurricane insurance.

And if you start looking at the various lines of insurance, most of them are really quite stable in terms of occupiers, liabilities, slip and fall cases, and stuff like that. But the wind thing is a huge, giant situation. So many of these companies in Florida realized that they were gonna lose a fortune, and they didn't want to stay there.

So they said, look, we're shutting down our Florida business on wind. And just to show you we're not trying to play any fancy games with you, we'll give up all our profitable lines as well. The profitable lines are only maybe 5% of what the wind insurance loses. And the state of Florida said, you can leave.

But the following condition is, we're gonna make an estimate today of how much you would have lost if you had stayed around for the next x years, and you have to pay that as a condition of leaving. And I thought, and argued, I think correctly, but not successfully, that an exit tax on this particular situation is a form of confiscation.

What you're telling people, in effect, is that you have to lose money whether you stay or not. We're gonna force you to enter into various kinds of businesses. And this is just a subtle way of saying, if I force you to buy $1,000 bond for $2,000, that extra $1,000 is, in fact, compensation, even though it's embedded in a sale transaction.

When you're looking at things like that, you have to make the estimates. So that's exactly what's going on here. Now, it's gonna be very tricky to estimate what the sustained exit tax is going to be. And the obvious cases in which it will apply are those cases where people are either at or over the whatever the magic line turns out to be.

And this is no easy situation to do it, but the non obvious cases may be more important. So suppose it turns out that you own shares of a company which may go public and be worth a great deal of money in a year. But you're not quite sure how much it's worth now, and you decide, I'm getting out of one of these wealth tax states before this is done.

The state will reserve the right to tax you as you leave on the amount of tax, that they would have been able to tax when you stay. Now, this is very difficult to do. I mean, it's not a joke. So just take the simplest kind of a problem.

This thing is worth $1,000 inside the state, you leave and it's now a year later it's worth $3,000. How much is the tax that you can impose? Is it on the expected gain of $1,000? You go from one to two? Or do you figure out how much they make in the other state and tax them for the full amount?

And this would be completely charming, if you have somebody foolish enough to go from California to New York and find themselves subject to a double wealth tax with each of them claiming the full value of this situation. All of these things essentially involve real valuation question at all times.

And an exit tax is extremely difficult to impose, but it's extremely coercive. And what will happen is the exit tax will have the following really demonstrable consequence. You tax people on exit after they create wealth, they're not gonna create wealth in your state. So if you're trying to figure out how some 20 year old in a garage is going to locate his or her business, they're not gonna be Hewitt and Packard and do it in Palo Alto.

Are they gonna do it in Austin, Texas, or some other state that has that? And so these states are essentially beggaring themselves because they assume, in effect, that the tax will only influence the behavior after the money is earned or collected or accreted, whereas in fact, it's going to influence everything up and down the line.

And so my prediction is that you'll see a lot of graduate students with advanced degrees in electrical engineering and so forth not setting up shop in California, because they don't wanna have to face that kind of eventuality. And we know that Palo Alto and San Francisco are not growing at anything like the rate of Austin, Texas and so forth.

And it's because of the relatively congenial environment. There's a peculiar insistence on the part of the states that are trying to wipe you out with one of these taxes or another. Is that what the tax will do is transfer wealth from you to them or to the public at large, what they could then spend on their more powerful constituencies.

But it won't influence your willingness to invest or to create wealth in a given state and that last assumption is just pure fantasy. The incentive effects have to be considered.

>> Tom Church: They have to be considered. But I wanna get back to, it doesn't seem constitutional, this exit tax strategy, because states, generally speaking, right, aren't allowed to compete with another on this in a, I wanna say a business sense, will it go down constitutional?

I mean, you're talking about if it's coercive or not.

>> Richard Epstein: Look, I think what you really wanted to say is something like, look, the whole purpose of the United States Union was to sort of create a common market for trade. And a common market of trade means that people have to be able to take their assets and move them from one location to another and take themselves to move from one state or another.

And so you don't envision the United States as east Germany in 1958, where if you wish to leave, they're gonna take everything that you have, you envision as a place that the competition between the states will encourage corruption. So I actually think that it turns out that the taxes are unconstitutional.

The question is what Richard Epstein thinks and what the courts will decide is a rather different sort of stuff. In the case that I was talking about with the Florida situation, I think, as I recall, the exit tax was upheld. The argument's gonna be, that was just a case in which it was a unique set of circumstances.

You can't generalize, or that would be, hey, this is a special instance of a more general phenomenon. So like everything else, something which starts in the insurance context may or may not be carried over to anywhere else. So if you're trying to figure out what the way this thing is going on, this question is sufficiently open that one of the things that you actually have to do is figure out who the justices are, who the judges are, who are gonna decide this thing.

The American tax system in many cases has tolerated lots of retroactive taxes and circumstances that I regard as utterly horrific. But most of the cases that you see are ones that say, well, there's special circumstances. We made a miscalculation with respect. We thought the effect of this particular deduction would be, and since we gave away too much money earlier on, we've got to take it back later on.

There's a case called Carlton which has exactly that kind of a rationale. And so the issue then is, can you get this out of special circumstances to saying, we don't care why it is that we did it in the previous case, if you got the wealth, we can tax it.

Now, there have been a number of learned scholars who have claimed that this is, in fact the case. Looking at previous precedent, I think on the precedents, they're wrong. And let me tell you what the key difference is from the earlier cases. In the earlier cases, what we did is we sustained the estate tax and we sustained the gift tax, and these were taxes that were imposed upon the transfer of property from one individual to another.

And it was generally stated, dubiously, in my view, that the ability to transfer property across generation is a privilege, and the government can decide that it can tax that particular privilege. This may be right or this may be wrong, but the key element in all the earlier cases, a case called Magoon, which is an Illinois case.

And then there's a Federal case whose name slips my mind for the second, which said this, Knowlton and Moore was the second case, it's a tax on the privileged. In this particular case, you're not moving the property anywhere. So there's no transfer at all to which you get a tax.

So you're now having to say it's not on the transfer, it's on the ownership. Now, there's a big difference. If you're dealing with a transfer tax, generally speaking, you could transfer the thing only once and so they get you and so forth. If you're dealing with a wealth tax, they can do it at this time next year, the year after that.

And so it's a much more dangerous kind of thing because it's more comprehensive. The offset is usually with estate taxes, they very quickly get up to 40 or 50% or something of that sort, which is highly confiscatory, but nonetheless generally legal. Whereas with the wealth tax, nobody is thinking of taking a 40% of you at one shot.

But you have to sort of look at it this way. There's still gonna be the estate tax at the end of the day, and the exemption from that is fine for real people like you and me. It's, say, now around 23 or $24 million a year for a couple, I mean, for the death of a couple.

But you're talking about people with 500,000, a million dollars, a billion dollars or whatever it is. That exemption doesn't get you very far. The way you have to think about the estate tax and the wealth tax is every year they're gonna hit you for 3% of this stuff and next year they're gonna hit you for 3% again.

And then when it's all done and you die, they're gonna hit you for a very, very large amount. Well, it doesn't take a genius to realize that you're working for the government under these circumstances. And the combined effect of an estate tax on the one hand, a wealth tax on another is going to be very, very heavy.

I have never liked the estate tax and let me give you the simple explanation. You have somebody who's 45 years at home, they have a spouse and two small children, and they die and they get hit with a tax. It's a heavy tax at the peak of life, it reaches maximum dislocation.

Somebody else has to pay the estate tax, only they live to 93 years old. They've given away most of their money. The practical incidence of the tax, given the fact that there's a 40 year difference from the time of its imposition and a huge difference in the amount of wealth that could be transferred beforehand.

It's basically a tax, depending on how old you are, can vary by amount of 100 fold. And it seems to me that taxes like that just don't make any kind of sense. And indeed, when I teach estate planning, you begin the class and there's a really a very effective way to avoid the estate tax, which is to be immortal.

And if you can't do that, try to be very, very old when you die. This is just not the way you wanna run this system. And the advantage of an income tax or a consumption tax is that it's on an annual basis. It's always on a fraction of what it is that you've earned.

It turns out there's relatively little strategic behavior in that because you're taxing somebody when their assets are reasonably liquid, and so they could turn it over to the government and still keep the rest of it. When you have this unrealization requirement, you can have a family business which may be worth, say, $100 million.

They decide to pose a wealth tax on you, say, $2 million. What are you supposed to do? You can't take in outsiders as shareholders and still run the business. If you start putting a lien on the property, a bank's gonna demand a lot of interest, because what the lien is for is to pay off money to somebody else.

It's not to borrow, to use the money that you've borrowed in order to create useful assets. So the entire dynamics of paying for a wealth tax, either immediately or on time, is going to be subject to an enormous amount of disputation and so forth. So what is it that you're gonna do?

You're gonna be walking into an unknown trying to figure out how it is that you structure these things. And there is the following thing. The government has infinite powers to be inconsistent and arbitrary, and taxpayers have infinite power to figure out how it is. They're gonna try to realign their assets that in order to escape detection and compensation, they'll divide assets up within families.

They'll move them to different jurisdictions, they'll make them deliberately illiquid. They'll do all sorts of things to try to reduce their value for the tax man without reducing the value for themselves. And this is a very destructive kind of circumstance. What you want people to do is to say, when they pay taxes, I'm paying taxes because I've been better off with the system that has generated it.

You don't want them to pay taxes and say, well, my wealth went down 10% this year. Now I got to pay 2% more. And one of the things I mentioned in this article, rich people are not invulnerable to economic cycles. And in the United States, the wealthy people managed to lose $600 billion this past year.

Worldwide, it was 2 trillion. Every financial estimate that you had of what the wealthcap could generate, is gonna be subject to these huge fluctuations in wealth. And now, just put it this way, what you do is you get the tax assessed on January 1st, 2023, and it's a really high number.

You get to pay it on January 1st, 2024, and it turns out that half the wealth has disappeared. It's going to be a real nightmare because the fluctuations in stock and bond markets are such that the collection of this tax on a deferred basis is gonna create some real anomalies in both directions, paying a tiny fraction in some cases and a huge fraction in the other.

Depending on which way the market moves.

>> Tom Church: Let's end by talking about one alternative. Many economists will look at the wealth tax and say this is an inefficient way to tax the wealthy, instead, let's tax consumption. Then you don't have to worry about valuations, any of this. Its just people have a lot of money and they spend money, then they pay taxes on it.

So in front of, well, not in front of Congress, but at least being proposed is the fair tax plan from a small set of GOP members who have proposed getting rid of all individual income and payroll taxes, corporate. Taxes, estate taxes, cap and gains and dividends, and replacing everything with a 23% national sales tax rate.

Now I don't think it's going anywhere, but give me your reactions.

>> Richard Epstein: Okay, well, first of all, there's a consumption tax and there's a sales tax, and they're somewhat different thing. Sales tax is, every time you enter into a particular transaction, you're gonna have to pay a value-added fee of one form or another.

What it does is it doesn't necessarily tax consumption because you could pay that on a capital asset that you're going to buy, and it's not gonna be reduced because you're going to not consume the particular element. One of the advantages of the value added tax, I think that people say, is you don't have to file a return.

And many libertarians like this particular tax, because once you have it in that particular way, the government doesn't get to keep a dossier on what you've earned. It would just simply the transactions get taxed, the money gets paid, but they don't have to report who is paying the tax.

They only have to report that the transaction has happened and I think there's a lot to be said for that. The reason why so many people are opposed to it is everybody says this is a great idea and then they'll add it on top of everything else. So making it good is extremely difficult because you put it into place and then all of a sudden the other taxes start to creep back in.

And now you've got n set of taxes instead of n minus one set of taxes, and this one is very big. A consumption tax is quite different and I'm a fan of a consumption tax. What happens is, if you look at income, the way in which you earn money turns out to make a great deal of difference.

So if you get appreciation on a capital asset, now you're taxed in one fashion. If it turns out you've earned income on a job, you're taxed in a very number fashion. Like everything else, pure types don't turn out to be pure types all the way down. So suppose what you do is you form a corporation, and part of the compensation you get is in fact in the form of shares or payments from the business down the road.

And you look at that money, you can say, hey, I made an investment in that. Is that a return on my investment, so a capital gain or a dividend? Hey, I've also worked in this business, so is it ordinary income? And all this carried interest stuff is essentially an endless fight trying to figure out how much of the gain that you get from being an entrepreneur, whos made an individual investment gets taxed on the income tax side and on the capital gains side.

What happens with a consumption tax is when the money comes in and is spent, we simply don't care how it was raised. So it doesn't matter whether it comes from capital gains or from ordinary assets or whatever. To do this is a little bit tricky. You certainly don't wanna be sort of measuring each individual transaction to figure out how much is saved or not.

I've always thought that it worked best with a kind of a lockbox technique. What you do is you get wealth, and you can put it into this lockbox, you can invest it in whatever way you want. The appreciation escapes taxation until you take the money out of the lockbox.

And when we take the money out of the lockbox, that's when we tax it. The whole amount, the 23% or whatever the number is. We don't wait to see when it's spent on individual situation. And then people can control the tax by deciding when they get the money out in order to do things.

And there's a lot of sense to doing it in that particular way. The argument against it is if you do it as a consumption tax, the base is necessarily smaller than if you do it as an income tax. Because an income tax puts a tax on money that is later gonna be used for investment.

Whereas a consumption tax does not tax money which is set aside in the lockbox and used for investment purposes. So you'd have to have a higher rate on the consumption tax to match what the income tax is going to provide you, I think it's probably worth it under these circumstances.

I think, in fact, it gets rid of a great deal of difficulties. If I were to try to tell you all of the complications that arise under the income tax, not only with respecting the cash, but taxing marketable and not so marketable securities. It would take a very long time to go to spin-offs and split-ups between corporations, reorganizations by way of recapitalization, merger, and so forth.

They all have very, very special rules. And what is characteristic of many tax rules is it's sometimes just a dollar's worth of difference that tells you this is not a tax-free reorganization, it's a sale. If you get 80% of the consideration in stock, that's a reorganization, 79%, it turns out to be a sale.

So people are always worried about falling off the cliff under these things, under the income tax. And that's why they pay the big bucks to tax lawyers to keep them from harm's way. So I think it's a perfectly responsible discussion. But the discussion about the income tax versus the consumption tax is one within the traditional parameters of tax theory.

The stuff that we're going on with respect to the wealth tax and with respect to taxing on unrealized gain is moving into very dangerous treatment. The basic theorem of tax principles should be as follows. First, what you do is you figure out what the optimal tax structure is.

And I think it has all of the rules dealing with realization and what they call non-recognition. You get property in a form that's not valuable, you don't tax it, you wait till it's converted a bit. And then what you do is, once you know what the rules of the game are, you set the rates to meet your revenue targets.

And what these people are trying to do is to expand the tax base beyond the income stuff. And they're playing it in a way which is gonna be quite deadly. Because by the time you engage in systematic confiscation, you're gonna see vast destruction in the amount of wealth in question.

If the states do it, you're gonna see a huge tilt to places like Texas and Alabama, anything colored red. And if you do it on a national level, what's gonna happen is foreign investment will dry up. And many people will renounce their citizenship in order to take the benefit of lower tax rates elsewhere.

>> Tom Church: You've been listening to The Libertarian podcast with Richard Epstein. Make sure to read Richard's weekly column, the Libertarian, published on Defining Ideas @hoover.org. If you found our conversation thought provoking, please share it with 3% of your friends, and rate the show on Apple Podcasts, or wherever you're tuning in.

For Richard Epstein, I'm Tom Church, we'll talk to you next time.

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