Proponents of Wealth Taxation Must Consider its Impact on Innovation

November 12, 2019

As policymakers and presidential candidates consider proposals to enact a wealth tax on the wealthy, lost in the debates about tax avoidance, administrative challenges, and revenue projections is the impact on innovation and entrepreneurship. Contrary to the claims of wealth tax proponents, policymakers should consider the negative impact of wealth taxes on economic dynamism in the United States, especially when combined with other tax increases.

But proponents of a wealth tax are less worried about the impact of the tax on innovation. A recent paper by economists Fatih Guvenen, Gueorgui Kambourov, Burhanettin Kuruscu, Sergio Ocampo-Diaz, and Daphne Chen argues that a wealth tax may encourage greater innovation. This is because, in their view, wealthy taxpayers who use their wealth in unproductive ways would be expected to earn a lower rate of return than superstar innovators. This would mean that the wealth tax would disproportionately impact the unproductive wealth, incentivizing those owners to deploy their assets productively in search of a higher return.

For example, consider someone with $250 million who leaves the asset in U.S. Treasury bonds, receiving a 3 percent return ($7.5 million), and an entrepreneur who uses $250 million to earn a 50 percent return ($125 million) by creating a successful startup. A wealth tax of 2 percent that exempts the first $50 million in net assets would impose a $4.15 million tax liability on the bondholder and a $6.5 million tax liability on the entrepreneur. 

Table 1. Example of a Wealth Tax’s Impact on Effective Income Tax Rates

Source: Author’s calculations

  U.S. Treasury Bondholder Entrepreneur
Asset $250 million $250 million
Return on Investment ($) $7.5 million (3% return) $125 million (50% return)
Wealth Tax Liability (2% on assets above $50 million) $4.15 million $6.5 million
Effective Income Tax Rate 55.3% 5.2%

Converted into an effective income tax rate, that implies a 55.3 percent tax rate on the bondholder ($4.15 million in tax / $7.5 million earned) and a 5.2 percent tax rate ($6.5 million in tax / $125 million earned) on the entrepreneur. The bondholder pays a higher effective income tax rate, as they earned a lower return on investment than the entrepreneur. This encourages the bondholder to pursue higher returns, as this would lower their effective tax rate under the wealth tax.

While this may incentivize some owners of unproductive assets to engage in innovation, it is a poorly targeted method to encourage greater innovation. Owners of wealth will be motivated to seek higher returns wherever they find them, though not solely through engaging in innovative activity. For example, the wealthy may lobby policymakers to create barriers to entry in their respective industries. This would raise their returns by limiting competition without creating new wealth. There is evidence that high marginal tax rates and wealth taxes may also make it harder for new entrants to build wealth, which stabilizes the position of the incumbent wealthy.

Most importantly, advocates of wealth taxation neglect the decision entrepreneurs make to engage in innovative activity at the beginning. Economists Emmanuel Saez and Gabriel Zucman point out that most of American innovation is conducted by younger entrepreneurs, who may not have accumulated wealth to tax. This makes it important that we consider whether wealth taxes alter the decision of prospective entrepreneurs as they weigh the economic trade-offs of their career decisions.

For example, entrepreneurs may require extensive training to create innovative ideas and implement them. As economist John Cochrane points out, “The big margin for economic growth is people’s human capital decisions—the decision to go to school, to take hard courses (computer programming) rather than softer more pleasant ones, the decisions to start businesses and invest enormous time when young developing them.” This is especially true if they consider alternative career paths that are remunerative but do not take on risk.

This point is especially salient when considering the combined effect of other taxes, which may raise the effective tax burden on entrepreneurs by more than the wealth tax alone. Slightly higher marginal tax rates may not dampen the entrepreneurial spirit of would-be innovators, but confiscatory levels of taxation may make entrepreneurs think twice before taking on risk.

A prospective entrepreneur will consider the effective tax burden—not just the marginal tax rate—when considering trade-offs related to their career. While many entrepreneurs are self-motivated or may not respond strongly to modest increases in tax rates, there is evidence that confiscatory tax burdens may affect entrepreneur behavior and lower quality-weighted innovation by up to 40 percent. This has broader effects on the entire economy: as economist Chad Jones put it, “Distorting the behavior of a small group of innovators can affect all our incomes.”

At a time when American productivity growth is falling and greater entrepreneurship is needed to raise economic growth, policymakers must consider how wealth taxes may lower innovation and productivity growth even further. Instead of raising revenue from a narrow tax base through high tax rates, policymakers should identify options to raise revenue efficiently through broad-based taxes consistent with sound tax policy.

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