Three Options for Taxing Wealth

Extremely high levels of wealth were not typically generated by people who were saving out of the income that they earned.

Instead, high levels of wealth are typically about assets that rose considerably in value–sometimes land or real estate, often stock in a company. Billionaires like Elon Musk or Kim Kardashian don’t have a basement full of dollar bills, like Scrooge McDuck. Instead the bulk of their wealth is held in shares in corporations, where those shares have risen in value over time.

Thus, if you want to impose taxes that will affect the wealth distribution, raising the top-level income tax rates is not the most useful answer. “How to Tax Wealth,” a group of economists from the IMF (Shafik Hebous, Alexander Klemm, Geerten Michielse, and Carolina Osorio-Buitron, IMF How to Note 2024/001, March 2024). They write:

This note discusses three approaches of wealth taxation, based on (1) returns with a capital income tax, (2) stocks with a wealth tax, and (3) transfers of wealth through an inheritance (or estate) tax. Taxing actual returns is generally less distortive and more equitable than a wealth tax. Hence, rather than introducing wealth taxes, reform priorities should focus on strengthening the design of capital income taxes (notably capital gains) and closing existing loopholes, while harnessing technological advances in tax administration—including cross-border information sharing—to foster tax compliance. The inheritance tax is important to address the
buildup of dynastic wealth.

I’ll add a few more words about the three options.

Income from capital can arrive in various ways, including interest payments, rent payments, dividends, share repurchases, or a pass-through firm that distributes profits to owners. But here, I want to focus on the problem of taxing capital gains: again, when you look at billionaire-level wealth, the wealth is commonly built on how the value of an asset, like stock ownership, has risen over time.

As the authors explain, the common approach is to tax capital gains when they are “realized”–that is, when the asset is sold. But this approach raises two issues. One is that if the asset has been held for a substantial period of time, the capital gains during that time have gone untaxed until they are realized–and deferring taxes for years is a substantial benefit.

The other issue is that it is often possible to roll one capital gain into a new asset without being taxed on the gain. In a US context, individuals can roll the capital gain from one house into the purchase of another house. If someone dies while holding stock, there is a “step-up” where the heir can value the stock at the price at the time of death, so the gains during the lifetime of the previous owner are not taxed.

The IMF authors describe the resulting problems in this way:

• Tax avoidance is encouraged, as there is an incentive to turn income into capital gains to benefit from lower taxation. For example, investment funds can reinvest rather than distribute earnings, and bonds can be designed to increase in value rather than pay interest.

• Tax legislation and administration increase in complexity as there is a need to address loopholes. For example, zero-coupon bonds are often taxed on their implied interest.

• Horizontal equity is diminished, because similarly profitable investments are taxed differently depending on the form in which they generate income.

• Vertical equity is diminished, because the share of income earned as capital gains rises with wealth and income. In the United States, the top 0.001 percent of taxpayers earned 60 percent of their income as capital gains (IRS 2022). In the United Kingdom, among the top 0.01 by income, almost 60 percent receive at least 90 percent of their remuneration in capital gains (Advani and Summers 2020).

• There is a lock-in effect as investors prefer to hold on to an asset even if the expected future returns are lower than those of alternative investments, as long as the tax saving from not realizing a capital gain outweighs the difference in returns.21 This leads to inefficient capital allocation. Some countries tax capital gains at lower rates (especially for long-term gains) to reduce this effect but thereby exacerbate the relative undertaxation of capital gains.

• In an international context, tax avoidance and evasion occur even on realized capital gains. For example, instead of trading a security directly, investors can trade a depository receipt in an offshore market that does not tax capital gains. Similarly, rather than directly selling a real asset, stocks or entire companies (registered in a different, conduit, country) that derive their values from that underling asset can be traded. The revenue loss can be significant in the case of high-value assets such as natural resources.

A final issue with taxation of capital gains involves inflation. If the increase in the value of my asset (say, my house) over time just matches inflation, then should this gain be treated as “income” to me when I sell the house?

There are ways to address all of these issues, but they aren’t simple.

With regard to a wealth tax, one immediate concern with a wealth tax is that a number of countries with wealth taxes decided to repeal them: basically, they were too much trouble to administer for too little revenue gain. The authors note:

[A]mong OECD members, those levying an explicit wealth tax declined from 12 in 1990 to only 3, while the Netherlands de facto also levies a wealth tax as part of its personal income tax (as does, outside the OECD, Liechtenstein). And where employed, the wealth tax is not a significant source of revenue, because of high
exemption thresholds and widespread evasion, amid severe enforcement challenges (Kopczuk 2019; Advani and Tarrant 2021). At 1.4 percent of GDP over the 2018–20 period, Switzerland has the highest revenue yield globally, but the country does not levy a capital gains tax (and its wealth concentration is high by international standards [Föllmi and Martínez 2017]). With the existing wealth taxes mostly modest and limited, studying them will not necessarily be indicative about the effect of more comprehensive or higher wealth taxes.

One can make a case on paper for a tax on the super-wealthy, like those with more than a billion dollars in wealth. But the reality that even lower wealth taxes were too difficult to collect should raise some doubts. And even a substantially more aggressive wealth tax on the super-wealthy would have limited effects on revenue: “The EU Tax Observatory (2023) estimates that a wealth tax of 2 percent on the world’s top billionaires in 2023 (about 2,800 billionaires, 30 percent of whom are in the United States according to the report) can raise about $250 billion (or 0.2 percent of world GDP).”

In terms of incentives, a wealth tax applies whether or not there is income. Imagine a risky investment. With a tax on capita income, the tax revenue goes up if the investment is a success–say, if it doubles in value–but the tax rate goes down and even becomes negative if the investment fails–say, falls to half its value. With a wealth tax, the investor still owes the wealth tax on whatever remains even if the investment has failed: in this way, a wealth tax increases risk. In addition, because wealth is typically held not in rolls of dollar bills, but in assets, paying a wealth tax may require selling off some of the asset itself.

With regard to an inheritance tax, the primary goal is to limit the intergenerational transfer of extreme wealth. The authors write:

Empirical evidence shows that the share of inherited wealth in overall wealth is large, though precise figures are hard to come by. One difficulty is that estimates differ much depending on whether capital income earned on inherited wealth is counted as part of the inherited share or not. Davies and Shorrocks (2000) argue that a share of 35–45 percent is a reasonable estimate, based on balancing different assumptions made in papers yielding much higher or lower estimates. With more detailed and recent data, which are available for a few European countries, Piketty and Zucman (2015) report results for France, Germany, and the United Kingdom, finding that in 2010, the share of inherited wealth ranges from just over 50 percent in Germany to close to 60 percent in the United Kingdom. Moreover, as shown by Acciari and Morelli (2020) using Italian data, inheritances appear to become larger (from 8.4 to 15.1 percent of GDP between 1995 and 2016) and more concentrated over time. According to a UBS (2023) report, new billionaires acquired greater wealth through inheritance than entrepreneurship.

The creativity of tax attorneys will pose challenges for an estate tax. What if a wealthy person leaves their money to a trust? What wealthy person leaves the money to a nonprofit, but also establishes their children with extremely well-paid jobs at that nonprofit? In what ways can wealth be transformed into untaxed forms? How does an inheritance tax after death compare with tax treatment of large gifts that are given during life? Is it right if an inheritance tax forces a family to sell off, say, a family home or a family farm?

In most countries, the inheritance or estate tax raises a relatively small amount.

For a follow-up to this post, see “The Super-rich and How to Tax Them” (November 17, 2020).

Empirical evidence shows that the share of inherited wealth in overall wealth is large, though precise figures are hard to come by. One difficulty is that estimates differ much depending on whether capital