Wealth Taxes II: Rationales
The fourth and fifth briefs will deal with international experience, the sixth with land taxes and the seventh with lessons for South Africa.
Introduction
This brief discusses the rationales for wealth tax, eight in total; reducing inequality, a source of funding, the views of Thomas Piketty, improved horizontal and vertical tax equity, reducing tax avoidance, encouraging efficient resource use, capital levies for special purposes and finally politics and history.
Reducing inequality
Excessive inequality leads to political polarization and lower economic growth. Inequality impairs productivity when those with low incomes suffer poor health or struggle to finance their education. It further damages growth when politicians exploit political polarization to abandon sometimes unpopular yet growth friendly economic policies.
Inequality can be viewed from different but related perspectives: inequality of income, inequality of wealth, lifetime inequality (income over a lifetime) and inequality of opportunity. All these concepts offer different yet complementary insights, providing better guidance to government policies aimed at addressing inequality [1].
Over the past three decades, 53 per cent of countries globally have seen an increase in income inequality [2] and a growing concentration of wealth has been reported in several advanced economies after many decades of equalization. [3] Wealth is very unequally distributed – even more so than income: in advanced economies, the top 10 percent own, on average, more than half the wealth. [4]
Assessments of the effect of tax measures on inequality are scarce. [5] That said, a comprehensive case study on Sweden and Germany entitled An Annual Wealth Tax published in 1975 by Cedric Sandford, a former professor of political economy at Bath University, concluded that the since abandoned wealth taxes in these countries were ineffective at reducing inequality. A far more recent study on France, published in 2010, found that despite the existence of a wealth tax there, inequality has kept growing. [6]
From an income perspective, Scandinavian countries are amongst the most equal societies in the world. Yet Denmark, Finland and Sweden no longer impose wealth taxes, leaving only Norway and Iceland with them still in place. The reasons for the enviable levels of equality in these countries seems most likely to be the population’s buy-in to social democracy, as well as effective centralized bargaining by trade unions [7] that represent around 70 percent of the total workforce for most these countries. [8]
A source of funding
Designing a broad tax base that provides stable and sustainable sources of revenue with minimal economic distortion is a central policy objective of tax authorities worldwide. While the objective may be a perennial one, it moved to the forefront of debate during the recent financial crisis when the sensitivity of some streams of government revenue to economic fluctuations became apparent at the same time as unprecedented demands were being made on expenditures. As a result, wealth taxes were re-introduced in Spain and Iceland in an attempt to raise revenue. [9]
In emerging markets the following factors pose additional risks to the fiscus:
- There has been heightened financial volatility and downward revisions of potential growth, [10] while a 1 percent decline in growth in emerging markets would on average result in a 0.3 percent of GDP deterioration in their fiscal balances.
- Estimates based on a sample of nine emerging market economies representing a cross-section of commodity exporters suggest that a 10 percent across-the-board fall in commodity prices would lead to a decline of more than 1 percent of GDP in budget revenues annually.
- Interest rate risks have increased due to potential sovereign debt rating downgrades and uncertainty around US interest rates. In the event of rating downgrades or a sudden rise in US interest rates, gross financing needs could increase sharply, particularly where the domestic investor base would be unwilling or unable to increase their holdings of government bonds.
- Contingent liabilities of state-owned enterprises too are a source of vulnerability (for example in China and South Africa). [11]
What makes the wealth tax appealing from a revenue perspective is a very large tax base. This leads proponents to believe that relatively low tax rates are sufficient to generate a substantial amount of revenue. As wealth is considerably more concentrated than income, the percentage of households liable for a recurrent wealth tax could be kept small and the rate low resulting in considerable revenue - at least in theory and assuming limited changes in behavior. [12]
Thomas Piketty
Thomas Piketty is a French economist whose work focuses on wealth and income inequality. Piketty is the author of the best-selling book Capital in the Twenty-First Century (2013), which emphasises wealth concentration and distribution over the past 250 years. Piketty is currently the most influential proponent of a progressive wealth tax.
Piketty believes that wealth tax will play an important role in public finance debates for decades to come because of at least two reasons: one theoretical and another empirical. Existing theories of optimal labour income taxation offer a useful basis for informed policy discussion but nothing close to this exists for theories of optimal capital taxation. Second, and maybe more importantly, in most OECD countries, aggregate household wealth to household income ratios have increased substantially since the 1970s, with an acceleration of the trend since the 1990s. This is due to rising asset prices (property and share prices) as well as a long-term recovery in countries strongly hit by the century’s world wars.
In theory, an increase in the capital/income ratio should push the tax mix in the direction of greater reliance on capital taxation. Piketty notes however that it would be misleading to make such predictions because historical experience suggests that the political economy of capital taxation involves complex, country specific and quantitatively important issues. [13]
Referring to a principle underpinning a number of property taxes, Piketty suggests that wealthier individuals benefit more from the protection of property rights enforced by government and therefore should contribute more to the costs associated with upholding these rights. [14]
In his earlier writings, Piketty posits that by the commitment of pledgeability, asset ownership is an important prerequisite to the access of credit: by easing funding constraints for less wealthy sub-populations, a more equitable distribution of assets might release entrepreneurship and innovation, and improve growth. [15] Some would argue that wealth taxes are a way of achieving a more equitable distribution of assets.
Piketty’s most radical proposal is a global tax on wealth. He admits that the idea is “utopian” but shouldn’t be beyond political imagination in the need for bold, dramatic efforts to combat inequality. [16] He argues that it may be made possible by the recent “revolution” in information exchange between countries - including moving toward global, automatic exchange of information.
Improving horizontal and vertical tax equity
Horizontal equity means those with the same ability to pay taxes should be taxed the same. Assume two individuals receive the same income but only one of them holds assets. The person holding assets is seen as having greater ability to pay taxes.
In cases of inherited wealth, consider a world where individuals are born with the same initial wealth (if any) and differ only in productivity. As they grow older their wealth will differ due to past labour income. In such a world, a well designed tax on labour income is sufficient and taxing wealth is just an indirect way of taxing past earnings. Now consider individuals with identical productivity but different levels of initial or inherited wealth. It is no longer true that a tax on labour income is sufficient. [17]
In a welfarist framework, the normative yardstick of tax design is individual utility and wealth is a source of utility in its own right. This includes power and command over resources, providing an advantage in bargaining situations, resulting in over-proportional political influence and rent-seeking. [18]
Vertical equity is based on the idea that those who earn more money, or have more economic resources, should be taxed at higher rates than those earning less. This idea underpins progressive income tax and is the most common income tax system globally. However, tax systems around the world have become steadily less progressive since the early 1980s. They now rely more on indirect taxes (on goods and services), which are generally less progressive than direct taxes (against corporate and personal income), reflecting most notably steep cuts in top marginal rates. [19] Taxes on capital income too are now often imposed at low effective rates or evaded. [20] Furthermore, since 2000 the labour share of income has fallen and forward technological progress might accelerate this trend through the substitution on capital for labour. So while the restoration of more progressive income taxation could contribute to a fairer distribution of tax burdens, some argue that such systems will need to be complemented with asset-based systems such as wealth tax. [21]
Wealth tax systems themselves can and have been progressive according to the amount of wealth, as advocated by Piketty.
Reducing tax avoidance
Two popular theories for using wealth tax to reduce general tax avoidance are:
a. As assets are declared, these can be used to cross-check income tax returns as there should be a close correlation between wealth in assets and income.
b. Annual asset declarations required by a wealth tax will help detect when owners do not execute a traditional sale when disposing of an asset in order to avoid paying capital gains tax.
I have found no material evidence of the above occurring in practice.
A less frequent argument for wealth tax in this regard was put forward recently by Martin Weale, Director of the National Institute of Economic and Social Research in the UK. Weale argues that if income can be easily dressed up at capital gains and the latter cannot be taxed as income, as is perhaps the case in the UK, there may be a case for a wealth tax.
Encouraging efficient resource use
Proponents argue that a wealth tax enhances economic efficiency because it induces to taxpayers to use their assets more efficiently to pay the tax or otherwise sell them to someone that can. Under this theory, investment would increase and the economy will grow faster.
From an economic perspective, the argument seems peculiar because the theory rests on the assumption that individuals are naïve and ignorant when making their investment decisions in a tax free world. Only if government puts additional pressures on taxpayers by claiming part of their wealth, the argument goes, will they be motivated to look for more profitable investment opportunities. [22]
Gabriel Zucman, an economics professor at the University of Berkley and a frequent collaborator with Piketty, does not envision that the wealth tax will have a meaningful effect on growth or investment. Zucman states that “There really isn’t any good empirical study on this question,” and “In theory, it can go in any direction. It could increase savings and investment or it could decrease savings and investment.” [23]
Capital levies for special purposes
The difference between a capital levy and wealth tax is that a capital levy is once off.
The sharp deterioration of public finances in many countries post the financial crisis has revived interest in a capital levy on private wealth to try and restore macro-financial stability/debt sustainability. Crisis-driven adjustments have tended to burden those with incomes from labour more heavily in the form of income tax surcharges. As such, some argue that wealth taxes could extend the notion of ability to pay to help bear the costs of the crisis. [24]
The appeal of such a capital levy is that if implemented before avoidance is possible and there is a belief that it will not be repeated, it does not distort behavior and may be seen as fair by some.
There is a large amount of experience to draw on, such as levies widely adopted in Europe after World War I and in Germany and Japan after World War II. The Japanese effort was a success because it was imposed by the occupying American forces, minimizing the negative impact on the reputation of subsequent sovereign government. However, all other experiences proved a failure to achieve debt reduction because delays in the introduction gave time for extensive avoidance and capital flight – in turn spurring inflation.
Currently the scope for a wealth based capital levy to restore macro-financial stability appears limited. From a sample of fifteen Euro areas countries, the IMF calculates that a tax rate of about 10% on positive net household wealth would be needed to restore debt ratios to pre crisis levels. [25]
Politics and history
Those that argue against the economic efficiency of wealth taxes find the reason for their existence in politics and history. They argue that when a candidate looking for (re-)election meets voters who know little about the economic effects of taxes, then fiscal policy appealing to the feeling of solidarity and wish for equality promises to be a successful political strategy.
Regards history, it is posited that countries like the US and UK have been reluctant to impose a wealth tax because there is a widespread belief that wealth reflects past effort and ability. In the US, feudalism has never existed, and in the UK, secure private property rights evolved very early even under monarchic rule. On the other side, as in continental Europe where wealth taxes have been common, commentators point to a supposed prevailing belief that being wealthy is the result of favourable circumstances felt to be not very respectable. These include having political protection, being born into a dynasty or simply good luck. [26]
In April 2013 a group of reporters called the International Consortium of Investigative Journalists (ICIJ) shattered the long-held view that offshore bank secrecy was impenetrable. The group had received leaks detailing around 2.5 million individual bank accounts and then uploaded them to their website. This propelled a global wave of stories about the finances of high net worth individuals, including perceived tax evasion and avoidance. This not only prompted governments to take action but further stoked public debate around wealth taxes. [27] Most recently, in November 2017, a similar leak by the ICIJ dubbed The Paradise Papers occurred, highlighting damning cases of tax abuse and questionable business practices involving multinational companies and high net worth individuals. No doubt this will promote the wealth tax debate.
Charles Collocott
Researcher
charles.c@hsf.org.za
References
[1] International Monetary Fund – Fiscal Monitor October 2017, p2
[2] International Monetary Fund – Fiscal Monitor October 2017, p3
[3] Glennerster 2012, p1
[4] International Monetary Fund – Fiscal Monitor October 2013, p38
[5] International Monetary Fund – Fiscal Monitor October 2013, p26
[6] Ristea and Trandafir 2010, p305
[7] http://www.economist.com/node/21564412
[8] http://www.worker-participation.eu/National-Industrial-Relations/Across-Europe/Trade-Unions2
[9] Lawless and Lynch 2016, p5
[10] International Monetary Fund – Fiscal Monitor October 2013, pvii
[11] Lawless and Lynch 2016, p7
[12] International Monetary Fund – Fiscal Monitor October 2013, p14
[13] Broadway, Chamberlain and Emmerson, p825 – 830
[14] Lawless and Lynch 2016, p7
[15] Iara 2015, p11
[16] https://newrepublic.com/article/117499/heres-what-we-know-about-thomas-pikettys-wealth-capital-tax
[17] Mirrlees et al. 2011 p822
[18] Iara 2015, p9 – 10
[19] International Monetary Fund – Fiscal Monitor October 2013, p34
[20] International Monetary Fund – Fiscal Monitor October 2013, p39
[21] Iara 2015, p10
[22] Schnellenbach 2012, p18
[23] https://newrepublic.com/article/117499/heres-what-we-know-about-thomas-pikettys-wealth-capital-tax
[24] Iara 2015 p10
[25] International Monetary Fund – Fiscal Monitor October 2013, p49
[26] Schnellenbach 2012, p18
[27] Ernst & Young, Wealth Under the Spotlight 2015, p5