Rebuttal: Warren’s Wealth Tax, a Rudimentary Fallacy in Basic Economics

Samuel Shih refutes the Quarterly’s latest leader on U.S Democratic Senator Elizabeth Warren’s proposed wealth tax.

Senator Warren’s wealth tax plan, as advocated in the Quarterly’s leader last month, is a hot issue among Democratic presidential candidates. Senator Warren is proposing an annual wealth tax on the richest households, motivated by claims about the fairness of income and wealth distributions in the economy. Unfortunately, it is fundamentally flawed and a poor tool in an attempt to fix income disparity.

Before setting off on explaining the fundamental failures of the highly vaulted wealth tax, we must first establish that the current American federal tax system is already highly progressive. When considering all federal taxes, Congressional Budget Office data show that the average effective tax rate for the top 1% of households is 33%, while the rate for the bottom 20% of households is less than 2%. The top 1% pays 25% of all federal taxes. The OECD examined the distributions of household taxes, including individual income taxes and employee payroll taxes, within member countries and found that “taxation is most progressively distributed in the United States” of all the nations it studied.

Targeting wealth for higher taxation is fundamentally misguided because in the most simple of definitions, wealth is simply savings that economies need for investment. The vast majority of the wealth of the richest Americans consist of active business assets that generate jobs and income. Increasing taxes on wealth would not help workers, but instead would undermine productivity and wage growth.

In this reply to the Quarterly’s leader, I’ll address the practical and economic problems facing the wealth tax that make it fundamentally impossible to effectively be carried out and morally unattractive to consider in the first place. Nonetheless, taxing capital in a fair and efficient manner is indeed a challenge that needs to be addressed and so as such, I argue that the best approach would be a consumption-based tax, a system that would tax capital income but in such manner that would not hurt investment and economic growth.

Capital Taxes are fundamentally and effectively a Bad Tax

Senator Warren is concerned that wealth is “concentrated” and that people with substantial wealth should be targets of heavy taxation. Indeed, the primary advantage of Warren’s tax plan is that it only taxes the very rich, those with assets with the values over $50 million.

But fact is that the wealth of the wealthy is mainly dispersed across the economy in productive business assets. According to a study by Matthew Smith, Owen Zidar, and Eric Zwick, of the top 0.1% of the wealthiest Americans, 73% of their wealth is equity in private or public companies, while just 5% is the value of their homes. Then looking at just billionaires, only 2% of their wealth is from their homes and personal assets (as depicted in the chart below). The overwhelming majority of their wealth is in productive business assets, which generate output for the broader economy.

Imposing heavy taxes on wealth would reduce living standards for everyone because it would reduce the overall size of the economy. A basic takeaway from economic theory is that everybody should want taxes on capital to be low or even 0, including those who have no capital income. The reason is that the supply of capital is elastic in regards to taxation so setting the tax rate to 0 would generate increased saving and investment. In turn, that would create rising worker productivity and wages as worker efforts are more valuable when they have more and better machines to work with. In the long run, the after-tax wages of workers would be higher under this policy than under a policy of imposing taxes on capital.

Of course, this assumes that the supply of capital is perfectly elastic or at least responsive. While that is not completely realistic, capital has become more responsive in today’s global economy. Economist Gregory Mankiw has noted that “logic for low capital taxes is powerful: the supply of capital is highly elastic, capital taxes yield large distortions to intertemporal consumption plans and discourage saving, and capital accumulation is central to the aggregate output of the economy.” From the average worker’s point of view, it is good for the wealthy to maximize their savings and reduce consumption. Capital and labor work in harmony: workers are more productive and better paid when they are supported by more capital generated by savers.

Not only is it economically damaging to a country but wealth taxes are an inefficient method for taxing the rich because they treat progress in the wrong manner. Wealth taxes exempt some above-normal returns to savings and tax the normal returns, which would distort savings and investment. In an OECD empirical study on wealth tax, the problem is apparent: “The taxation of normal returns is likely to distort the timing of consumption and ultimately the decision to save, as the normal return is what compensates for delays in consumption.” In a study by the Penn Wharton Budget Model, a nonpartisan economic think tank, they projected that Warren’s wealth tax will raise between $2.3 trillion and $2.7 trillion over ten years, roughly about $1.0 to $1.4 trillion less than the Warren campaign’s estimate and that the proposed wealth tax would shrink the economy between 0.9% and 2.1% by 2050 (as seen below in the chart), depending on how the additional tax revenue is spent. In addition, average hourly wages in the economy, including wages earned by households not directly subject to the wealth tax, are projected to fall between 0.8% and 2.3% due directly to the reduction in private capital formation.

Wharton Budget Model

In short, Warren’s wealth tax would be economically damaging to America while failing to raise enough money for the various programs that she’s promised would help the average American, showing that the wealth tax has no moral standing upon which to advocate. It wouldn’t be decreasing income disparity in America or create enough money to lift up the underprivileged in American society. Instead, it would drag the economy down, reduce investment into the economy, and create a worse economic situation for the average worker in America, the very people that Warren and the Leader claims to help with the wealth tax.

Complex Administration

The leader for the Quarterly imagines a system that is simple, easy to administer, and lucrative for the government. However, a wealth tax would be an entirely new tax system, not a small additional levy. Currently, the IRS only asks about income. A wealth tax would require an entirely new reporting regime and a much larger IRS to determine the level of wealth possessed by the taxpayer.

The Quarterly’s leader disagrees with this portrayal of the wealth tax by arguing that two of the advantages of Warren’s wealth tax is that (1) there are no exemptions reporting assets and that (2) owners may self value their assets. If their value is considered too low by the government, the government reserves the right to buy that asset away from them. Note that the government still needs to be able to value assets in order to determine if owners are undervaluing or overvaluing the assets.

Given this, Warren’s wealth tax may require taxpayers to report valuations, not just of financial securities and homes, but also of such items as pensions, farm assets, and family businesses. Many of these assets have no universally known market valuation. Accounting for wealth held in trusts would also be difficult, and for people with non-traded ownership in family businesses, book and market valuations can differ substantially. Furthermore, valuations of assets change over time, so a large industry of accountants would be needed to prepare regular valuations for tax returns.

How do you evaluate the valuation of natural beauty of a farm or its assets?
(@King Sport-News)

The difficulty of wealth valuation can further be seen in an IRS study that compared valuations on estate tax returns to valuations of the same estates on the Forbes 400 list of wealthiest Americans. The study stated, “This research highlights the inherent difficulties of valuing assets which are not highly liquid…Portfolios are made up of highly unique assets and often the value of assets are very closely tied to the personality and skills of the owner. Many forms of wealth are difficult or impractical to value, from personal effects and durable goods to future pension rights…Determining a precise value for these assets can involve more art than science.” Furthermore, consider that while the IRS handled 12,700 estate tax returns in 2017, Warren’s proposed wealth tax would require annual filing by at least 75,000 taxpayers. In a recent survey of economists, 73% agreed and only 7% disagreed that Senator Warren’s wealth tax would be “much more difficult to enforce than existing federal taxes because of difficulties of valuation.” Furthermore, Warren’s tax plan would have Congress impose the tax on worldwide assets, giving the IRS the nearly impossible task of auditing everything affected U.S. residents owned on a global basis and judging whether the valuations on all those foreign assets were fair.

Taxpayer liquidity would be another issue. Wealth tax payments would be difficult for people who mainly held assets that are not liquid and do not generate regular cash flows, such as homes, artwork, and ownership shares of some family businesses. This is not only a theory but the reality for many of the European countries that have tried out a wealth tax (OECD study).

In short, Warren’s wealth tax would not achieve the fairness that supporters are seeking. It would rather generate tax avoidance and lobbying by the wealthy for exemptions. In turn, that would increase public mistrust in the tax system. In the previously mentioned OECD study, the OECD concluded, “A major concern with net wealth taxes is the ability of wealthier taxpayers to avoid or evade the tax. This has…contributed to perceptions of unfairness.”

Tax Avoidance

Another advantage that the Quarterly’s leader stated was the low evasion rate that the wealth tax would have. Indeed, Senator Warren and the economists who designed her wealth tax plan say it would cover all assets above the exemption amounts. But actual wealth taxes have not worked that way. The flow of capital across international borders has greatly increased since the 1980s due in part to corporations and individuals increasingly moving their investments to countries with better growth opportunities and lower taxes. Most nations have responded by cutting their tax rates on capital to defend their tax bases and spur economic growth. The OECD nations have recognized that wealth and capital income are responsive tax bases. High rates make the tax base shrink due to the double whammy of domestic avoidance and international mobility.

A few statistical studies have measured the responsiveness of taxpayers to wealth taxes. A study by Katrine Jakobsen examined responses to Denmark’s wealth tax, which was repealed in 1997. They found “sizable” responses to the tax with the effects being much larger at the top end of the wealth distribution. As another study on the Swedish wealth tax by Magnus Henrekson and Gunnar Du Rietz finds, the problem with capital outflows is that governments not only lose wealth tax revenues, but also lose other tax revenues that would have been generated by outgoing individuals and assets. In other words, not only would Warren’s wealth tax not achieve its intended financial goals but it would also harm other sources of tax revenue, further lessening the budget that the executive would have access to work with.

Then what do we do?

All of the above arguments raises what appears to be a dilemma. Given the proven inefficiency and harm that a wealth tax would do, how can we have a tax system that does not penalize beneficial wealth accumulation but also distributes the tax burden equitably? In other words, how do we make sure that the rich pay a fair share of taxes while not discouraging saving?

The answer is consumption-based taxation. Consumption-based taxes can be taxes on transactions, such as retail sales taxes and value-added taxes. Andrew Yang, another presidential candidate most famous for his “Freedom Dividend”, advocates for a value-added tax (VAT) which is another example of a consumption-based tax.

Both income and consumption-based taxes tax income from labor and capital. But unlike income taxes, consumption-based taxes exempt the return to capital, which removes the wealth tax’s bias against saving and investment. Economist David Bradford argues that “sources of great wealth,” such as monopolies and highly profitable technology firms, are taxed under both income and consumption-based systems. However, by exempting the normal returns, the latter system is more conducive to growth. Bradford also long argued that consumption-based tax systems allow for much simpler administration and compliance. Consumption-based systems are also better at equalizing taxes on capital across activities and industries, and they capture some activities that escape taxation under the income tax.

Tax law professors Joseph Bankman and David Weisbach note that consumption-based taxes would tax the “idle rich,” while economists Kevin Hassett and Alan Auerbach agree that “if the disproportionate political power of the wealthy is the concern, a consumption tax is a more powerful tool.” In a bit of throwback to what our beloved Econ Prof Kerstin Holzheu taught us, Bankman and Weisbach further note in the same study that “a properly designed consumption tax is Pareto superior to an income tax.”

In short, consumption taxes hit wealth without interfering with the incentive to save while wealth taxes effectively tax the safe rate of return on investment because they don’t depend on actual rates of return.


Wealth is accumulated savings, which is needed for investment. The vast majority of the wealth of the richest Americans consist of socially beneficial business assets that create jobs and income, not private assets. Raising taxes on wealth would boomerang against average workers by undermining their productivity and wage growth.

Senator Warren says that she wants rich Americans to “pay a fair share, so the next kid has a chance to build something great and the kid after that and the kid after that.” But encouraging the well-off of America to invest in new and expanding businesses is what allows these kids “to build something great”, not some populist tax code that has a fundamental misunderstanding of basic economics.

Creating a fair and efficient method of taxing capital is a challenge, wealth taxes are the wrong and inefficient way to go about it. In the words of Economist Chris Edwards, “Rather than being sin taxes, wealth taxes are virtue taxes that penalize the wealthy for being financial prudent and for reinvesting their earnings.” A better and more efficient way to redistribute wealth and decrease inequality is through consumption-based taxation, which would tax wealth but in a much more simple manner that does not negatively affect savings, investment, and growth.

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