Wealth taxes can make capital markets more efficient when they are optimally combined with lower capital gains taxes, argue Sergio Ocampo, Guttorm Schjelderup, and Floris Zoutman in new research.
High levels of wealth concentration in the United States (and many other countries) have brought renewed attention to the use of wealth taxes. Most recently, lawmakers in California endorsed Proposition 40, which would impose a one-time 5% tax on the assets of billionaires living in the state, but this is just the latest in a series of pushes for wealth taxes. Several countries already have long-standing annual wealth taxes, including Norway, Colombia, and France. In all cases the tax remains controversial and faces frequent pushback.
The debate over the merits of wealth taxes has focused on broad objectives to curb wealth inequality and concerns over the tax disincentivizing wealth accumulation. However, we argue in our recent paper that this debate misses an important aspect: Wealth taxes can be used to make capital markets more efficient when they are levied jointly with capital gains taxes. This effect is stronger when the wealth tax is used to reduce capital gains taxes.
Capital gain taxes lock in capital
To see how wealth taxes improve the working of capital markets, it is best to take a step back and consider the way we tax capital today. Most countries, including the U.S., tax capital gains instead of taxing wealth itself. Capital gains are taxed only when they are realized, which happens when an asset is sold after appreciating in value, similar to income from investments that is taxed when dividends are paid. This gives investors control over the timing of their tax payments, as payments occur only when investors choose to realize gains. These carefully timed gains are one of the key forces behind the large increase in wealth inequality we have observed in recent decades.
For example, suppose an investor owns an asset they bought for $10,000. The asset appreciates and is now worth $110,000. Selling the asset would trigger a capital gains tax today on the $100,000 gain (a tax in this case between 9-13% in California, which taxes capital gains as normal income). Alternatively, the investor can delay selling and borrow money against the asset to finance their expenditures today, without having to pay taxes on their accrued capital gains. This practice is widespread among the wealthy. More importantly, this practice generates an inefficiency in capital markets called capital lock-in. Postponing the tax can be advantageous to the investor even when the future returns on their asset are below the return available in the market.
In these cases, deferring the sale of the asset is privately optimal, but capital remains locked into a less productive investment, resulting in an inefficient use of capital. For example, with a combined state and federal capital gains tax rate of 35% and a market return of 10%, the investor would still find it optimal to delay selling even if their own private return from holding the asset is as low as 7%. This gap between the private return and the higher market return is where the efficiency cost of capital lock-in comes from. It can amount to significant losses once we take into account the billions of dollars in the portfolios of the wealthiest Americans.
This is precisely the problem with capital taxation that we study. The current tax structure generates a gap between the market return and the private return at which investors want to sell, a gap that grows as capital gains are taxed more heavily. Some investors retain low-return assets even when they have higher-return alternatives to invest because selling them would trigger the capital-gains tax. We show that a properly designed wealth tax, which applies to the historical value of an asset, can undo this distortion. This makes it so that wealth is invested where it is the most productive, instead of being locked in unproductive assets. This provides an efficiency rationale for wealth taxation that improves portfolio allocation and shifts the focus to whether money is well invested instead of who owns that wealth.
How wealth taxes unlock capital
The historical-value wealth tax operates on the past value of the asset before appreciation and returns (the $10,000 in our example above) and works by changing the after-tax returns faced by investors, making the deferral of capital gains less valuable. We show that the wealth-tax rate that unlocks capital changes depending on the capital-gains-tax rate and the market interest rate, and is about 1.5-2% for the U.S.
To see how a tax on the historical value of wealth improves efficiency, it is easier to focus on what happens when investors try to delay paying capital income taxes. They do this by delaying selling an appreciated asset, but in doing so they accrue more taxable wealth, increasing their future wealth-tax bill. At the appropriate wealth-tax rate, delaying selling no longer reduces the present value of taxes. This takes away the incentives to delay selling the asset purely to delay paying capital income taxes. Instead, delaying the sale is only profitable if the expected future return to the asset is higher than the market return. This is precisely the efficient choice. So, a wealth tax on the historical value of an asset reduces the incentive to hold relatively unproductive assets. Instead, investors are incentivized to sell their assets to shift funds to more productive ones.
The wealth tax not only unlocks capital but also raises tax revenue. This makes it possible to decrease the capital gains taxes, unlocking capital further and increasing efficiency. It is this combination of lower capital gains taxes with wealth taxes that ultimately improves portfolio allocation in capital markets. These gains have to be weighed against the costs of capital taxation. Both wealth and capital income taxes discourage saving. The point we make is that they differ on the portfolio margin: a capital gains tax creates lock-in, while a historical-value wealth tax unlocks capital.
Other research has shown more ways in which wealth taxes improve efficiency. Reducing capital income taxes in favor of wealth taxes reallocates wealth toward high-return, more productive entrepreneurs and investors with more profitable projects. This is because capital income taxes are paid precisely by entrepreneurs and investors with the highest returns, reducing the ability of profitable businesses to grow and develop as they have to forgo up to 40% of their returns to taxes, while wealth taxes are paid regardless of the profitability of the investment and do not scale up with the returns of the business. Â
So, in terms of returns, wealth taxes are only high for low-return projects, and they get progressively lower as returns increase. For example, if a project has a 20% return, a 25% capital income tax will take the first 5% of the return to pay, but a 1% wealth tax only takes 1% of the return to pay. Of course, if the return had been low, say 2%, the investor would rather pay the 25% capital income tax that amounts to losing 0.5% of their return, instead of the 1% wealth tax that takes half of their return.
Similarly, the same change in taxation incentivizes innovation and entrepreneurial effort. Investors and entrepreneurs can keep more of the upside of their projects for any level of wealth because their returns and profits are taxed at lower rates. Thus, they have an extra incentive to come up with new projects and manage their investments to increase their returns.
How to tax wealth
Tax design is crucial for the implementation and efficacy of wealth taxes. In particular, most proposed wealth taxes are taxes on the market value of wealth, which differs from the historical-value wealth tax we study. A market-value wealth tax combines two instruments: a tax on historical wealth and a tax on accrued capital gains. The accrued-gain component taxes returns before realization; those gains are then taxed again when eventually realized. Moreover, taxing unrealized capital gains generates capital lock-out, inducing investors to sell productive assets too early in order to pay the tax.
We are therefore not proposing to tax accrued gains. The mechanism we study relies on taxing the historical value of wealth carried into each period (as is currently done in Norway). This requires no real-time valuation of capital gains and does not tax contemporaneous returns. Historical value also does not mean freezing the original purchase price forever: the way the base is updated when investors make new investments matters for avoiding additional lock-in.
Capital taxes should be evaluated together by weighing the upsides and downsides of capital gains and wealth taxes. Wealth taxation is usually discussed in terms of redistribution. Our results identify a separate efficiency role: an appropriately designed wealth tax can unlock capital and improve portfolio allocation, resulting in gains from a revenue-neutral shift in the tax mix from capital-gains taxes to wealth taxes.
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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