In this week’s article, Professor Glogower examines two proposals to reform the current tax system and improve progressivity. The first is a reformed capital income tax that would tax unrealized appreciation. The second is a wealth tax, under which individuals each year would pay a percentage of their net wealth. He evaluates these two proposals by considering their economic effects, administrability and avoidance opportunities, and constitutionality.
The author notes that if all capital produced a similar rate of return, then a reformed capital income tax and a wealth tax would be functionally equivalent: given a fixed return of x%, a y% income tax would be the same as an (x*y)% wealth tax. It is only because capital does not produce a fixed rate of return that the equivalence breaks down: relative to a reformed capital tax, a wealth tax would over-burden lower-yielding assets and would under-burden higher-yielding assets. Thus, in the real world, the normative question becomes: are we seeking to mitigate inequality of wealth or inequality of income? The former would best be served by a wealth tax, while the latter would best be served by a reformed income tax.
Perhaps the primary practical difficulty with implementing either a reformed capital income tax or a wealth tax is that of valuation. In the absence of a market transaction, determining the value of a taxpayer’s assets – real and personal, tangible and intangible – is likely to prove beyond the capacity of tax administration. However, as this difficulty is common to both proposals, the author argues that it does not appear to tip the scales one way or the other. One method – familiar from the income tax literature – to overcome the valuation issue is to wait for realization and then apply an interest charge as compensation for the deferral. The author opines that eliminating the disincentive to sell assets will produce more transactions and will supply more data that will then facilitate the valuation of unsold assets. The author also considers the possibility that under a wealth tax, taxpayers could reduce their tax base by the use of strategic debt and proposes some possible solutions for that problem.
With regard to the constitutional issue, both a wealth tax and a reformed capital tax could be subject to constitutional challenges, and the ambiguity inherent in the terms “direct tax” (Article I, Section IX) and “income” (Sixteenth Amendment) make this a contentious and unresolved issue.
The rest of the article compares the merits of the two proposals from the perspective of the goals of a progressive tax structure.
One point that I felt could have been further elaborated on was the relationship between a wealth tax and the income tax: is the wealth tax that the author is considering supposed to replace the current income tax or to complement it? Since the choice is presented as being between a reformed capital income tax and a wealth tax, it would appear that the wealth tax is intended to replace the current income tax, at least as far as income from capital is concerned (otherwise, under a reformed income tax, income from capital would be taxed once, while under a wealth tax it would be tax twice: once under the current albeit flawed income tax and once, effectively, under the wealth tax). However, if that is the case, how would other income, and particularly income from labor, be treated? Consider for instance business income, which ordinarily derives both from capital investment and from labor. If the capital investment is subject to the wealth tax, then it would presumably be necessary to extrapolate the return to labor and tax that separately (unless the wealth tax the author considers includes an individual’s human capital in the tax base, with all the attendant and much discussed problems of endowment taxation).
A follow-up point concerns the different rates of return to capital, which as the author notes can create a disparity between a wealth tax and a reformed capital income tax. The different rates of return can be traced to risk-taking, skill or labor, or luck (here). Replacing the tax on capital income with a wealth tax while retaining a tax on labor income (and presumably also on windfalls) would raise the question of how to treat these various elements of what is commonly grouped together under the over inclusive heading of return to capital.
As discussions of possibly radical reform of the tax base move to the mainstream political discourse, the academic literature must continue to provide its input into the discussion. This article is an important contribution to the field.