California’s proposed wealth tax on billionaires will struggle to accurately value and tax their assets. Rather than fund the state’s massive budgetary commitments, the bill may drive away its largest taxpayers, write Ray Ball and Andrew Sutherland.
California is facing serious fiscal challenges related to its pension and retiree health obligations, Medi-Cal cost growth, Proposition 98 education funding, and climate and wildfire-related costs. Since 2019, spending from the General Fund, California’s primary operating fund, has grown by nearly 70%, or $100 billion. On the revenue side, the state has a highly progressive tax system that relies on a small number of high-income earners, which increases revenue volatility and exposes California to the risk that they will flee the state. A recent Governor’s Budget Summary highlights that the share of total resident personal income tax liability of the top 1% of income earners in the state has exceeded 40% in 17 of the past 20 years. The share fluctuates with capital gains and initial public offerings, which are difficult to forecast.
Against this backdrop, California recently passed a ballot initiative—Proposition 40, the “Billionaire Tax Act” (hereafter, the Act)—proposing a one-time retroactive 5% tax on the assets of residents with net worth exceeding $1 billion. Voters will decide whether to approve the measure in November’s general election.
Unlike income or sales taxes, which are assessed on realized flows, wealth taxes are assessed on stocks of assets. Under the Act, the tax would be assessed on various assets owned by billionaires, including commodities, ownership interests in firms with publicly traded securities, ownership interests in private firms, real estate, and artwork.
In this article, we discuss the perverse incentives that wealth taxes create and describe problems and inequities associated with measuring wealth using standard accounting practices, which the Act intends to employ. We also question whether the design of the proposed tax is consistent with the rationale given for it.
Distorting future investment incentives
The effects of the Act on future taxpayer behavior might seem to be limited because it would impose a one-time tax on California resident billionaires as of January 1, 2026. However, given the structural fiscal challenges facing California, and a populist wave in the state that shows little indication of diminishing, it would seem rational for actual and potential billionaires to suspect that further wealth taxes will be levied on them in future. There is also the possibility that in the future, the wealth threshold will be reduced to below $1 billion. Channeling Milton Friedman, nothing is so permanent as a temporary tax. The United States federal income tax originated as a temporary measure to fund the Civil War; Britain’s was to fight Napoleon.
Anticipating such developments, wealthy people might flee the state, taking with them their companies and the employment, tax revenue, and other benefits those companies generate. They might also start diverting their investments away from the types of assets that are more likely to be captured by the wealth tax. Capital flight would only worsen the very budget problems that the wealth tax was designed to address.
Valuing private firms presents many problems
It should come as no surprise that much of the wealth generated by California billionaires is in the form of ownership interests in privately held firms. Many of the largest technology companies were founded in California, and the state maintains a vibrant innovation ecosystem. However, assessing taxes on private firm ownership is challenging. Whereas shares in public companies are traded in liquid markets and have observable prices, there are no quoted, arm’s-length prices for private firms.
The Act therefore proposes the following valuation scheme for private firm shares:
The sum of the book value of the business entity according to generally accepted accounting principles [GAAP] as of the end of the tax year plus a present value multiplier of 7.5 times the annual book profits of the business entity-as averaged over the current tax year and the preceding two tax years, if available-according to GAAP. (pp. 14-15).
This proposal introduces several complications.
First, many private firms do not prepare audited GAAP-compliant financial statements. A recent survey of chief financial officers at U.S. private firms found that only 68% prepare financial statements using GAAP. Of this group, only 60% undergo financial statement audits. Unsophisticated reporting is prevalent among the emerging technology firms that are vital to California’s economy. How, then, will the state assess a wealth tax on the book value of the assets and book income if firms are not using a consistent reporting standard or subjecting their financial statements to external verification?
Second, even if a company prepares GAAP-based financials. GAAP affords management considerable discretion in making estimates that meaningfully affect asset and income numbers (depreciation is but one example). This discretion can be abused to reduce a billionaire’s tax burden.
Third, GAAP produces inconsistent results across companies and sectors. Notably, for a given amount of expenditure on assets, two firms can have entirely different book values depending on whether they spent the money on intangibles such as research versus tangible assets such as real estate or equipment. Effectively, the Act would impose different taxes on firms based on their sector, which introduces equity and economic efficiency issues.
Finally, even supposing that the state can determine the “right” book values and income for each firm, there is no agreed-upon approach for estimating a valuation based on accounting numbers. Firms differ in their growth prospects, management quality, competition, and other characteristics that can have a first-order effect on valuations.
Forced asset sales
In addition to the problem of valuing private firms, some categories of assets have low cash yields, which means the only way to pay a tax on the asset may be to sell all or part of it. The obvious example is art, which produces no cash income and incurs holding costs such as storage and insurance, so it typically produces a negative cash yield. Less obvious—but potentially much more important for California—is the case of investments by entrepreneurs in businesses whose values are based on future growth prospects. These businesses are typically years away from paying dividends or repurchasing owners’ stock. In the extreme, the tax could force entrepreneurs whose wealth is entirely held in high-growth businesses to sell 5% of their holdings, with possible loss of corporate control. Unlike income taxes, wealth taxes are not based on realized outcomes, which presents unique problems.
Administrative costs of wealth tax regimes
Measurement issues such as these contribute to wealth taxes having comparatively high administrative burdens (i.e., a high cost per dollar of revenue raised). As we have discussed above, wealth taxes can impose significant appraisal and verification costs. Moreover, tax authorities often lack the information or expertise required to value and track unique assets that are common in billionaires’ portfolios. Tracking certain types of assets, such as art or gold, is particularly difficult. Overall, wealth taxes are not an efficient method of raising revenue: they distort investment incentives, often are based on shaky legal grounds, and are costly to administer.
What has been the experience with wealth taxes?
The short answer is: not good. Colombia, Norway, Spain and Switzerland currently have wealth taxes, but a considerably larger number of countries including Austria, Denmark, Finland, France, Iceland, India, Luxembourg, Sweden and the Netherlands have implemented and subsequently repealed them. The reasons given for repeal include capital flight, adverse effects on entrepreneurship and innovation, administrative costs, legal problems, and disappointing revenue. Capital flight and avoidance remains an issue for the countries that have maintained their wealth tax.
What the Act’s design reveals about the real rationale for a wealth tax
A central rationale given for the tax is to raise revenue to address California’s fiscal crisis. An additional—and apparently politically persuasive—rationale is this:
Billionaires have built their extraordinary fortunes with the help of California resources. … It therefore is both necessary and equitable to ask those who have benefited most from California’s resources to contribute proportionately to support health care, education, and nutrition in California through a one-time 5% tax on billionaire wealth. (Act, p. 4)
Yet, Californian billionaires will have created much (perhaps most) of their wealth from doing business outside of the state: in the language of the Act, with the help of the other 49 states’ resources (and those of other countries). If, say, one-twentieth of the wealth of a particular billionaire benefited from Californian resources, a 5% tax on that person’s total wealth would imply an effective 100% tax on the wealth that benefited from the use of California’s resources.
Wealth held in the share prices of public companies such as Google and Meta reflects the earnings and growth prospects of their operations in all 50 states, as well as internationally. Estimates of wealth based on the book values of ownership in private companies incorporate assets owned outside California. Their earnings typically are generated from operations around the country, perhaps internationally. Certified valuations of private companies reflect projected earnings or cash flows in multiple jurisdictions, not simply in California. If the Act truly intended to charge billionaires for their use of California’s resources, it would be designed to measure assets and earnings inside California alone. It is difficult to avoid concluding that the real motivation of the Act is to address the fact that the state spends more money than it collects.
Authors’ Disclosures: The authors report no conflicts of interest. You can read our disclosure policy here.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
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