Why Wealth Taxes Have Always Been a Terrible Idea

There is a good reason we don’t tax wealth directly. Actually, there are many good reasons. But that’s not stopping some states from giving it a try.

The best thing to be said about their efforts is that they probably won’t work. But it’s still a bad idea because even attempting to collect this tax will require resources states don’t have.

There are much more effective options for targeting wealthy people for tax revenue that are better for the economy. Some we’re already doing, such as state property taxes, federal capital gains taxes and estate taxes on inheritances. The last two are collected upon an event, when assets are sold or are transferred to another person.

6 States’ Plans

But new bills introduced this week by California and Washington propose taxing their richest residents 1% to 1.5% each year. Four other states including New York and Illinois propose taxing unrealized capital gains, or taxing wealth based on how much it grew in the last year whether or not you sold any assets. How these states will handle assets that lost value is unclear.

Crafting good tax policy starts with a question: How much will it distort economic behavior?

Taxes that impose the fewest distortions incur the least waste and harm to the economy. Many economists argue that wealth taxes create the most distortions, followed by income and consumption taxes.

The problem with wealth taxes is that they discourage saving and investment. A 1% or 2% wealth tax may sound small, but it’s actually very large compared with current tax rates. Since it’s levied each year, it’s better compared to our current taxes on realized capital income.

If your assets return 4% in a year, a 1% wealth tax is the same as a 25% capital income tax, and that is on top of existing federal capital gains taxes. These plans drastically reduce the return on risky investment, and rewarding risk is an important element of economic growth.

Implementation Woes

But even if you don’t think such things are important, the wealth tax bills are a bad idea because they’ll be impossible to implement effectively. They may not even be constitutional. But they’re certainly impractical. Income is relatively easy to measure: Your employer sends you a regular paycheck that can be documented and has an objective value.

Overall wealth, and unrealized capital gains in particular, are much harder to measure. On what day do you assess the tax liability? What if asset values fall between when the tax is assessed and the tax bill is due?

If the result of such a tax is that people sell their stocks and bonds around the same time each year to pay their tax bills and just generally lower the return on investments, it can depress asset values for everyone, not just the wealthy.

Very rich people also tend to hold a lot of their wealth in assets that aren’t publicly traded, either in private equity, in the businesses they’ve started, fine art or other possessions. California claims it will hire people to make this assessment. But it’s not easy.

The arbitrary nature of valuing a private asset is a big reason why many people think private equity returns are unreliable. And because privately held assets are so hard to value and easy to manipulate, it creates an incentive to keep assets private for longer and avoid public markets.