Death by Wealth Tax

The country’s preoccupation with income inequality has become the fount of many bad ideas. Among the very worst comes from Stanford University professor of economics Ronald McKinnon. Writing in the Wall Street Journal, he proposes the most radical of reforms under the most soothing of titles: The Conservative Case for a Wealth Tax.

His argument falters at every level. To be sure, McKinnon starts out with the unexceptionable observation that inequality and unemployment remain two hot issues in the upcoming election. But he advances the ball on neither front by his respectful bow to Occupy Wall Street. Far from proposing a solution, McKinnon has become part of the problem.

Attacks on the inequality of wealth always miscarry when they fail to show that the wealth in question has been acquired by tainted means. Otherwise, the hard work that improves the lot of one person, without reducing the wealth of anyone else, should count as a social improvement.

   
 Illustration by Barbara Kelley

The great danger of egalitarianism is that it is all too comfortable leveling down, such that the cardinal virtue of any reduction of inequality is that it hurts the rich more than it does the poor. In such a system, the government invests public resources to achieve an end that does nothing to benefit members of either group. Worse still, our prolonged economic downturn undermines our overblown tax and transfer economy. Less wealth in the hands of the rich reduces the revenues that federal and state governments have available to spend on their preferred clientele.

As to unemployment, the blunt truth is that all grand monetary and fiscal policies will fall short without extensive deregulation of labor markets. The Obama jobs bill, which still languishes in Congress, is so larded with mindless restrictions that even the most ardent Keynesian should blush to mention it in polite company.

Yet, if McKinnon’s ends are dubious, the means he chooses to achieve them are far worse. He begins his discussion by stressing two key points, both true, and both misapplied. The first is that high marginal tax rates on income deter productive economic activity. The second is that the application of an income tax regime to high-net-worth individuals creates a genuine conundrum for the tax system in how best to tax the endless array of “capital gains, stock options, interest and dividends,” not to mention the stock of imputed income that arises from the ownership of second homes, tony art collections, and fancy yachts.

McKinnon thinks that a wealth tax will produce more wealth without raising marginal tax rates, and further, that it will make these other assets a source of government revenues. The payoff is a proposal to impose annually a three percent wealth tax on each person’s assets, both domestic and foreign, which exceed $3,000,000. That proposal could lead, he claims, to the rationalization of the income tax, presumably by lowering marginal tax rates, although it is hard to say by how much, given the current political climate. It also has the added virtue of hitting hard at inherited wealth, which when cautiously invested, produces relatively little income. McKinnon does not mention anything about whether he would eliminate the estate tax, but he need not worry. With this proposal in place, there will be little left to tax at death anyhow.

The wealth tax is essentially a tax on income.

The major objection to this proposal is that it fails to meet its own policy criterion. It is, for example, false to say that the wealth tax does not operate as an additional tax on income, when of course it does for the simple reason that today’s income, when saved, becomes part of tomorrow’s wealth.

Start with a hypothetical person who has zero net worth but high human capital, so that in his first year of business he earns $13 million dollars. Let us assume that this is taxed at the outset at 40 percent, so that after paying $5.2 million in ordinary taxes, he has at the end of the taxation year a sizeable asset portfolio of $7.8 million, of which $4.8 million is subject to the three percent wealth tax, producing an additional tax of $160,000. For that first year, the de facto income tax rate moves up just a bit to around 40.8 percent, not too small to notice.

That, however, is the situation after one year. Those same dollars are also subject to another tax the following year, and yet another tax the year after that. In each case, the wealth base has shrunk by the additional taxes of the previous years. In each instance, the income generated by that wealth is first taxed at the 40 percent marginal bracket, with the residue added to the wealth base. And in each case, the combination of the wealth tax on accumulated wealth and the income tax on new earnings is over 100 percent of net income.

And just to top things off, if this entrepreneur manages to earn $10 million dollars in each of the following years, he has already exhausted his $3 million exemption, so for that person, the 3 percent wealth tax hits the entire $7.8 million that remains, for an effective income tax in the first year of 41.8 percent.

For each successive year, the effective combined tax rate on accumulated wealth shoots up, savings decline, and the system falls into paralysis.  The situation gets truly dangerous in those years in which the asset base shrinks in value, for the wealth tax still remains to drive net worth even lower. In this frosty economic environment, conspicuous consumption turns out to be the most sensible response to a wealth tax, with the consequent loss of investment.

The effects of the wealth tax are far worse than this scenario plays out, because of its incredible administrative burdens. Professor McKinnon’s major area of academic expertise lies in international economics. But the key question falls outside that area of expertise into the mundane question of how to administer either an income or a wealth tax. As he rightly notes, for persons whose incomes are in cash or marketable securities, the valuation questions are generally a cinch. But for the top one percent, who are the target of a wealth tax, the taxation of income presents a bewildering set of real challenges that are not so easy for even the best experts to resolve.

I began my erratic career as a tax lawyer as a student in the late Professor Boris Bittker’s 1966 tax course at Yale Law School. The opening case was United States v. Drescher, which asked the question of how to tax a single-payment annuity, with a cost of $5,000. The annuity was payable either to the plaintiff or his beneficiary. It was also retained by the employer and not assignable by the plaintiff. Our travail with this case was not inconsiderable, because none of us understood exactly what this transaction was about.

Conspicuous consumption is the most sensible response to a wealth tax.

So Bittker, in his relentless fashion, quizzed us about whether the cost to the employer should be regarded as the correct measure of value to the employee, whether the income should be taxed now, or whether taxation should be deferred until the money was paid out under the terms of the policy. We were a collection of clueless wonders.

One obvious source of concern in this simple example was whether it made sense to tax Drescher on the value of the policy when he did not have the cash to pay it. Of course, he could pay for the annuity out of other assets, but in some cases, he might have to borrow on these assets in order to get out of the liquidity trap. And if he had to pay the money without the cash, the waspish Bittker then asked, what about the young associate who has been told that he has been made a lifetime partner of the firm? That shift in status results in a huge increase in economic value, but should it be taxed at that time? If so, what should be done in later years, if the value of the partnership increases or decreases? What should the result be when cash is distributed by the firm? Is that distribution now a return of capital on an annuity already taxed, or does it count in part as taxable income, which might be offset in part by a decline in the value of the partnership interest now that the arrangement has on average one year less to run?

The average reader will glaze over at these complexities. The practical answer is that the government will try to tax the vested value of the annuity unless there is some explicit statutory provision that calls for a different tax treatment. The standard (Haig-Simons) definition of income includes all consumption during the tax period plus any increase in net worth. But no tax law anywhere uses Haig-Simons to define the tax base. The current income taxation system thinks that discretion is the better part of valor and taxes neither. The consumption income is outside the system altogether, but the economic income is usually picked up at some later time.

Given progressive taxation, postponement of income past peak years could easily lead to a reduction in government revenue. That deferment in turn is, ironically, encouraged by the conscious Congressional decision to allow people to defer taxation on their pension plans until some future date.

One basic motif of the income tax, therefore, is to figure out the major deviations from the Haig-Simons formula to allow the system to function. I know of no serious tax lawyer who thinks that an effort to tax all increments in net worth makes sense. The question of how to tax these various items of wealth, however, does come to the fore in connection with the estate tax, which now is defined in a fashion that includes, with various bells and whistles, all of the decedent’s assets in the tax base.

The administrative complications of figuring out the estate tax are far greater than those for the income tax for one simple reason. With the income tax, defer now and pay later is always a viable strategy. With the estate tax, either the government takes its cut now or it forever holds its peace. It therefore has to engage in the thankless task of assigning value to all the complex financial pieces that remain in the decedent’s estate. For large estates, this is no easy matter, for it could include the valuation of all sorts of partial interests in privately held corporations, where there is no active share market to aid valuation. These capital structures tend to be highly complex, and the simple fractional ownership of shares is only a first estimate of value that is influenced, for example, by the control rights within the firm and the discretionary salaries, dividend policies, and growth plans of the business. It typically takes years to resolve these disputes, longer if they go to litigation. Drescher was a 1950 case that resolved disputes over Drescher’s 1939 and 1940 tax years.

We need to simplify the tax code. That means a flat tax.

Drescher is child’s play compared to the current environment.  For anyone who wants a foretaste of what the estate tax looks like, try a brief visit to the IRS website or take a gander at Form IRS 706, which must be filed for all taxable estates. It is no accident that the usual timeframe for filing an estate tax form is nine months, with frequent extensions for large estates. The liquidity issues remain difficult for family businesses and farms, so that the Internal Revenue Code contains special provisions for deferred payments. The tax collector becomes in effect a lender of last resort.

The implications for McKinnon’s proposals are enormous. The wealth tax is nothing more than an annual estate tax, at a far lower rate. There is no way that the system can work on that time cycle. Most estate taxes are for older persons who have consciously simplified their holdings prior to death. The wealth tax hits productive people at a time when their activities are highly jumbled. Liquidity is often at a low ebb. The well-to-do have stakes in venture capital firms; they have long term royalty arrangements, where the value of the contract rights depends in large measure on work that owners have yet to do. They often own foreign assets, whose valuation is heavily influenced by a wide range of local regulations. These people often have complex liabilities—guarantees on loans to closed corporations, for example—that have to be deducted from assets to give an accurate position of net worth.

All the estimates are likely to be wrong. The cost of figuring them out, moreover, is deductible from both the income and the wealth tax. The first tax year will not be closed before the second year form has to be filed. Yet its wealth base will depend on the findings of an earlier year.

The nightmare gets still worse. Once these valuations are made, almost always late, the liquidity crunch is sure to hit. The assets in question are often not of the sort on which banks are prepared to make loans. They are not of the sort that can be sold, if they can be sold at all, without destroying the internal control structure of the business. The amount of liquid assets will decline as there is an annual rush to sell them in order to cover the liabilities on the illiquid ones. Art dealers and collectors will have to unload parts of their collections in a down market. Yet once they are sold, that will trigger a downward revaluation of the retained assets. Forget about private school tuition. The new planning challenge for the wealthy is getting dinner on the table.

In the end, therefore, McKinnon has it exactly backwards. The income tax prudently backs off from all of these fearsome complications by reducing the tax base to cover only receipts in cash or cash equivalents. The lesson here is that valuation is not just the tail on the dog. It is often the dog itself. Anyone who has worked in the trenches knows that forced evaluation causes nightmares whenever it is required, whether it be for the estate tax, divorce, eminent domain, or bankruptcy. What is needed is a sense of modesty, not of adventurism.

Anyone who looks over the estate tax forms might gain some sense of why I began my academic career as a tax specialist, but have developed a fierce and abiding distaste for the entire estate tax venture. In the end, simplification should be a driving force that pushes us into a flat tax on consumption. It is a pity that this lesson has escaped Professor McKinnon.