Wealth taxes are a bad idea

Since I made the mistake yesterday of writing about my unpopular views on tax policies, let me follow up today with another one: I think wealth taxes are a bad idea and create so many unintended consequences that we are better off not introducing them in the first place.

I can already hear readers moan about how the rich banker is talking his book, but trust me, I lived in a country where there are wealth taxes (Switzerland), and even though wealth taxes are de minimis, people tried to game the system.

For one, many people used flexibility in assessing the value of hard-to-value assets to avoid paying wealth taxes. For most people, their homes are the most valuable assets they own. But homes are hard to value on a daily basis and there is considerable flexibility in how much a house is worth at any given time. Arguably not as much flexibility as the Trump Organisation claimed, but still enough to provide a significant influence on a person’s wealth tax bill.

The result is in Switzerland, people regularly have their homes revalued to a lower level in order to save on wealth taxes. Once they want to sell their homes again, they call for a new valuation and their homes miraculously increase in value. This effect is so strong that a 1% decrease in wealth taxes leads to a 20% increase in house prices after six years.

In a review of the literature on wealth taxes, Robin Morgan from Harvard Law School showed that this is a predictable behavioural response to the introduction of wealth taxes. Because wealth taxes are raised on the entire value of an asset (principal plus any return on it) while capital gains taxes are raised only on the return, even a small wealth tax is equivalent to a large capital gains tax. To give you an idea, Morgan states that the historic average capital gains taxes in the US are equivalent to a 1.18% wealth tax in terms of total impact on household cash flows. Introducing a wealth tax of that magnitude would effectively double the capital gains tax rate we had in the past. However, given low capital gains taxes in recent decades, the impact of introducing even a small wealth tax would be much larger today. Introducing a 3% wealth tax today would be equivalent to raising capital gains taxes by 724%, according to Morgan’s calculations.

Guess what? If a government tried to raise capital gains taxes by more than 700% it would be a political nonstarter and at the same time, nobody would be surprised if people found all kinds of creative ways to avoid paying these exorbitant capital gains taxes.

One way to avoid paying wealth taxes that are this high is to lower the taxable value of assets they own as we have seen already. But two other levers may be pulled to reduce wealth tax bills.

First, people will have a huge incentive not to invest in risky ventures anymore. Whether it is equity investments, venture capital or simply starting a business. If people are subject to wealth taxes, they will be more reluctant to do any of these things because if they are successful, they will face a massive tax bill for being successful. And if people are more reluctant to start a business or invest in young, fast-growing businesses, then how would we create jobs for the people who are looking for work? Small businesses have been responsible for roughly two out of three jobs created in the US between 2000 and 2021 but if fewer people are willing to start a business, job creation would inevitably slow down.

Second, people who have large wealth would simply find ways to avoid paying these taxes on assets they own. Private equity and hedge fund managers are often criticized for paying fewer taxes than their secretaries because of the carried interest tax loophole. Basically, they don’t pay taxes on investments held in their funds as long as they remain there. Once they take money out of their business, they pay long-term capital gains taxes, not income taxes on this ‘income’.

If these investments would become subject to a wealth tax that is equivalent to a capital gains tax levied every year (no deferral possible) and worth several 100% of income, these people would simply pay themselves a higher salary and pay regular income tax on that. That is fine, you may say, but the incentives don’t just stop there. The incentive for management would be to strip the business of any excess cash not immediately needed. It even provides an incentive to not invest money in future growth because future growth would be taxable as wealth. Instead, managers and shareholders would have an incentive to rob the business blind and let it go under once they got their investment back.

It is an extreme version of what infrastructure companies have been accused of doing with UK water utilities over the last three decades. Pay themselves the highest dividends possible and neglect any investment in infrastructure or maintenance. The end result is leaking pipes and sewage in our rivers. Now imagine what would happen if all businesses were run under such an incentive scheme.

In sum, if you ask me, a wealth tax would create all kinds of incentives to game the system that would make us worse off in the end. The only wealth tax that could work in practice is a de minimis wealth tax like it exists in Switzerland. But then the tax revenue for the government would be de minimis as well. And in the end, it would simply be better and more straightforward to change the capital gains tax rate. At least there, we don’t create all kinds of unintended consequences.