Taxing Net Worth: Theoretically Flawed and Unrealistic

November 15, 2011

To tackle its economic crisis, Italy is reportedly considering a wealth tax—a tax levied on individuals with a net worth above a certain threshold.

This type of tax is already levied on individuals in half a dozen countries in Europe—most notably, France. The tax is generally imposed at a rate between 1 and 2 percent; however, it is often progressively structured. That is, the more one is worth, the higher rate one pays.

Let’s hope such a tax never sees the light of day in the United States. The obvious moral argument against it is that it double-taxes earnings. However, the tax fails from theoretical and practical perspectives as well.

It fails the litmus test from a theoretical perspective in that it introduces a huge moral hazard problem into the public economy. Moral hazard is exhibited when a party that is protected in some way from risk acts differently than it would have acted had it not had such protection. In the case of wealth taxation, the protected party is the federal government. It can use monetary policy to manipulate the money supply, exacerbate inflation, and thus artificially raise the prices of nearly every kind of asset. So the government can control money, but an individual cannot control for house prices and the prices of other assets. That seems anything but fair.

Any tax simultaneously letting the federal government increase revenues and hedge any downside by using the Chairman of the Federal Reserve’s magical interest rate wand is insultingly flawed.

If you remain unconvinced, think about the administrative complexity involved in levying such a tax. To begin, the government would need to ask and answer the following questions:

1. What threshold of net worth must be exceeded before the tax is levied?

2. Should the tax be flat or progressive?

3. What assets should be taxed?

4. Who assesses the value of the assets and when?

What should the threshold be? Who knows? There will be a tradeoff here between how much revenue the government hopes to reap and what happens to compliance rates. The two will certainly be inversely proportional.

Like nearly every tax enacted in the OECD, the answer to the second question would likely be “progressive,” if not only for political feasibility.

Does the government tax liquid and illiquid assets? While a lot of value lies in securities and cash, it would be wrong to penalize an investor for prudently picking stocks which appreciate in value (unfortunately, this is already accomplished by the capital gains tax). Property would be much easier to tax (some would say it would be fairer as well), but like securities, these would have to be “marked to market.” This simply means that the tax would depend on a fair assessment of the property’s value, which is not only constantly fluctuating, it is also inherently arbitrary.

The timing of the valuation also matters because it could take months to assess the net worth of targeted individuals, especially if the threshold is low. During those weeks and months, the market could crash, a housing bubble could burst, etc…

The United States should not ever rely on a wealth tax. It’s too complex, too arbitrary, and gives government too much leeway to manipulate its revenues. If that doesn’t constitute poor tax policy, nothing does.

Follow David S. Logan on Twitter @Loganomix

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