Economists have no professional expertise to object to redistribution or argue for it. You may not like redistribution for political, moral, or other reasons, or you may be all for it, but economists have no special insights into the right amount of redistribution. If it were possible to take money from A and give it to B without creating any adverse incentives, economists would have no special standing to cheer or to object.
Economists can tell us about incentives. Economists can point out that taking money from A and giving it to B causes A and B to change behavior, usually in ways that make things worse for all of us. Economics can tell us something about tax rates but not much about taxes.
Thus, the theory of optimal taxation is straightforward. It answers the following question: How can the government raise a given amount of tax revenue while generating the least perverse disincentives? The theory of optimal redistribution offers an additional wrinkle: How can the government give money away while generating the least perverse disincentives to recipients as well as payers?
Disincentives include evasion—what accounting moves will people make to avoid taxes? And disincentives include changes to economic behavior—will people move, stop working, invest less, choose different careers, or make other choices in response to taxes? Evasion loses the government revenue and employs a lot of lawyers and accountants. But the real damage to the economy comes from the behavioral disincentives.
In this traditional understanding of how to analyze taxes, the wealth tax is a very inefficient way for the government to raise money. It generates a swarm of avoidance and does a lot of economic damage per dollar raised. That is why most of Europe has abandoned wealth taxes and the United States has not imposed one.
One basic conclusion of optimal tax theory is “don’t tax rates of return.” Wealth taxes essentially impose a heavy tax on the rate of return to savings and investment. If you consume money fast rather than invest it, you save a bundle of wealth taxes. People react to a tax on rates of return by saving less and consuming more. Over the long run, even small changes in consumption versus investment behavior result in a lot less investment capital. Like any other famous result in economics, of course, this one attracts a beehive of theorists looking for ways to unseat it, but in my view, it is pretty solid. It stems essentially from the principle to tax inelastic things and not tax elastic things.
A tax on rates of return taxes when you consume, not your overall level of consumption. You have some money. Should you consume it all today or invest it and consume tomorrow? If there is a high tax on rates of return, you consume more today and less tomorrow to avoid the tax. It is like taxing groceries at Whole Foods but not at Safeway. A better tax would tax consumption equally today and tomorrow and not distort when you choose to consume.
Put another way, the wealth tax—like a rate of return tax—taxes money that has already been taxed. People earn money, pay taxes on it, invest it, and then pay taxes again. The government should only tax it once. A great lie is that the rich pay lower taxes than us when tax rates on capital are lower than tax rates on wages. It is a lie because it only counts the second‐round tax on the returns to savings, not the first‐round tax on the income that produced the savings.17
A substantial wealth tax would be a neon sign to the wealthy: Don’t save your wealth, consume it now! Take a private jet on a round‐the‐world tour! Give your money away to political candidates before it can be taxed! (I highlight that because supporters argue that a wealth tax would reduce the political influence of the wealthy. But its incentives are the opposite.) Also, a substantial wealth tax screams: don’t get wealthy in the first place by working hard or starting a business because the government will just take it away from you!
A progressive wealth tax, like the progressive income tax, strongly discourages risk taking. Suppose you have $20 million and a choice between investing in a Silicon Valley startup with a 1 in 4 chance of making $100 million or in the quiet safety of government bonds. A progressive wealth tax induces people to invest in the government bonds. If you are choosing careers between entrepreneur and lawyer, the wealth tax tells you to become a lawyer—especially a tax lawyer.
Underlying this analysis are the two distinctive features of modern economics: decisions are made comparing the present to the future, and considering risk, decisions respond to incentives.
A wealth tax also focuses its disincentive to invest on people who have already made a lot of money. But who will fund the next immensely valuable company? A wealth tax means that the people who made the last successful investment will not make the next one. But people who have been successful at starting companies in the past have skill at it and are precisely the ones we want investing in and starting new companies.
Now, optimal taxation theory does say that a wealth tax can be a perfect tax—if the government confiscates wealth completely and unexpectedly and promises credibly to never do it again. That way, the government gets the revenue but produces no distortions. People have no choice but to go back to work and save and build that wealth up again. Such a “capital levy” is a true tax on wealth without taxing rates of return.
The catch: such a tax has to be truly unexpected and happen only once. If people see it coming, they scramble to get out of the way. And having been impoverished once, people wonder if maybe the government might do it again; then they refuse to work, save, and build wealth that might be taken again. Capital levies are something governments can do only in extremely rare, visible, once‐per‐century crises, with some strong precommitment never to do it again. That is not the currently proposed wealth tax!
The proposed wealth tax would tax away the incentive to get rich. That is bad because people get rich by inventing new and better products, starting new companies, increasing efficiencies, and lowering prices.
Advocates belittle these arguments with a claim that the wealth tax rate is small. A rule of thumb from the theory of taxation is that the economic damage of a tax is proportional to the square of the tax rate. Roughly, the damage equals the price distortion times the quantity distortion. The quantity is proportional to the price, so damage is price squared.
So, a 2 percent or even 6 percent wealth tax rate might not seem so bad. But one should compare those tax rates to the rate of return, not to the principal amount. Take a fixed‐income investment, which these days may only pay interest income of 1 percent per year. We currently tax that interest income at federal, state, and local levels. If you pay a 50 percent income tax, then you get 0.5 percent return after taxes. A 0.5 percent wealth tax is the same as a 50 percent income tax in this case. A 6 percent wealth tax would be effectively a 600 percent capital income tax rate!
Hank Adler and Madison Spach in the Wall Street Journal noted that to pay a wealth tax you have to sell assets, which multiplies the size of the tax.18 If you sell assets, you have to pay federal and state capital gains tax in addition to paying the wealth tax: