The Human Condition:

Taxing the Wealthy – February 12, 2012

It has become clear to everyone on the Democrat/liberal/progressive side of the aisle that the only way to pay for the Federal government’s obligations to Social Security, Medicare, and other safety net and health care entitlements, as well as for government programs in support of defense, education, and the rest of the cabinet list, and still pay down the Federal debt, is to raise taxes on the wealthy.1 These fortunate individuals must pay their “fair share” of the government’s burden.

The only problem with this, aside from the usual Republican/conservative/libertarian objections,2 is that extremely wealthy individuals usually don’t have much of what’s considered traditional income to tax. As we’ve seen recently with the tax disclosures by billionaire Warren Buffett and presidential hopeful Mitt Romney, the extremely wealthy in this country don’t make much in “wages, salaries, and tips”—the substance of everyone else’s tax return. The wealthy make most of their money through capital gains, earnings from the investment of money and assets they already have.

While the tax rate on investments held for less than a year is equal to the individual’s ordinary income tax rate, taxes on long-term investments (i.e., held for more than a year) are lower.3 This encourages people to invest their money in things like savings accounts to support bank lending, and company stocks and corporate bonds to provide a source of capital to build the economy.4

As an effort to get the wealthy to pay their “fair share,” the tax on long-term capital gains might be raised to the individual income rate, as if these earnings were the same as short-term gains and wages. Or the long-term rate could be set even higher, as a way of taking more from the wealthy. Of course, this would have a hugely depressive effect on investment and the capital available to build our infrastructure and industry. If earning money through investment is going to be punished, why not put your dollars in Swiss chalets, fancy yachts, sports cars, and artworks?

All of these tax rates apply to money earned or gained during the tax year. If you take last year’s earnings and put them under the mattress this year—or buy land, gold bars, or a yacht with them—that value disappears from the tax rolls. It doesn’t reappear as taxable income until you start investing the mattress money or sell the fixed assets and realize an increase in their value.5 The government has no method for taxing a person’s wealth directly or the assets on which he or she spends it.6 The money and goods that you have—as opposed to what you earn during the year—is yours forever … or at least until the inheritance tax kicks in.

That little quirk of fate is spelled out—at least by omission—in the U.S. Constitution.

Article 1, Section 8 of the Constitution, in describing congressional powers, states up front: “The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States …”7 An “impost” is a tax or duty, such as upon imported goods. An “excise” is a tax on the manufacture, sale, or consumption of goods.8 One would think that all this allowed the Federal government to tax personal wealth itself, but clearly legislators and jurists of the early 20th century thought otherwise. That is why they went to the trouble of proposing and ratifying with a majority of states the 16th Amendment to provide for a tax on personal income.

Amendment 16 to the U.S. Constitution, ratified in 1913, states: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” The two clauses about “apportionment” and “census or enumeration” mean that the tax falls directly on individuals and is not adjusted based on the size or population of the state where they live.

So, even with the 16th Amendment, the Federal power to tax is limited to taxing income received during the year, not the total wealth of the individual. Generally, the states follow the lead of the Federal government in terms of taxation. Individual states may tax income, and some tax certain kinds of property such as automobiles, but none so far has a tax on existing net worth, or wealth.

On January 9 in The Wall Street Journal, Ronald McKinnon, a Stanford University professor and senior fellow at the Stanford Institution for Economic Policy, wrote an opinion piece titled “The Conservative Case for a Wealth Tax.” His thesis was that “a modest levy on the overall wealth of the very rich would allow lower incentive-distorting income tax rates for them and everyone else.” His proposal was an annual 3% tax on personal wealth in excess of $3 million. The tax would include all domestic and foreign assets, not just cash on hand and savings accounts; so the wealth tax would require an annual listing and evaluation of a person’s stock portfolios, bond holdings, homes, art collections, and anything else of value he or she might possess.

This would raise several problems. First, it would probably require a separate constitutional amendment, because the 16th Amendment addresses only income, not net worth or assets.

Second, absent any effort to build up new wealth through investment, the tax would erode the value of the assets and the resulting tax revenue over time. For example, a net worth of $1 million, taxed at 3% per year, yields $30,000 in taxes in the first year and a remaining wealth of $970,000. In the second year, the tax take is $29,100 on that $970,000, and the remaining wealth is only $940,900. By the 24th year, half the wealth is gone, and the take is only $14,889. After two centuries, the individual is a pauper with a net worth of $2,332 and a tax burden of $70—but, of course, long before this the inheritance tax will have taken the lion’s share of that initial wealth.

Third, if determining the amount that an individual owes in income taxes and capital gains during the year is an accounting nightmare, consider the process of identifying and valuing all of a person’s assets. While annual income can be checked against mandated Internal Revenue Service filings by employers and institutions using forms such as W-2s and 1099s, what body exists to notify the IRS about ownership of a second home, a luxury sports car, or artwork? Certainly, local property taxes can be dragooned for this purpose in the case of land, and bills of sale can be requisitioned for the year of purchase and original valuation of other assets. But over the long term, the individual will be asked to register and provide a narrative history for every asset he or she possesses: Still owned, and at what estimated depreciation or appreciation in value? Sold, and if so when and at what price? Acquired, and if so when and at what price? The bureaucracy required to establish and track each purchase and sale would make current IRS operations seem … simple.

Fourth, if such a wealth tax is initially aimed at the “truly wealthy”—as in McKinnon’s choice of a $3 million cutoff—over time, inflation will bring a larger and larger percentage of the population into the process. This happened with the Alternative Minimum Tax, which started in 1969 as a tax on about 150 high-income households that had managed to shield their income through deductions and writeoffs. The AMT now falls due on more and more middle class taxpayers every year. Over time, a wealth tax—no matter how well intentioned—would be eroding the assets of any individual or family that had any assets or savings. And, in this case, those assets would include college funds, retirement plans, and other individual hedges against future uncertainty.

Fifth, by its nature, a wealth tax would force the sale of assets to pay the percentage owed in taxes. This would merely be a drain on liquid assets such as bank accounts and stocks. For illiquid assets like homes, cars, and artworks, the tax would either accelerate the drain on ready cash or force a sale. And if the asset was a private business or farm, the tax would cut heavily into operational funds and capital, force a sale of business assets, or liquidate the business altogether.

A wealth tax might sound like a way to make the “truly wealthy” pay their “fair share.” It might even start that way. But over the long term it would become a way to impoverish families and small businesses. Over time, the average citizen would be encouraged to own nothing, save nothing, have no plan for the future. The wealth tax would create a nation of paupers and clients of an even larger welfare state. It would, de facto, impose a limit on the amount and kind of property a person could own, similar to the restrictions in the old Soviet Union.

In short, a wealth tax would change the face of American society—and not for the better.

1. Certainly, cutting spending is off the table. For one thing, these are entitlements, which means that someone somewhere is, by law, owed the benefit and will suffer and complain if the benefit is denied. For another, cutting any other part of the Federal budget—from the Pentagon to any of the cabinet departments and the institutions they support and the grants they award—means putting someone somewhere out of work and adding to the unemployment rolls. Raising revenue by actually lowering taxes and thereby encouraging taxable economic activity is, to the Democrat/liberal/progressive mindset, an obviously blown economic theory that is no longer worth the time and effort to refute.

2. Briefly, that the top 1% of taxpayers already pay more than 36% of the Federal income tax revenues, and the top 10% pay more than 70% of those revenues, while the bottom 50% pay just 2.3% (source: Tax Foundation as of 2009). So the income tax rates are already steeply progressive. Add to this the conservative belief that government spending, left unchecked, will always outpace government revenues (or, in a corollary to Parkinson’s law, the appetite for benefits and programs increases to consume the resources available). And finally, that increasing economic activity will increase the wealth available to a society, which means more jobs, more goods and services available to people, and more tax revenues for government (i.e., the theory of raising revenue by increasing economic activity ain’t dead by a long shot).

3. Through 2012, the long-term capital gains rate on individuals in the 10% and 15% income brackets is 0%, while for higher brackets it’s 15%. In 2013, the rate rises to 10% for individuals in the 15% bracket, and to 20% for all higher brackets.

4. Usually, investment in municipal bonds is free of Federal and State taxes, to encourage investment in local infrastructure.

5. Of course, if you sell your yacht or artwork at a loss, there’s no tax to be paid on the transaction and you may even use that loss to lower taxes owed on other investment income.

6. With the exceptions that local governments usually impose annual taxes on property like houses and land to pay for local infrastructure and services like education; some states tax assets like automobiles to pay for road building and maintenance; and many local governments and states—but not so far the Federal government—impose a sales tax on various categories of spending.

7. See U.S. Constitution Online.

8. The Federal government—so far—has apparently only dabbled in excise taxes, such as the tax on tires. While the Federal government doesn’t have a sales tax, many on the Democrat/liberal/progressive side would like to impose a European-style value added tax (VAT)—kind of a super sales tax on every step in production and distribution—which would be a massive money-raiser. It would essentially tax on production and consumption in parallel with existing taxes on investment and income. This article of the Constitution would appear to support such a move.