A modest levy on the overall wealth of the very rich would allow lower incentive-distorting income tax rates for them and everyone else.
The Occupy Wall Street protests have faded from the news, while the unemployment rate fell to 8.5% in December, the lowest level since February 2009. Still, unemployment and income inequality remain justifiable concerns for tens of millions of Americans and are two of the most pressing issues in the 2012 presidential election.
Reforming the income-tax system is commonly seen as the principal way to reduce inequality. But any attempt to impose higher marginal tax rates on even moderately high income earners—as President Obama wants for families earning more than $200,000 per year—can lead to losses in economic efficiency and even to losses in sorely needed government revenue if high earners work less or seek out more loopholes and tax shelters.
The basic problem is that defining "income" becomes progressively more difficult as income and wealth rise. Straight wage income is relatively easy to define and tax for middle-income earners—through payroll taxes for Social Security or through the personal income tax. But wealthy people live much more off returns from their asset holdings. They receive capital gains, stock options, interest and dividends; and carried interest for owners of hedge funds that, to avoid double taxation, are taxed at lower rates than wage income. They may receive imputed rental income from multiple homes and major consumer durables such as automobiles, art collections or yachts, which the federal income tax misses altogether.
In order to have a fairer tax system, we should implement a new federal wealth tax in addition to the federal income tax. Unlike the current income tax, the wealth tax would not rely on how income is defined. Rather, it would require that households list all their domestic and foreign assets on, say, Dec. 31 in the relevant tax year. With a large exemption of $3 million that effectively excludes more than 95% of the population, a moderate flat tax—say 3%, on wealth so defined—could then be imposed. ...
[A] wealth tax designed to hit only the very well-off would render moot the critics' major complaint that a flatter income tax would not hit the rich hard enough. A wealth tax is a necessary political condition for much needed rationalization of the income tax.