Taxation Tuesday: Don’t Try to Pass a Wealth Tax

Good morning; let’s talk about tax policy! 

One of the ways Senator Bernie Sanders has offered to finance his suggested health care plan is a wealth tax. A wealth tax does what it says on the box: taxes assets, as opposed to our current tax structure, which taxes income.

This is far from the first time someone has suggested such a tax. It feels simple—if extremely rich people’s wealth is asset-based, not income-based, then an income tax doesn’t actually capture money based on ability to pay. Tax the wealthy fairly by taxing wealth.

Well, the first problem is it’s unconstitutional.

A wealth tax is what’s called a direct tax. In the United States, that is the term we use to describe a tax that is exercised directly on an owner because he is an owner—“levied upon or collected from persons because of their general ownership of property.” Bromley v. McCaughn, 280 U.S. 124, 135 (1929). A wealth tax would be a direct tax because you would get taxed based on what you own, because you own it.

Direct taxes are unconstitutional unless they are allocated per state based on population, due to Art. I, §9, cl. 4 (“No capitation, or other direct, Tax, shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”). In 1895, the Supreme Court held that an income tax is a direct tax, which is why the Sixteenth Amendment exists.

What does that mean? It would mean the tax rate of a wealth tax has to vary by population, so that the amount of tax collected per capita is the same for every state. Or, in other words, it would be impossible—first, because there’s no relationship between the number of extremely rich people in a state and that state’s population, and also, because people move. Matthew Franck did the math in 2012—Wyoming, with .18% of the country’s population, would owe .18% of the total tax collection target. California, though, would owe 12%. If seven people moved from California to Wyoming, or just moved their assets, those numbers wouldn’t budge, even if the seven wealthiest people in California were the ones to do it.

The practical effect of this is that everything has been defined out of being a direct tax, because there’s no functional way to do it. For example, gift taxes, corporate income tax, and estate taxes have all been deemed “excise taxes” rather than direct taxes. The apportionment requirement has been described as “absurd and inequitable,” but it remains a part of the Constitution. So, absent a constitutional amendment, the federal government cannot skim 1% off all of the billionaires just because they are billionaires.

It’s also not a great idea.

Whether something is constitutional and whether something is a good idea as a matter of policy remain, even in this political climate, two distinct inquiries. So, though absent a constitutional amendment a wealth tax is unlikely, it’s still a good exercise to contemplate the implications.

After all, there is a lot of wealth in the United States that is unaffected by changes in marginal tax rates. Many people at the top of the pile pay very little in taxes because of the favorable structure investment losses receive.

The concept of a wealth tax catches a lot of varying proposals, some of which imagine replacing income taxes all together, or completely eliminating capital gains taxation. Senator Sanders’ proposal is an add-on, specifically to fund Medicare—a 1% annual tax on everything over the first $21 million.

The main structural problem with this is valuation.

It is impossible to measure the value of many of the assets this kind of tax would attempt to capture, like art, private businesses, closely held stock, private equity, limited partnerships, and other things like goodwill. We deal with that currently by taxing these kinds of things based on what you gain or lose when you sell it based on what you paid for it, instead of trying to calculate at any given moment what it’s “worth.” This means tax assessments are more accurate when people are savvy purchasers, because they correctly value what they buy and sell. Most extremely wealthy people are, or they hire people who are.

But an annual tax on household assets would require an annual evaluation of illiquid assets, as well as things that change valuation dramatically while they are being held. Many of these types of assets are subject to a sort of Schrodinger’s principle—they might be both extremely valuable and nearly valueless while they are being held. The tax assessment would vary wildly based on what day it happened and how the valuation was going to be assessed.

This is called a “mark to market” system, where you mark everything you own as if it were currently on the market. We don’t do it for income because it’s inadministrable. That wouldn’t change when the person doing the marking is extremely wealthy.

Also, the assets targeted by this kind of tax are usually very illiquid. Often the market for extremely high-value items, like Picassos and yachts, is very slow-moving. Generally, those who would be caught by this kind of super-wealth tax are assumed to be liquid in other ways, though that’s not necessarily the case. Tax assessments of non-liquid property introduce distortions into the market as is—this is one of the justifications for a high-threshold estate tax, so that large family enterprises don’t have to be broken up to pay the tax.

Other issues would be the likelihood of expatriation of assets, or the inevitable development of different tax-favored structures. It would also be very complicated, though everyone caught by this tax, at least at the level Senator Sanders has proposed, is probably already investing in intelligent tax management.

Tax policy can never exist in a vacuum. Every choice is an affirmative choice. There is no such thing as neutral. Our current tax code plays favorites with different kinds of wealth. But a wealth tax is both unconstitutional and impossible to orchestrate.

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