How To Tax the Rich, And Do It Smarter

SMITH BRAIN TRUST – What is the best way to tax the wealthy in America?

Among economists and politicians, it’s a hotly debated topic. The current administration favors low taxes for the wealthiest Americans, saying it’s stimulative for the economy and promotes investment and growth. Its critics, meanwhile, argue that it only concentrates riches. They say lower taxes on middle and lower classes has a more stimulative effect, since those Americans are more likely to spend and less likely to stockpile money.

In the months since the Democrats regained a majority in the House of Representatives and as key policymakers have declared their intention to seek that party’s presidential nomination, the debate over how to tax the richest classes has grown louder.

“It strikes me that the debate going on now is really about inequality and less about the best system of taxation,” says Kislaya Prasad, research professor and academic director of the Center for Global Business at the University of Maryland’s Robert H. Smith School of Business.

“There are relationships between the two, but the terms of the debate are very different when you think of it as a push to try to fix the level of income inequality in the United States.”

Among the proposals drawing the most attention is New York freshman Congresswoman Alexandria Ocasio-Cortez’s proposal for a 70 percent marginal income tax rate for people earning more than $10 million per year.

In a close second is the suggestion from Massachusetts senator Elizabeth Warren, who is seeking the Democratic presidential nomination, that the United States apply a tax to accumulated wealth, at a rate of 2 percent for wealth exceeding $50 million, and 3 percent for wealth that exceeds $1 billion. Senator Kamala Harris, another contender for the Democratic nomination, has proposed tax credits of up to $3,000 a year for workers with incomes less than $50,000 (and $6,000 a year for families making less than $100,000).

They, and many others, says Prasad, are framing a discussion about wealth inequality as a discussion about tax reform. And while it is true that taxes have become less progressive even as there has been a dramatic increase in wealth inequality, it is not clear that changes in taxation alone will address this very complex problem. But they would have to be part of any serious attempt to moderate the impact of rising inequality.

“When you think about things from the tax reform standpoint, you think about how best to raise the revenues needed to cover new or existing programs or for reducing debt,” Prasad says. “And you think about the most efficient way of doing so.”

Prasad recommends following these two guiding principles.

Create a tax that’s efficient: “You want to have taxes that create the fewest distortions -- in other words, taxes that don’t give people the incentives to change their behaviors to avoid paying the taxes,” Prasad says.

The classic analogy, he says, is how some commuters will opt to take a longer, slower route to work just to avoid paying a highway toll. From the economy’s perspective, resources are not being used in the most productive manner, and the government is not raising as much in revenue. “You don’t want that. You want to create the taxes that are the most efficient.”

Create a tax that’s fair: “People in similar circumstances should be taxed at the same rate,” Prasad says, “and typically fairness dictates that people with higher incomes should face higher marginal tax rates.”

However, he adds, in all tax plans we are forced to trade off these two goals of efficiency and fairness. Among the criticisms of Ocasio-Cortez’s plan to increase the marginal tax rate on individuals who earn more than $10 million a year, is the argument that the proposal wouldn’t raise enough money. Critics have said it’s punitive, without commensurate benefit. A criticism of Sen. Warren’s plan is that it would wipe out a substantial part of the return on invested wealth and so would make investment less attractive.

In part, Prasad says, that’s because people will take steps to avoid taxes. They might choose leisure over working harder – although there is little evidence of this with small changes in the marginal tax rate. But at 70 percent, who knows?

It is well-documented that people move to avoid taxes. This can be a move across state borders within the U.S. and even internationally. A study of European soccer players found, for instance, that players choose countries and teams taking their tax burden into account. Additionally, complex money schemes help the country’s ultra-rich conceal their taxable income. The Panama Papers and Paradise Papers investigative projects, he says, “revealed to us the extent to which the super-rich are able to move money to tax havens and use loopholes and tax shelters to avoid paying taxes. One can imagine that if you begin to tax wealthy people more heavily, some will do much more of that.” Companies regularly cross international borders in pursuit of tax advantages, setting up subsidiaries in jurisdictions with low corporate tax rates, such as Ireland, Singapore, Hong Kong, Luxembourg, Bermuda and elsewhere. “That’s completely legal,” he says, “But what individuals do can be a bit more shadowy, moving money into anonymous Swiss bank accounts, setting up shell companies as we saw in the Panama Papers.”

None of this is an argument for doing nothing.

Growing wealth gaps are a problem not just for the United States. And as countries grapple with broader questions related to the wealth gap, some are beginning to develop proposals that could make it more difficult for the super-rich to conceal their wealth, Prasad says. Stricter reporting requirements for financial institutions, sharing of information between governments, stricter enforcement, and global registries of financial assets, all have a role to play in this. This would of course require a considerable degree of global cooperation. To be sure, Prasad says, if there are taxes, people will do things to try to avoid them. Nonetheless, he adds, “a lot can still be done to make it harder to run schemes like those. And in general, I think most people agree it’s a good idea.”

There are also taxation options available that might result in less avoidance. Increases in the estate tax and adjustments to the capital gains tax, perhaps by eliminating the reset of the cost basis, Prasad says, could raise significant tax revenue and avoid some of those pitfalls. Taxing capital gains at the taxpayer’s income tax rate is another idea that would be generally less distortive to behavior, especially in light of the recent reduction in the corporate tax rate.

To many supporters of the recent tax plans the standard terms of tax reform debates misses the point. The plans are as much a gesture against growing inequality as anything else. That’s part of the reason why the plans put forward by Ocasio-Cortez and Warren have gotten so much attention.

“These new tax proposals and the people behind them, they are making a completely different argument – that the concentration of wealth is corrosive to our democracy and it’s creating a cadre of super rich who have an inordinate amount of political power and control. And that they manipulate the rules of the game to their own benefit, and to the detriment of everyone else.”