Last September, I proposed (“The Warren Buffett Tax”) that the most effective way to extract a lot of tax revenues from Warren Buffett would be to impose a wealth tax.  My tongue-in-cheek proposal was this:  Tally up your assets and liabilities, calculate the difference (net worth) and then pay a tax of 20% on net worth above a threshold of $20 million.  I called this the “20 after 20” plan.  Based on official estimates of household wealth, the proportion of households that would be affected by this tax is very small, only about 100,000 households or .1% of the population.  But this sub-population has approximately $9 trillion or 15% of entire household net worth.  If it could be collected, then this tax would generate huge tax proceeds, completely wiping out the federal deficit this year.  My calculation was this:  tax base of $7 trillion ($9 trillion total net worth less the threshold amount of $20 million for each of the 100,000 households that would be affected) times tax rate of 20% yields $1.4 trillion in revenues.  No pain on 99.9% of households and the budget is balanced!  That is, it is balanced for this year.  In future years even the theoretical proceeds of this tax would decline.

In a Wall Street Journal editorial¹ on Monday, January 8, Stanford Professor Ronald McKinnon proposes a similar idea.  His plan is to place a tax rate of 3% on all wealth in excess of $2 million (the “3 after 2” plan).  The McKinnon plan would affect more households (approximately 2 million, or 2%) than my plan, but the tax rate would be a lot lower.  Potential revenues from the McKinnon plan are smaller than the 20 after 20 plan, but still are pretty substantial.  The top 2% of households have about $30 trillion in net worth.  After netting the threshold of $2 million per household, this leaves a tax base of $26 trillion, 3% of which is $780 billion.

The rationale for the professor’s plan is that Republican plans to flatten the income tax structure will always be vulnerable to the charge of “tax cuts for the rich.”  By combining a flatter income tax structure with the addition of a wealth tax, this charge would be muted.

Even though I am pleased that such a leading economist as Professor McKinnon has followed in my footsteps, I would like to make one point clear:  I was only kidding!

While it is true that a wealth tax would probably find a positive reception from the Occupy Wall Street crowd, it is really not such a good idea. There are huge problems in measurement, compliance and incentives.

Measurement Issues

What is wealth and how can we measure it?  Wealth is the value of assets minus the value of liabilities.  It is easy to measure the market value of some assets, like publicly traded securities or insured bank deposits.  But it is not so easy for other assets, like non-traded securities, non-public companies, real estate and art.  And then there is the problem of coverage.  Presumably retirement funds should be included, including the value of pension fund accounts and 401K plans.  If a wealthy person funds a charitable foundation, should that be included in his or her net wealth?  If not, that is a gaping loophole.  For example, since Warren Buffett has pledged the bulk of his wealth to the Bill and Melinda Gates Foundation, if charitable foundations are not subject to tax that even the Buffett Tax won’t hit Mr. Buffett.

Compliance Issues

Even if the measurement issues could be adequately addressed, the compliance cost of implementing the tax could be enormous.  Some means of tracking or validating the values of tens of millions of homes and small businesses would have to be developed and maintained. 

Incentive Issues

There is debate about the incentive effects of a wealth tax.  One argument is that a wealth tax would encourage rich people to move out of low yielding assets like cash and take greater investment risk.  Another is that such a tax would encourage capital flight out of the U.S. as entrepreneurs moved their businesses to more tax favored countries. 

International Experience

Many countries currently have wealth taxes including France, Switzerland, Norway, The Netherlands and India.  The rates are generally about 1% on net worth above a modest threshold.  Lower rates lessen the disincentive effects, but not the measurement costs.  One study in the Netherlands concluded that the administrative cost relative to revenue raised was five times higher for the wealth tax than the income tax.  Perhaps this is one reason why many countries have eliminated the wealth tax.  The ranks of countries that formerly had a wealth tax and have subsequently eliminated it include Austria, Denmark, Finland, Germany, Iceland, Sweden and Spain.

A wealth tax is another tax on capital and likely would impair capital formation.  Capital formation is a key driver of improved productivity and economic growth.  This is where growth in real wages comes from.  If you really want the rich to pay more tax, a better direction is to create a highly progressive consumption tax where a threshold amount of consumption is not taxed at all (say, $30,000) but huge consumption expenditures are taxed at very high rates, like 100% or more.    

¹Ronald McKinnon, “The Conservative Case for a Wealth Tax,” The Wall Street Journal, January 9, 2012.