A deeper look at new wealth tax proposal from Elizabeth Warren

Senator Elizabeth Warren of Massachusetts, a prominent candidate for the 2020 Democratic presidential nomination, recently proposed a wealth tax on the 75,000 American households that have net worth greater than $50 million. The annual tax rate would be 2 percent for most of the affected taxpayers, with a 3 percent rate on those with net worth above $1 billion.

Compared to the top income tax rate of 37 percent, or the 70 percent top tax rate recently proposed by another prominent Democrat in Congress, tax rates of 2 percent or 3 percent appear quite low. But appearances are deceiving. The proposed tax rates are actually very high. The first thing to note is that they are not just 2 percent or 3 percent. They are 2 percent or 3 percent each year. Wealth taxes operate differently from income taxes because the same stock of money is taxed repeatedly year after year.

{mosads}Under a 2 percent income tax, an investor pays taxes each year equal to 2 percent of income that year, and similarly pays taxes each decade equal to 2 percent of income that decade. In stark contrast, a wealth tax is cumulative. Under a 2 percent wealth tax, an investor pays taxes each year equal to 2 percent of his or her net worth, but in the end pays taxes each decade equal to a full 20 percent of his or her net worth.

To understand whether wealth tax rates are high or low, it is helpful to convert them into equivalent income tax rates, which are more familiar and easier to understand. Consider a taxpayer who holds a long term bond with a fixed interest rate of 3 percent each year. Because a 2 percent wealth tax captures 67 percent of the interest income of the bondholder makes each year, it is essentially identical to a 67 percent income tax. The proposed tax raises the same revenue and has the same economic effects, whether it is called a 2 percent wealth tax or a 67 percent income tax.

A 67 percent income tax is clearly a high tax rate. The tax rate is no less high when it is relabeled as a 2 percent wealth tax each year. Changing labels does not change reality. The 3 percent wealth tax that Warren has proposed for billionaires is still higher, equivalent to a 100 percent income tax rate in this example. The total tax burden is even greater because the wealth tax would be imposed on top of the 37 percent income tax rate.

These basic points also apply to investors who hold risky investments rather than safer fixed rate bonds. Although the wealth tax would be less burdensome in years with high returns, it would be more burdensome in years with low or negative returns. It would be lighter on investors who earn high returns due to monopoly power or special skills, although the relatively lenient treatment of those investors has economic drawbacks.

No matter how high the tax rates are, the very affluent households that are targeted in the proposal could certainly afford to pay them. Furthermore, the high rates make the tax a more powerful instrument to break up the concentration of wealth in the United States. On the other hand, the high rates make the tax a drain on the pool of American savings. That effect is troubling because savings finance the business investment that in turn drives future growth of the economy and living standards of workers.

These issues, and others raised by the wealth tax proposal from Warren, should be thoroughly explored. The starting point in that exploration must be a clear understanding of the high tax rates outlined in this new plan.

Alan D. Viard is a resident scholar with the American Enterprise Institute, where he studies federal tax and budget policy. He previously served as an economist at the Federal Reserve Bank of Dallas, the White House Council of Economic Advisers, and the United States Joint Committee on Taxation.