The Importance of Taxing Capital

A proposal to slow down the wealth accumulation of the super-rich

“At present, when zero interest rates make capital costs as low as they have ever been but corporate profits are at record levels, there needs to be much less concern with capital costs and more concern with the distributional aspects of capital taxation.”

That’s Larry Summers — with whom I have often disagreed in the past — at a Brookings event on the tradeoff between equality and efficiency. For most of our lives, government policy in the United States and most of the developed world has been focused (at least in theory) on efficiency: colloquially speaking, making the pie bigger rather than worrying about how the pie is divided up. Rising tide, boats, you know the rest: Laffer Curve, unleashing the job creators, and so on. Inequality is something we profess to regret while doing nothing about it.

Now, however, inequality has become a first-class issue of its own. I hear that the Republican presidential candidates are climbing over each other trying to show empathy for the working poor. But what to do?

When Summers says that we need to worry less about “capital costs” and more about the “distributional aspects of capital taxation,” he’s talking about how we tax capital. This may sound socialist — since “capital” is the root of “capitalism,” taxing it must be some pinko plot, right? But we’re just talking about doing something the United States has been doing for a century: taxing income from investments, whether housing rent, bond coupons, stock dividends, gains on sales of paintings, etc. We call all that stuff (housing, bonds, stocks, paintings, etc.) “capital” because it has the magical property of making money all by itself, without any effort by its owner (what we call “labor”).

Capital matters because, for all we like to talk about entrepreneurs like Bill Gates, it is capital — previously accumulated wealth — that makes the rich get richer, ultimately producing this kind of wealth distribution:

That was the central principle that gave rise to Pikettymania one year ago. With preferential tax rates for capital — such as the 23.8% maximum rate on capital gains and qualified dividends in the United States — it really doesn’t matter what the top labor tax rate is. The people at the top of the pyramid make almost all of their money from capital, and they laugh at the 43.4% rate on earned income.

The justification for lower tax rates on capital has generally been that we need to encourage saving in order to fund investments. The main problem with this argument is that it doesn’t work that way in practice: the empirical evidence that higher tax rates reduce saving by the rich is weak to nonexistent. (This makes sense, too: when we’re talking about the 0.01%, there’s just so much you can consume, and you save everything else.)

Piketty’s proposed solution in Capital in the Twenty-First Century was an annual tax on net wealth (assets minus liabilities). This idea was roundly rejected across the political spectrum for a host of reasons, some bad, some good. I recently wrote a paper examining different tax instruments that might achieve the goal of reducing the rate of return on capital and thereby limiting or reversing the growth of wealth inequality. Ultimately, my preferred option is a version of a retrospective tax conceived by Alan Auerbach more than twenty years ago, in which investors pay tax when they sell assets and the tax rate is based on the length of their holding period. It’s not hard to show that this tax scheme is substantively similar to a wealth tax, and therefore can reduce the rate of growth of capital by a fixed number of percentage points.

In the paper, I also calibrate the proposed tax. I estimate that this capital tax could replace most existing taxes on investments (including most taxes on individual investment income, the corporate income tax, and the estate tax), while exempting 95% of households and charging an effective wealth tax rate of only 0.3% on the next 4% of households. In other words, the tax could be precisely calibrated to affect the households that have the most capital income and whose assets have been growing at the highest rates. (For details, see Table 3.) It’s an academic paper, so some of it is pretty dense, but you can read the whole thing here. (It will be published by the Cornell Journal of Law and Public Policy later this year.)

Of course, I don’t expect Ted Cruz and Jeb Bush to adopt my proposal. At the end of their day, their campaigns depend on donors who care deeply about tax rates on investment income. But I think it’s important that we think creatively about what policy tools exist to actually do something about our large and growing levels of inequality — rather than just pretending that we care about them.

James Kwak is, among other things, an associate professor at the University of Connecticut School of Law. Find more at Twitter, Medium, The Baseline Scenario,The Atlantic, or jameskwak.net.