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I wrote on wealth taxes last week, reporting on Emmanuel Saez and Gabriel Zucman’s latest analyses. But the wealth tax is a gift that keeps giving, because more and more interesting work on wealth taxes is being put out. There is, of course, Thomas Piketty’s latest book, which is garnering reviews in English although the book is currently only available in French. Read, for example, Leonid Bershidsky’s review, which says Piketty redefines “radical” by calling for a 90 per cent (!) wealth tax on the biggest fortunes to restore equality and fairness.

But the most interesting by far is a working paper just released by Fatih Guvenen and a team of co-authors, which makes a very different argument: that a wealth tax is good for economic productivity because it increases the rewards for productive investments relative to unproductive ones. One might say the wealth tax acts as capitalism’s handmaiden by rewarding good entrepreneurs and punishing bad ones.

The authors’ starting point is the ample evidence that investment ability is “heterogeneous”, ie some people are better at putting capital to work productively than others. But the economic models traditionally used to compute the best way to tax the economy, and capital in particular, have usually assumed away these differences.

Taking them seriously goes a long way to explaining the actual patterns of the accumulation and increased concentration of wealth in most countries in the past 40 years. But it also has profound implications for the economy’s overall ability to grow its potential for creating prosperity by investing in productive capital. Here is a simple explanation why:

“Two entrepreneurs start out with the same wealth level . . . but earn different returns on their wealth [say 0 and 20 per cent]. Under capital income taxation, the unproductive (first) entrepreneur will escape taxation because he generates no income, and the tax burden will fall entirely on the more productive (second) entrepreneur because he generates positive capital income. Under wealth taxation, on the other hand, both entrepreneurs will pay the same amount of tax on wealth regardless of their productivity, which will expand the tax base, shift the tax burden toward the unproductive entrepreneur, and reduce (potential) tax distortions on the productive entrepreneur.[If] differences in productivity are persistent, a wealth tax will gradually prune the wealth of idle entrepreneurs and boost that of successful ones, leading to a more efficient allocation of the aggregate capital stock, in turn raising productivity and output. In this sense, wealth taxation has a ‘use-it-or-lose-it’ effect that is not present in capital income taxation.”

The potential of a wealth tax to boost productivity, at least in theory, is almost entirely missing from the political and policy debate around actual wealth taxes or proposals for them. That is a huge shortcoming, because Guvenen and his colleagues find that this potential is surprisingly large.

They carry out two quantified thought experiments on the productivity gains a wealth tax could bring. The first is a revenue-neutral tax reform in the US that would replace the existing system that taxes capital income with a tax on capital (wealth) holdings, bringing in the same amount of money for the government. The productivity boost that would result (measured in consumption per person per year) is 7 per cent to 8 per cent. That is a huge number; it could undo most of the shortfall of US output from the pre-crisis trend. Note how a wealth tax brings these gains: it is by allocating capital more efficiently (to those who invest it better) and incentivising a larger accumulation of capital as a consequence.

Their second thought experiment calculates the best way to set rates (flat rather than progressive) rates for taxes on wealth holdings, capital income and labour income simultaneously. They find that the optimal wealth tax rate is about 3 per cent, the rate proposed by Saez and Zucman for the very wealthiest. That sizeable tax, in turn, allows for cutting labour taxes from current levels, to 14.5 per cent. In this scenario prosperity would again increase by allocating capital better but also by encouraging people to work more — with consumption both higher in aggregate and more equally distributed than with today’s tax system.

Put simply, “wealth taxation can increase efficiency, grow the economy, and reduce inequality all at once”.

A particularly interesting aspect of the wealth tax is that it is likely to hit those who have held their wealth longer (heirs or older entrepreneurs, who are likely to be or have become less productive) and help those who have yet to make their fortune (productive young entrepreneurs). It does, therefore, strike a direct blow at the rentier economy (on which do read Martin Wolf’s sweeping indictment), just like the wealth tax proposals of Piketty, Saez and Zucman. But the two strands of wealth tax proponents emphasise different motivations. The Piketty-Saez-Zucman camp highlights the unfairness and power inequality that come with inherited or accumulated wealth. For Guvenen and his colleagues, however, the problem with such wealth is that it is wasted, and a wealth tax would put capital in more productive hands.

Both arguments can of course be valid. But Guvenen’s deserves greater attention — partly because it is newer and lesser known than the other, but also because it will resonate with quite a different part of the political spectrum.

One final mention on the economics of wealth taxes. Last week I reported Lawrence Summers and Natasha Sarin’s disagreement with Saez and Zucman over how much revenue their wealth tax proposal would raise. Summers has pointed out to me when he and Sarin contrasted the current revenue from US estate taxes of $25bn with Saez and Zucman’s expectation that a wealth tax could raise perhaps eight times more, this was not their estimate of the realistic revenue from a wealth tax. Rather they said this was a lower bound and the actual revenue would probably be higher — though they were sceptical it would get close to what Saez and Zucman think.

Other readables

  • I argued earlier this week that something is shifting in euro countries’ attitude to fiscal activism — and feel obliged to the Dutch government for promptly enacting an expansionary budget.
  • A new report on inclusive growth has measured local broad-based prosperity around the UK. It finds that traditional economic measures such as local value added miss a lot of variation in more comprehensive measures of wellbeing between communities, and highlights the differences in healthy life expectancy: “The range in average healthy life expectancy across local authorities is 16 years. This is the same as the difference between the UK and Sudan.”

Numbers news

  • The Federal Reserve cut interest rates for a second time, but splits are deepening between members of its rate-setting committee. 

Letter in response to this newsletter:

Effects of wealth tax are painfully familiar / From Harry Carney, London, UK

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