Should We Tax Wealth and Not Profits?

Yes, we need a wealth tax, but not at the expense of taxing corporate and investment profits.

In the inaugural contribution to this discussion series, A Business Case for a Wealth Tax, enterprise analyst Douglas Hopkins argues for replacing the current federal tax on investment and corporate income, as well as the estate tax, with an annual tax on wealth of over $250,000.

Such an annual wealth tax, Hopkins holds, would encourage a more productive allocation of capital, equalize tax rates on labor and capital, and ultimately result in more job creation.

By taxing profits but not wealth, he adds, we’re currently subsidizing unproductive capital. Substituting a wealth tax for the tax on investment income would “stimulate an aggressive redeployment of capital in search of more productive opportunities — and trigger a massive stimulus investment program financed entirely with private capital.”

Would this proposed tax, in actual practice, have these impacts? I have my doubts. For starters, I see difficult enforcement issues. The line between investment income and labor income has always been blurry at best. Tax avoidance planners are “earning” small fortunes today turning income from labor into investment income.

But I would still be uncomfortable even if we could solve enforcement issues like this one.  The reason? Pardon my skepticism, but it seems that replacing taxes on profits with an annual tax on wealth would reward two groups above all others: investors who make high-risk investments and succeed and those who build successful enterprises with “sweat equity.” Indeed, under this proposed approach, the most lightly taxed Americans would be those who manage to reap windfall profits.

The math actually is easy to understand. Our starting point: the Hopkins approximation of the appropriate rate for the wealth tax.

“If we assume an average available return on investment target of between 6 and 8 percent,” he writes, “a 25 percent income tax rate would be equal to a 1.5 to 2 percent annual tax on net wealth.”

Let’s go with a 2 percent rate. For investors who hit the 8 percent target return on investment, their wealth tax would indeed equate to a 25 percent tax on investment income.

But what would happen to the risk-averse crowd? That grouping would include many people who can’t afford to lose capital. I’m thinking specifically here of retirees. What would be the effective income tax rate on their paltry 2 percent return on treasury bonds and certificates of deposit? Yes, your math is correct. A 2 percent wealth tax rate would be the equivalent of a 100 percent income tax rate.[pullquote]If we relied exclusively on a wealth tax and a tax on income from labor, our taxes would be more regressive.[/pullquote]

How about those fortunate souls who strike it rich? How would they fare? Really well. Suppose Warren turned his $1 million investment into $10 million in one year. His wealth tax then would be $200,000, an effective rate of barely more than 2 percent on his investment gain. Yes, Warren would have to continue paying the annual tax on his increased wealth, but further increases in wealth would cover the tax in subsequent years.

Meanwhile, in the search Hopkins envisions for “more productive opportunities,” which group would succeed, those with modest wealth or those with substantial wealth? If history is a guide, the latter group would. The rate of return on investments increases as wealth increases.

That means that if we relied for our revenue exclusively on a wealth tax and a tax on income from labor, as Hopkins proposes, our effective rate of tax on income would be regressive. The wealthiest would pay the lowest effective tax rate.

Which raises the question: Under a tax system that taxes least very wealthy people who make stupendous profits from their investments, how could wealth not become even more concentrated?

Bob Lord, an Institute for Policy Studies associate fellow, practices law in Phoenix.