As California’s proposed wealth tax heads to the polls, many exhausted taxpayers may be wondering why the amount they already are paying isn’t enough.
Claiming that the wealthy don’t pay their “fair share” (as Bernie Sanders says) ignores that the top one percent of 2023 income earners earned 20.6% of adjusted gross income, and paid 38.4% of federal income taxes. They paid an average tax rate of 26.3%. In California, high-income earners were tapped with higher tax rates in 2004, 2012, and 2016, and currently face a top rate of 13.3%. The top 1% of earners pay half the state’s income tax.
Taxpayers also get double- or triple-taxed on that same income before and after they pay income tax: before, when the corporations they own pay corporate taxes before distributing dividends, and after, when paying gift or inheritance taxes.
The top half of earners pay 97% of federal income taxes, meaning that half the citizens who vote to decide income tax policy are exempt from paying it.
Adding insult to injury, the vilification of the wealthy is now a favorite pastime, with several Nobel Laureates in Economics recently calling the rich “oligarchs.” It’s as if people don’t know that wealth comes from creating value—for all of us. As the 2022 book, The Myth of American Inequality, by Phil Gramm, Robert Ekelund, and John Early, showed, the technological progress that has driven America’s amazing growth has seen the consumption of the poorest quintile of the population increase more than any other in percentage terms—by 700% from 1947 to 2017.
In America, wealthy individuals also support a vast network of charities. Charitable giving was $617.2 billion last year. New England’s Senators don’t account for much of that; neither do economists.
And yet, despite all the bad arguments for taxing the rich, and despite the poor design of California’s proposed billionaire tax, there is a legitimate justification for adding a new tax geared toward making some very wealthy people pay their “fair share.”And it’s justifiable on “optimal taxation” grounds: the least distortive tax is one on consumption, not income, because consumption taxation does not disincentivize saving, while an income tax does.
The problem that needs addressing is that consumption for some is far greater than income. Recently wealth has grown dramatically relative to disposable income. For most of the postwar era, household net worth was roughly five times disposable income, but since the 1990s it has grown, and is now eight times disposable income.
Furthermore, individuals’ propensities to consume from wealth have grown over time. Stanley Longhofer, William Miles and I showed in a 2012 paper that wealth effects on consumption were sometimes large, prone to change, and likely to grow as wealth increased and the population aged. A new paper by Ruxandra Boul and Mickey Levy (“The Wealth Effect and Influences on the Economy and Monetary Policy”) updated our study to show that the wealth effect has indeed grown since 2012. Today, a dollar more of housing wealth, after controlling for other factors, leads to about seven cents more consumption.
What kind of additional tax would address the problem of “missing tax revenues” from people whose wealth and consumption are rising much more than income? The best choice would be to replace the income tax with a consumption tax. Note that consumption taxes can be as progressive as income taxes. And they don’t require you to keep receipts for purchases. Consumption is computed from cash flows already tracked by your accountants. Consumption equals income, plus any new borrowings against wealth, plus proceeds from liquidating investments, less the amount invested or given to charity.
Replacing income taxation with consumption taxation is probably too much to expect from Congress. Another option would be to add a new tax that covers the consumption not already taxed by the income tax. A wealth tax doesn’t do that;many people with wealth are already paying substantial taxes on their income.
What would do the trick? An alternative minimum consumption (AMC) tax. The idea is to calculate consumption (as indicated above) and require that people with consumption above a certain amount (say, those consuming more than $1 million per year) are subject to an AMC that requires them to pay an income tax that is at least as high as some percentage of their consumption (either a flat rate of, say, 20%, or a progressive rate that rises with consumption).
Consider someone earning $2 million in adjusted gross income, but consuming $10 million. Assuming he pays the 26% average federal tax rate for the wealthy, he pays $520,000 in federal income taxes. With an AMC that begins at a consumption level of $1 million and a flat rate of 20%, that individual instead would owe $1.8 million.
To avoid creating distortive and unfair double taxation (when someone has a jump in income in one year, consumed in the next), it’s desirable to compute the AMC by averaging over a long retrospective period, then defining this year’s AMC amount as a fraction of the retrospective average (e.g., 20 percent, if the period is five years).
How to treat purchases of residences? Deem some fraction (say, five percent) of any home purchase as consumption in the year it is purchased and in the following nineteen years, assuming the house is not sold during that time.
An AMC isn’t perfect (tax proposals never are), and others will have good ideas for improving it. But I hope to shift our discussion of taxing wealth to taxing the consumption of the wealthy, and doing so without adding to distortive or double taxation. Unlike the proposed California billionaire tax, an AMC tax is attractive on fairness grounds, defensible on efficiency grounds, and could make a significant difference for increasing tax collections without discouraging investment.
