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Friday, September 22, 2023

Weekly SSRN Tax Article Review And Roundup: Elkins Reviews Morgan's Measuring Wealth Under A Wealth Tax

This week, David Elkins (Netanya; Google Scholar) reviews Robin Morgan (S.J.D. 2022, Harvard), Valuation: Measuring Wealth Under a Wealth Tax (2023).

Elkins (2018)

Valuation is the Achilles heel of any tax system that relies upon…well, valuation. Income tax does its level best to avoid valuation, often simply by adopting a head-in-the-sand attitude and ignoring anything that is difficult to value. Unrealized appreciation is perhaps the notable example but others abound: disputed income, doubtful debt provisions, and certain types of fringe benefits to name a few. On other occasions, ignorance-is-bliss is not a sustainable policy and there is no option other than to attempt the frustrating task of valuation. The theory of practice of transfer pricing is a testimony to the suspicion that the attempt is more often than not an exercise in futility. Property taxes and estate taxes are similarly plagued with problems of valuation. Consider, for instance, the dispute surrounding Michael Jackson’s estate, which the executors valued at about $7 million and the IRS valued at $1.125 billion.

Of course, not all taxes rely upon valuation. King William III’s infamous window tax required the tax collector simply to count the number of windows in a building. Tax imposed on the number of items produced, sold, or imported does not require valuation, nor does a tax paid in kind (e.g., a tithe of 10% of one’s harvest).

In this week’s feature article, Robin Morgan considers some of the problems of valuation that would arise within the context a wealth tax. Although wealth tax discussions typically focus on easy-to-value assets class such as publicly traded stocks and bonds, the author provides extensive empirical data to show that among high wealth individuals such assets constitute a relatively small portion of their portfolios.

Illiquid assets present obvious valuation issues. One complicating factor is the relatively long mean time between transactions, which can vary from months to decades in the case of residential real estate, 8-11 years in the case of institutional real estate, 40-70 years in the case of art, and 50-60 years in the case of institutional infrastructure. Furthermore, buying and selling these assets often involve heightened transaction costs. The OECD has suggested that market prices for illiquid assets should be discounted by 15% or 20% to account for these and other costs. The author notes that although such a rule would be easy to apply administratively (once the extremely difficult task of valuing the assets is accomplished), it would privilege assets with lower transaction costs. Furthermore, liquidity discounts fluctuate drastically over time. For instance, during the 2008 financial crisis, the liquidity discount of certain assets reached upwards of 50%.

Even in the case of publicly traded securities, stockholding by the very wealthy presents valuation problems. For most portfolio investors, the value of a holding is equal simply to the number of shares held times the current price per share. For those who own large amounts of stock, the calculation is complicated because one needs to consider the control premium (which makes the large block of stock more valuable) and illiquidity (which makes the large block of stock less valuable).

One of the largest headaches for a wealth tax would come from the need to value privately held businesses, which account for about 35-50% of the assets of taxpayers with reported net assets worth more than $50 million. The intrinsic value of a firm is the present value of its future profits. However, beyond contending with the unpredictability of future profits and uncertainty regarding the appropriate discount rate, we would also need to consider risk factors, including the fact that individual taxpayers tend to be under-diversified. The author also discusses some of the difficulties that arise with regard to valuing private funds.

Perhaps the most interesting section of the article is where the author considers the inclusion of human capital in the tax base. One does not ordinarily consider an individual’s capacity to earn income to be an appropriate subject of taxation, and indeed Saez and Zucman argue that a wealth tax should not tax human capital. However, the author points out that disregarding human capital may be problematic. By some estimates, most of the income derived by high-income business owners flows from human as opposed to financial capital. One practical conundrum with not including human capital in the wealth tax base is that founder-CEOs could arrange to pull out each year most of their corporation’s earnings via wages, reducing the profit of the corporation. As the value of an enterprise is a function of its expected profits, the salary expense would reduce the current valuation of the corporation. Although the author does not cite these sources, it is notable that a tax on human capital has been discussed in both the philosophical and the economic literature in the context of an endowment tax. Rawls, for one, rejected such a tax on the grounds of liberty, contending that it would effectively force individuals to exploit their natural talents in the manner most valued by the market, just in order to cover their tax liability.

The public discussion of a wealth tax, which reached a crescendo during the 2020 election campaign, seems to have abated somewhat, presumably because of doubts regarding its political feasibility (even the conceptually much more modest proposal to tax unrealized gains of the wealthiest taxpayers within the framework of the current income tax was not able to generate the necessary support). Thus, for the time being the subject of wealth taxation may be more of academic than of practical interest. However, even within the academic discourse practical considerations cannot be lightly ignored, and perhaps the foremost practical challenge that a wealth tax would face would be the problem of valuation.

Here’s the rest of this week’s SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2023/09/weekly-ssrn-tax-article-review-and-roundup-elkins-reviews-morgans-measuring-wealth-under-a-wealth-ta.html

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