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Income tax rates are a misleading indicator

Summary:
The Wall Street Journal discusses Elizabeth Warren’s tax plan: Consider a billionaire with a ,000 investment who earns a 6% return, or , received as a capital gain, dividend or interest. If all of Ms. Warren’s taxes are implemented, he could owe 58.2% of that, or in federal tax. Plus, his entire investment would incur a 6% wealth tax, i.e., at least . The result: taxes as high as on income of for a combined tax rate of 158%. The rate would vary according to the investor’s circumstances, any state taxes, the profitability of his investments and as-yet-unspecified policy details, but tax rates of over 100% on investment income would be typical, especially for billionaires. Warren’s plan is every bit as bad as the WSJ suggests, but not for the

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The Wall Street Journal discusses Elizabeth Warren’s tax plan:

Consider a billionaire with a $1,000 investment who earns a 6% return, or $60, received as a capital gain, dividend or interest. If all of Ms. Warren’s taxes are implemented, he could owe 58.2% of that, or $35 in federal tax. Plus, his entire investment would incur a 6% wealth tax, i.e., at least $60. The result: taxes as high as $95 on income of $60 for a combined tax rate of 158%.

The rate would vary according to the investor’s circumstances, any state taxes, the profitability of his investments and as-yet-unspecified policy details, but tax rates of over 100% on investment income would be typical, especially for billionaires.

Warren’s plan is every bit as bad as the WSJ suggests, but not for the reasons they provide.  There is nothing wrong with rich people paying more in tax than they earn in income.  And this example does not actually involve a 158% income tax rate, rather the tax rate on income is 58.2% and the tax rate on wealth is 6%.

Consider the following analogy.  An Illinois farmer has a 640-acre soybean farm, which usually provides an income of $140,000/year.  In 2019 his income falls to only $10,000 due to low soybean prices.  Suppose his annual property tax bill is $12,000.  Would you say the farmer pays a 120% income tax rate?  Of course not.  And note that a property tax is similar to a wealth tax, but only applies to one type of wealth.

To see the actual problem with Warren’s plan consider a billionaire who donates a fraction of her wealth to charity.  For the remainder of her wealth she has two choices, consumption and saving.   (I.e.  choice between current consumption and future consumption.)  If she consumes the wealth immediately, then no wealth tax must be paid.  If she saves the money, then an annual wealth tax of 6% must be paid.  That distinction is illogical, unfair, and inefficient.

The reader might assume that I am just being an apologist for privileged rich people.  Not so.  I actually have no problem with very high tax rates on the rich, if done correctly.

Consider a retired billionaire with several mansions full of servants, a big yacht, and a private jet.  Assume they have an annual investment income of $50 million and an annual consumption level of $100 million.   I see no problem with making that person pay a 60% consumption tax, or even more.  If we accept the methodology of the WSJ, that tax ($60 million) would represent a 120% tax on income. It would not be an income tax, however, it would be a consumption tax.

In the past, when I’ve suggested that income is meaningless and that we need to focus on consumption, some of my progressive commenters would defend the relevance of income.  They point out that under my progressive consumption tax proposal some very thrifty rich people would pay very low rates of income tax.  Ok, but two can play that game.  If you really want to insist that income is the correct variable for tax purposes, then you open yourself up to exactly the sort of criticism made by the WSJ.

Yes, the Journal’s criticism of Warren’s plan is somewhat unfair, but only because consumption is the correct base for a tax system, not income.  And that means that Warren’s wealth tax is highly flawed for an entirely different reason. The real problem is that it favors current consumption over saving (future consumption), not that it imposes high tax rates on the rich.

Income tax rates are a misleading indicator

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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