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While Elizabeth Warren has fomented a good deal of productive debate about the egregious concentration of wealth among the 0.1% with her wealth tax proposal, there’s a lot not to like about her scheme. We’ll focus on one glaring issue: that a substantial amount of wealth is held in the form of investments in private companies. What they are worth is legitimately subject to question and therefore open to gaming. This is such a significant issue that her estimates of what her tax would yield look considerably overstated.
Shorter: there are other ways to skin the fat cats that would work just about as well if not better and not have as many stumbling blocks, both legal and practical. So it is odd that someone vaunted as a technocrat chose a problematic path to achieve her aims.
We were working on this post, which is long overdue, just as some new stories on the Warren and Sanders wealth tax plans came out. Our timing had nothing to do with these articles.
For instance, a New York Times piece, Democrats’ Plans to Tax Wealth Would Reshape U.S. Economy, has a subhead that stresses the risks to growth:
Proposals from Elizabeth Warren and Bernie Sanders have raised concerns from economists and business leaders who fear the plans would sap economic growth.
We are not going to address these claims at length here. We’ve pointed out regularly, based on quite a few economists’ studies, that high income and wealth inequality are negatives for growth. Highly unequal societies are even detrimental to health, including that of the rich. Admittedly, there would be transition costs in moving to a wealth tax, but that does not appear to be the argument the critics are making.
Even though Sanders advocated a wealth tax before Warren did, in 2014, and his tax is also more sharply graduated than hers (a top rate of 8% versus 3% for hers), the program she announced earlier this year has gotten more media and economist attention, and so we will focus on it.
Overview of Warren’s Plan
The key elements of Warren’s “ultra millionaires” tax:
A 2% annual tax on wealth over $50 million, with any assets over $50,000 subject to reporting (more on that shortly)
A 1% surtax on wealth over $1 billion
Inclusion of world-wide assets
40% “exit tax” on the net worth over $50 million of citizens who renounces their citizenship
She claims her tax would produce $2.75 trillion over ten years, based on estimates by economists Gabriel Zucman and Thomas Piketty.
One argument in favor of her tax is based on an aside in an article by Lee Sheppard in Tax Notes. Warren’s 2% tax is what you’d expect to see in the way of returns on conservative investments. So despite setting up the tax as a tax on assets, conceptually, one could think of it as a way to cut into the investment returns of the top wealthy. Most should not have to sell holdings but turn over income.
The Confused Objectives of Warren’s Plan
Warren and Sanders have both made revenue raising one of the centerpieces of “why this tax” We see that as a mistake. It serves to take the focus off compelling reasons for redistribution: fairness, economic efficiency, and curtailing corruption. Polls find that roughly two-thirds of Americans support a wealth tax, consistent with the idea that they recognize that economic mobility has fallen because the well-off can entrench their advantaged position. But both seem to have underplayed the notion that concentrated wealth undermines growth, particularly in supporting an outsized, “talent”-misappropriating financial services sector.
Needless to say, Warren’s tax plan, like that of all of the Democratic contenders, has the unfortunate effect of reinforcing the notion that the Federal government needs to tax in order to spend. As a currency issuer, the Federal government can always create more dollars to fund any so-called “net” (meaning deficit) spending; it is constrained by the risk of generating too much inflation. Taxing and issuing bonds are political holdovers from the gold standard era. Notice how no one ever worried about where the next billion for a bombing run in Iraq was coming from. The recent discovery of $21 trillion of heretofore unaccounted for military spending over the decades is one proof that the US does not need to tax to spend.
In addition, there are other ways to get at wealth concentration that are less fraught but would be as effective over time….even assuming Warren’s assumptions about how wealth would effectively be subject to her tax are accurate.
The Practical Problems with Warren’s Plan
Warren presents the policy wonk’s version of the economist’s famed “Assume a can opener”. Her version is “Assume effective IRS enforcement on the super rich.” Good luck with that.
The rich and super rich hold the overwhelming majority of their assets in these forms: publicly traded securities, real estate, and private companies. The example from Warren’s website is shockingly inaccurate: “Consider two people: an heir with $500 million in yachts, jewelry, and fine art…”
The problem that Warren is hand-waving away is that private companies are hard to value and even real estate isn’t as easy as one might assume.
M&A professionals, the type who eat liability to issue fairness opinions, will tell you valuation of companies is an art, not a science. Even with public companies, they do not opine that the price paid to the selling shareholders in a merger is correct, merely that it is “fair”. Remember, in these cases, the company being bought has a trading history and the investment bankers can work up comparisons of merger premiums for similar deals.
Anyone who has valued private companies (which yours truly has done for decades, professionally, for US and Japanese companies, billionaires, and private equity firms) or even just a cash flow model for a large corporate project, will tell you that if you vary the key assumptions within a reasonable range, you will regularly get a difference in projected cash flows (which is the basis for valuing the company) of X to 5X.
Similarly, it is hardly uncommon in private equity to have several firms invested in the same deal. Limited partners who by happenstance are investors in the private equity firms that all invested in one company regularly find that the valuation of that company reported to them differs wildly. The concerned limited partners ask for explanations and the general partners have perfectly logical-sounding explanations for why their valuation looks high or low relative to the others.
Moreover, coming up with an independent valuation for a meaningfully-sized business is labor intensive, since you need to sanity-check the owner’s assumptions, particularly if you are assuming liability for your work. Attentive readers may recall that we’ve discussed how private equity is the only type of institutional asset management where the asset managers value the holdings themselves, and then only monthly. All other types require monthly valuation by a third party.
Why is private equity different? Because the cost of valuing a private company by a reputable firm like Houlihan Lokey would be on the order of $30,000 (and that may be low), and that’s deemed to be costly enough to impair returns.
But Warren seems to be relying on the IRS version of the UK’s technological solution to the Irish backstop:
For example, the IRS would be authorized to use cutting-edge retrospective and prospective formulaic valuation methods for certain harder-to-value assets like closely held business and non-owner-occupied real estate.
This is bafflegab. You can’t use “formulaic valuations” because the hard part is not crunching the numbers, it’s coming up with a solid forecast of revenues, costs, and required investments (such as in working capital) based on an understanding of the company’s competitive environment.
Similarly, even valuing real estate is not as simple as one might assume. Even for their personal holdings, the middling and super rich often hold unique or at least distinctive properties. Looking at comparables would give a wide range of values.
Even commercial properties are tricky. If you have a large office building, you need to look at lease escalations and rolloffs, as well as tenant quality (default is always a risk). An office building that has a lot of rolloffs in the next five years is going to be more of a finger-in-the-air exercise than one that has them mainly more than five years out and then well staggered.
So far, we’ve discussed mature, income-producing assets. What if you are dealing with a major developer who has projects underway, and say has also bought distressed properties as a turnaround play?
Warren’s description of her plan describes argues that it will be possible for a muscled-up IRS to be able to find and value assets of the super-rich all over the world. In fact, the valuation issues posed by her plan are similar to the ones the IRS faces with imposing estate taxes on large estates. Lee Sheppard pointed out in Tax Notes:
Warren’s answer to the obvious administrative questions would be an enlarged IRS budget and mandatory audits for rich households. Our readers know the IRS has never won a large estate valuation case (e.g., Estate of Newhouse v. Commissioner, 94 T.C. 193 (1990)).
As much as there is good reason to take what Larry Summers says with a fistful of salt, in the last four plus years, he’s staked out the position of selling left-leaning leading edge conventional wisdom, routinely taking more forward-thinking positions that Paul Krugman (admittedly, that’s way less hard to do than it once was). More relevant, Summers as former Treasury Secretary has the IRS reporting to him and so dealt with tax collection issues first hand. By contrast, as much as Warren’s advisers on her plan, Zucman and Piketty, are highly regarded for their work on wealth and income concentration, they are not experts in tax. And more generally, economists know bupkis about anything as nitty gritty as tax administration. For instance, Zucman and Piketty used the Forbes 400 list as one of their guides as to how many super rich there were and what they have. Even though I don’t get around much, I have personally had three clients who at the time I was working with them that were well over the level that should have gotten them on the US or international Forbes 400 list but weren’t. One stated that he was delighted not to have been found out.
Zucman and Piketty estimate that only 15% of wealth will escape from the tax man via avoidance and evasion. That number looks extremely light given that that is the estimated level of cheating for all Federal taxes, which consists mainly of income and payroll taxes, where where employers report W-2 and 1099 income.
In April in a Washington Post op ed, Summers and Natasha Sarin, who is an assistant professor of law at the University of Pennsylvania Law School and an assistant professor of finance at the Wharton School, took a sharp pencil to the Warren/Zucman/Piketty estimates of and found them wanting. Their estimate was that the IRS will be able to collect only 40% of Zucman’s and Piketty’s assumption. That was a generous estimate, giving some credit to Warren’s claim that she will tax wealth comprehensively, since making a generous extrapolation from estate tax results, the authors found that Warren would collect only 1/8 of what she’d expected.
Summers and Sarin cautioned that tax experts would considerably haircut their forecasts of what new taxes or tax changes would yield, since taxpayers are very skilled at changing behavior to mitigate the impact:
We suspect that to a great extent it reflects the myriad ways wealthy people avoid paying estate taxes that in some form will be applicable in any actually legislated wealth tax. These include questionable appraisals; valuation discounts for illiquidity and lack of control; establishment of trusts that enable division of assets among family members with substantial founder control; planning devices that give some income to charity while keeping the remainder for the donor and her beneficiaries; tax-advantaged lending schemes; and other complex devices known only to sophisticated investors. Except for reducing a naive calculation by 15 percent, Saez and Zucman do not seem to take account of these devices.
Warren further contends the IRS will be able to find and value foreign assets. Again, for private businesses and real estate, that’s a tall order. And going back to her outlier example of the rich heiress, pray tell, how would one find what jewelry someone owns? Jews of means fleeing persecution would often carry cut diamonds as a way to hide their fortunes.
On top of that, trends are against Warren. A dozen countries had wealth taxes in 1990. That’s now down to three. From the summary of a 2018 OECD report:
Decisions to repeal net wealth taxes have often been justified by efficiency and administrative concerns and by the observation that net wealth taxes have frequently failed to meet their redistributive goals. The revenues collected from net wealth taxes have also, with a few exceptions, been very low…
Overall, the report concludes that from both an efficiency and equity perspective, there are limited arguments for having a net wealth tax in addition to broad-based personal capital income taxes and well-designed inheritance and gift taxes. While there are important similarities between personal capital income taxes and net wealth taxes, the report shows that net wealth taxes tend to be more distortive and less equitable. This is largely because they are imposed irrespective of the actual returns that taxpayers earn on their assets.
The Warren and Sanders wealth tax ideas are also certain to be challenged as unconstitutional. Even though Warren got a roster of legal experts to support her plan, litigation is not a popularity contest. At a minimum, implementation would be delayed. And a win is not certain. From New York Magazine:
“I think a constitutional challenge to an actual tax on wealth is inevitable,” says Michael Graetz, a professor of tax law at Columbia University. “That it would fail does not seem to me to be obvious.”
Finally, we’ll only briefly address that there are other types of taxes that would be economically similar in their effects to a wealth tax and would be less hairy legally and practically. A paper by Daniel Jacob Hemel of the University of Chicago Law School describes a couple of alternatives. From the abstract:
An annual wealth tax, a mark-to-market income tax, and a retrospective capital gains tax are three approaches to capital taxation that yield roughly equivalent outcomes under certain conditions. The three approaches differ starkly, however, in their exposure to uncertainty of various types. This essay seeks to highlight the effect of uncertainty on the implementation and operation of alternative capital taxation regimes. An annual wealth tax is highly vulnerable to valuation uncertainty and constitutional uncertainty, but less so to political uncertainty. A retrospective capital gains tax, by contrast, minimizes valuation uncertainty and effectively eliminates constitutional uncertainty but remains highly exposed to political uncertainty. A mark-to-market regime falls somewhere between the two extremes on dimensions of political and constitutional uncertainty but shares in a wealth tax’s exposure to valuation uncertainty. Ultimately, the choice among alternative capital taxation regimes reflects a tradeoff among uncertainties of different varieties.
Despite these issues, it’s nevertheless good to see Warren and Sanders moving the Overton window to the left and challenging the idea that the rich deserve their lucre. It would be nice if they could find an approach here that would have popular appeal as well as delivering the goods.