What happens when we tax wealth instead of income

Let’s think about the income vs. wealth tax in another context. Suppose the U.S. government were a company like DropBox, let’s call it GovBox. Here’s what the business model would be:

1. We are an enterprise company, you must use GovBox.
2. You may store as much data as you want in GovBox for free (no wealth tax).
3. When you copy data into GovBox, we will charge you based on how much you copy (the income tax).
4. We will donate a percentage of what you pay each month to charity (social welfare, cost not proportional to property or income).

This has to be one of the worst business models of all time. There’s never an incentive to delete data, since it costs you nothing to store, and drives your unit economics down. The earlier and more aggressively you start using GovBox, the more you benefit relative to everyone else. This bears resemblance to a pyramid scheme.

The only way to get your money’s worth is to store as much data as possible for yourself, until you are storing at least as much as you are actually paying for each month. For latecomers, this is extremely difficult to do, as the accumulation of data over time is working against you. In other words, we’re each individually incentivized to race to our break-even point, straight into the heights of unsustainability.

We wouldn’t run our own businesses this way, so why should we build the foundation of our economy on this model? Under the current income tax system, the middle and lower classes are effectively subsidizing the wealthiest individuals, companies, and banks. This is akin to serfdom, and will hopefully be looked back upon by later generations as a barbaric detour of civilization.

Why we should tax wealth instead of income made the moral argument that taxing property is the only fair way to cover the cost of protecting it. We now look at implications of a wealth tax, and address the most salient argument against it.

Why we shouldn’t tax wealth

Marc Andreessen, a most thoughtful and successful entrepreneur and investor, says that the reason not to tax wealth, is that doing so would drive rich people to consume more and invest less:

To support this argument, Andreessen invokes Milton Friedman opining on a 100% inheritance tax. We can probably all agree that a 100% inheritance tax would have severe consequences. It’s something of a straw man, as this sort of taxation is not being proposed.

A more realistic wealth tax

For the sake of discussion, let’s deal with some concrete numbers. According to Daniel Altman, a 1.5% flat wealth tax is more than enough to replace the revenue of all income, estate and gift taxes. There are other ways to implement this, but that gives us a good enough sense of scale (for now).

It will also be important to think about the sort of return people can typically expect their total wealth to generate. According to WealthFront, a rate of 4–6% pre-tax might be a reasonable expectation.

At what point does a wealth tax drive rich people to consume more and invest less?

People get value out of consumption, in general this value goes down the more they consume at once. At some point they prefer to save, so they can consume later on. As long as the rate of return on investment of wealth is greater than the tax rate, people are incentivized to invest rather than consume. If the tax rate is greater than the rate of return on investment, people will still invest, but relatively less.

At a 100% wealth tax rate, people would likely consume a good deal of their wealth as quickly as possible. At a 1.5% wealth tax rate, the effect is surely much smaller. But while its true that a wealth tax may encourage the most wealthy to consume more, this is not necessarily a bad thing. And if they don’t like it, they don’t have to do it.

In a moment, we’ll talk more about what exactly it means to consume something, and whether its good or bad. And we’ll see later on that the income tax actually drives consumption in another way. But first, let’s look at the claimed problem with consuming more, which is that it leaves less capital for investment, and thus results in less economic growth.

The presumption is that there are people who are only investing because their wealth is not taxed. These are the people who will start consuming as soon as their wealth is taxed. Given this behavior, we can assume that the only reason these people are investing, is to accumulate more wealth. That is, they don’t care at all whether they are creating or capturing value, as long as it accrues to them.

If the goal is economic growth, then investment only matters when it results in value being created, rather than merely captured. How do we get people to focus on creating value? One answer turns out to be through a wealth tax. Under a wealth tax, every dollar created anywhere in the system benefits everyone, which means everyone is incentivized to help create more value, even if they don’t capture it directly. It can take a while to see this, so we’ll look more carefully at exactly how this happens.

How a wealth tax incentivizes wealth creation

We’ll see how the wealth tax is not only the ethical way to tax, but produces the economic effect we want better than an income tax does. First, let’s define some terms that will keep us on the same page.

Creating vs capturing; Ownership vs consumption

Suppose we have an economy consisting of Alice, Bob, and $100 dollars of money. Alice and Bob both have $50. Bob is a farmer, and this year he grew corn. Alice offers Bob $10 in exchange for a few ears of corn. Bob accepts, and Alice takes the corn home and puts it on the table.

At this moment, before Alice eats the corn, our economy has $110 dollars of wealth in it. The transaction between Alice and Bob created $10 worth of value. The $10 that was created is stored in the corn.

As soon as Alice eats the corn, it loses its stored value, as it is no longer in a form anyone else would pay for. At this point we can say that Bob has captured $10 from Alice.

Different things hold value for different amounts of time. When we create things that people want to own, we are effectively creating wealth for a period of time. When we create things to be consumed, we are capturing wealth by satisfying other people’s demands.

When we consume something, we transform it from something that people would pay for into something that is not. In this way, it can be said that we are destroying value. When we buy something to consume right after it was created, we are effectively transferring wealth.

The effect of the wealth tax

Remember, we tax wealth to pay the cost of protecting property, as well as to compensate everyone for upholding the social contract. As long as the amount of compensation is non-zero (and arguably even if its not), something remarkable happens.

Since the tax is a function of the total wealth in the economy, whenever wealth is created anywhere if the system, we all benefit. If we keep the total tax needed constant, we realize the benefit in the form of a lower tax rate. If we keep the tax rate constant, we realize the benefit in the form of greater compensation each tax cycle.

Under the wealth tax, we are incentivized to create things and help everyone else create things that hold value for a long time. When we become wealthy, we are systematically encouraging everyone to behave like the best technology investors already do. We become dis-incentivized to focus on financial tricks and things that help us capture other people’s wealth.

Why this wouldn’t work under an income tax

Even if the income tax weren’t immoral, it doesn’t incentivize the creation of value like the wealth tax does. Under an income tax, the system only benefits when there is an increase in total income. That begs the question, how does one invest in increasing total income?

Total income goes up when value is created, but also whenever wealth is merely captured. Under an income tax, we don’t really care how long value gets stored! As long as a transfer of wealth occurs, its just as profitable as actually creating wealth. Because its generally easier to consume than to create, its not hard to imagine what happens. If you can’t imagine, just open your eyes and look around.

Ethics of the income tax aside, we should seriously consider whether we want to align ourselves around increasing total wealth, or to continue focusing individually on taking whatever we can.