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By RONALD MCKINNON

The Occupy Wall Street protests have faded from the news, while the unemployment rate fell to 8.5% in December, the lowest level since February 2009. Still, unemployment and income inequality remain justifiable concerns for tens of millions of Americans and are two of the most pressing issues in the 2012 presidential election.

Reforming the income-tax system is commonly seen as the principal way to reduce inequality. But any attempt to impose higher marginal tax rates on even moderately high income earners—as President Obama wants for families earning more than $200,000 per year—can lead to losses in economic efficiency and even to losses in sorely needed government revenue if high earners work less or seek out more loopholes and tax shelters.

The basic problem is that defining "income" becomes progressively more difficult as income and wealth rise. Straight wage income is relatively easy to define and tax for middle-income earners—through payroll taxes for Social Security or through the personal income tax. But wealthy people live much more off returns from their asset holdings. They receive capital gains, stock options, interest and dividends; and carried interest for owners of hedge funds that, to avoid double taxation, are taxed at lower rates than wage income. They may receive imputed rental income from multiple homes and major consumer durables such as automobiles, art collections or yachts, which the federal income tax misses altogether.

In order to have a fairer tax system, we should implement a new federal wealth tax in addition to the federal income tax. Unlike the current income tax, the wealth tax would not rely on how income is defined. Rather, it would require that households list all their domestic and foreign assets on, say, Dec. 31 in the relevant tax year. With a large exemption of $3 million that effectively excludes more than 95% of the population, a moderate flat tax—say 3%, on wealth so defined—could then be imposed.

If on Dec. 31 a household declares total net assets of $5 million, and the "standard" wealth tax exemption is $3 million, then its wealth tax is $60,000 ($2 million x 0.03). Because wealth will generally present a much larger tax base than income, tax rates can be kept low and still raise substantial revenue. The incentive for tax avoidance is minimal—unlike the incentive created by a high marginal income-tax rate of 40% or more for earners paying both federal and state income taxes.

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Another advantage of a modest wealth tax, in contrast to high marginal income-tax rates, is that it would hit old wealth along with new wealth. Wealthy people living off their inheritances who are not affected much by the income tax would be hit relatively harder by a wealth tax, whereas "strivers" with higher wage and salary income would be hit less hard. This is especially true if marginal income-tax rates could be reduced because of revenue generated from a new wealth tax.

The new wealth tax would be levied on both the domestic and foreign assets of Americans. Overseas real-estate holdings—an Italian villa or a Parisian "pied-à-terre"—as well as foreign bank accounts, many of which their holders try to keep secret, would all be taxable. In 2009, when the Union Bank of Switzerland was fined $780 million for hiding the bank accounts of wealthy Americans, bipartisan outrage set in motion the Foreign Account Tax Compliance Act, or Fatca, which passed in 2010. By 2013, foreign financial institutions will be responsible for reporting to the U.S. Treasury American assets held with them. So Facta would nicely complement collecting a new wealth tax as well as a flatter income tax.

Beyond mollifying Wall Street protesters, a modest flat wealth tax is the key to flattening the income tax to make it more revenue-efficient. Everyone agrees that the current U.S. income-tax system, with its many deductions, exemptions and special credits, is an inefficient mess. The GOP candidates want to simplify the tax code by flattening the rate structure and closing "loopholes."

But they all want to keep the two biggest loopholes: (1) to allow charitable or philanthropic contributions to be deducted, and (2) not to tax the imputed rental value of owner-occupied homes while allowing full deductions for mortgage interest rates. Owners of mansions and possibly multiple other properties are the biggest beneficiaries. Both (1) and (2) disproportionately benefit the very wealthy—aka "the top 1%."

Perhaps a look back at the most successful income-tax reform of modern times, the nonpartisan Kemp-Bradley Act of 1986, can give a clue about what a flattening of today's income tax can do. Harvard economist Martin Feldstein, then chairman of President Reagan's Council of Economic Advisers, nicely summarized the results of Kemp-Bradley in these pages last Oct. 24:

"The 1986 agreement between President Ronald Reagan and House Speaker Tip O'Neill reduced the top marginal rate to 28% from 50%. A conservative Republican and a liberal Democrat could agree to a dramatic reduction in top rates because the legislation also eliminated a wide variety of tax loopholes. . . . The actual experience after 1986 showed an enormous rise in taxes paid by those who experienced the greatest reduction in marginal tax rates."

Why don't we move forward with a Kemp-Bradley II to reduce our appalling fiscal deficit? Unfortunately, Ronald Reagan's bipartisan income-tax cut is today more remembered for benefiting the rich than for rationalizing the tax system and increasing economic efficiency. Not surprisingly, today's critics of a flatter income tax echo this theme.

But a wealth tax designed to hit only the very well-off would render moot the critics' major complaint that a flatter income tax would not hit the rich hard enough. A wealth tax is a necessary political condition for much needed rationalization of the income tax.

Mr. McKinnon is a professor at Stanford University and a senior fellow at the Stanford Institution for Economic Policy Research.

OL FU wrote:I had to think about this one a little more and again I skimmed the article (just too dang long to read)

But I think he mentioned a wealth tax of 3%. A tax on assets effectively assumes that the assets are income generating (if they aren't such a tax will trigger sales of those assets as the cost of maintaining will not be worth it) so effectively it is an income tax without the requirement of income. So let's take a couple of examples.

a 75 year old with no risk tolerance worht $20,000,000 invested in 100% TBills earning 3%. (forget the excluded amount, just complicates the calculation.) That person's top marginal rate is 35% plus the 3% asset tax gives them a marginal tax rate of 135%.

So no wealthy person invest in Tbills. So Tbills get excluded because we can't incent people to forgo loaning the government money.

Next guy invest expecting to earn 8%. Earns 1.6M pays income taxes of app $500,000 and pays and asset tax of $600,000 (3% of $20M) for a combined marginal tax rate of 68%.


The problem with an asset tax is the percentage mentioned above is way to high it would have to be more like one-half of a percent and then of course as congresses change it would be increased way to easily. If we have to have a tax increase it should be on capital gains, not wealth. One could exclude the first $X of capital gains form the higher rate.


thi

OL FU wrote:Marginal rates or effective rates, not real important except for the capital gains rate. But I agree, valuing private companies is one of these in the eye of beholder things.

danefan wrote:

OL FU wrote:Marginal rates or effective rates, not real important except for the capital gains rate. But I agree, valuing private companies is one of these in the eye of beholder things.

Agreed. But his assumption is that most of the people this would hit (>$3m in assets) would be greatly benefiting from the reduced capital gains rate.

Still, unemployment and income inequality remain justifiable concerns for tens of millions of Americans and are two of the most pressing issues in the 2012 presidential election.

JohnStOnge wrote:

Still, unemployment and income inequality remain justifiable concerns for tens of millions of Americans and are two of the most pressing issues in the 2012 presidential election.

I didn't need to read any farther than that sentence to know I disagree with this person. It's the same old thing about income inequality automatically being a concern.

Right now the median household income in the United States is about $51,000. Suppose the median household income in the United States 10 years from now is $200,000 per year in today's dollars (inflation adjusted) but "income inequality" has increased. Is that "bad?" Or let's say that 10 years from now median household income is still $51,000 in todays dollars but income inequality has decreased. Is that better?

Of course it's not. This whole thing about "income inequality" necessarily being "bad" is crap. Income inequality is not, in itself, a "justifiable concern."