Taxing the superrich
Mar 2022
Taxing the superrich
Many think billionaires are spared too much by the taxman compared to average earners. Where does this impression come from? A commentary by Florian Scheuer.
This article was originally published in «Frankfurter Allgemeine Zeitung» on 30 January 2022. Translated and edited for layout purposes by the UBS Center.
Last autumn, an analysis by the US government caused a stir, according to which the tax burden of the 400 wealthiest Americans is only about 8 percent of their income. This is significantly less than the average tax rate of many average Americans. How can it be that billionaires pay less tax in relation to their income than, say, people with medium incomes?
To do this, one must consider the income structure of many superrich people. Take, for example, Elon Musk, currently the richest person in the world. His income is currently estimated by the Bloomberg news agency at around 220 billion dollars. He does not receive any salary income worth mentioning, and the companies he founded, Tesla and SpaceX, do not pay any dividends either. This means that Elon Musk only has taxable income if he sells his shares in the company: In that case, he realises capital gains. This pattern is typical: while for most people wage income is the only form of income, capital gains are the most important source at the top end of the distribution.
And this is also the reason for the lower tax burden of the «super – rich”– because in many countries, capital gains are given preferential tax treatment compared to labour income. In the USA, for example, the 20% tax rate on capital gains is only half as high as the top tax rate on regular income. The situation is similar in Germany: capital gains are either taxed at a 25 % flat rate (plus solidarity contribution) or, in the case of larger company shares, only 60% has to be taken into account for income tax purposes.
Many think billionaires are spared too much by the taxman compared to average earners. Where does this impression come from? A commentary by Florian Scheuer.
This article was originally published in «Frankfurter Allgemeine Zeitung» on 30 January 2022. Translated and edited for layout purposes by the UBS Center.
Last autumn, an analysis by the US government caused a stir, according to which the tax burden of the 400 wealthiest Americans is only about 8 percent of their income. This is significantly less than the average tax rate of many average Americans. How can it be that billionaires pay less tax in relation to their income than, say, people with medium incomes?
Florian Scheuer, UBS Foundation Professor of Economics of Institutions
Only realised gains are taxed
Even more important, however, is the rule that capital gains only have to be taxed when they are realised, i.e. when the underlying assets are sold. This allows tax liability to be avoided by simply not realising the capital gains. Elon Musk, for example, only sells a marginal number of shares in the companies he owns in comparison to his annual growth in wealth. If one puts the resulting tax burden in relation to the increase in wealth, the result is the rather modest average tax rate for billionaires mentioned above. And this phenomenon is by no means new: star investor Warren Buffett complained over ten years ago that his secretary was faced with a higher tax rate than he was.
In addition to personal income tax, the profits of the superrich are subject to corporate income tax at the company level. However, this has been steadily reduced across countries in the past decades, especially because many multinational companies, particularly in the technology sector, can reduce their effective tax burden further by shifting profits to tax havens. This makes the OECD's recent efforts to at least limit these possibilities, for example through an international minimum tax, all the more important.
In view of these trends, do the superrich still contribute their "fair share" to the financing of our social system? Calls for a higher tax contribution for top earners and assets have recently increased once again, particularly in view of the additional burdens on national budgets caused by the Corona crisis.
At this year's World Economic Forum, a group of 100 millionaires and billionaires called for a global wealth tax for the rich to reduce inequality, which increased further during the pandemic, and, for example, to produce enough vaccines for the whole world.
Even more important, however, is the rule that capital gains only have to be taxed when they are realised, i.e. when the underlying assets are sold. This allows tax liability to be avoided by simply not realising the capital gains. Elon Musk, for example, only sells a marginal number of shares in the companies he owns in comparison to his annual growth in wealth. If one puts the resulting tax burden in relation to the increase in wealth, the result is the rather modest average tax rate for billionaires mentioned above. And this phenomenon is by no means new: star investor Warren Buffett complained over ten years ago that his secretary was faced with a higher tax rate than he was.
In addition to personal income tax, the profits of the superrich are subject to corporate income tax at the company level. However, this has been steadily reduced across countries in the past decades, especially because many multinational companies, particularly in the technology sector, can reduce their effective tax burden further by shifting profits to tax havens. This makes the OECD's recent efforts to at least limit these possibilities, for example through an international minimum tax, all the more important.
Vague differentiation
A wealth tax, such as the one in Switzerland, has the advantage that it generates tax revenue from the superrich even if they do not realise capital gains. However, there are also disadvantages.
First, the tax burden is independent of the actual realised capital gains: an annual capital gains tax of 2 %, for example, is equivalent to a capital gains tax of 50 % on a hypothetical nominal return of 4 %. If, however, the superrich achieve higher actual returns, for example because the companies they founded have market power, these excess returns remain effectively tax-free, which makes little economic sense. In recent years, research has produced increasing evidence of such monopoly profits. The high valuations of companies such as Amazon or Apple, for example, are largely due to their dominant market positions.
A second disadvantage is that the distinction between labour income and capital gains is often blurred for entrepreneurs, who make up a large proportion of the superrich. Start-up founders are usually remunerated in the form of company shares, which are initially only valued at a low level, but experience massive increases in value in the event of a successful takeover or IPO. The increase in value may look like a capital gain, but it is ultimately compensation for the work done in the initial phase of the company. It is difficult to justify taxing such de facto labour income based on a fixed, hypothetical target return, as the wealth tax does.
A wealth tax, such as the one in Switzerland, has the advantage that it generates tax revenue from the superrich even if they do not realise capital gains. However, there are also disadvantages.
First, the tax burden is independent of the actual realised capital gains: an annual capital gains tax of 2 %, for example, is equivalent to a capital gains tax of 50 % on a hypothetical nominal return of 4 %. If, however, the superrich achieve higher actual returns, for example because the companies they founded have market power, these excess returns remain effectively tax-free, which makes little economic sense. In recent years, research has produced increasing evidence of such monopoly profits. The high valuations of companies such as Amazon or Apple, for example, are largely due to their dominant market positions.
Yellen takes aim at book profits
The capital gains tax avoids both disadvantages, as it also covers extraordinary gains or relabelled labour income. This points to reforming the taxation of capital gains instead of a wealth tax. Besides a higher tax rate, the fundamental issue is when capital gains become taxable. US Treasury Secretary Janet Yellen, for example, is currently considering ways to tax the book profits of billionaires annually, even if they have not yet been realised. However, as with the wealth tax, the question arises as to what causes the increases in value. In the case of company shares, there are essentially two possibilities: firstly, higher (current or expected future) company profits or, secondly, a lower interest rate, which also discounts a constant flow of future profits into a higher present value and thus increases the value of the company.
In fact, globally real interest rates have fallen significantly in the past decades, which, to a significant extent, explains the increase in asset values to a significant extent. While the first possibility, i.e. increased corporate profits, goes hand in hand with an actual increase in wealth for the owners, the second possibility, i.e. valuation gains due to falling interest rates, are merely "paper gains".
In this way, if future company profits remain the same, the real consumption opportunities of the owners also remain unchanged. If the interest rate falls, the asset value increases, but it is also needed to finance the same annual payout as before. In view of this, there may be false assessments if unrealised annual capital gains due to interest rate fluctuations are used as the basis for tax assessment.
This becomes particularly clear in the case of book losses. In this case, the tax burden would be negative, so the tax authorities would ultimately have to reimburse the owner for part of the losses. Apart from numerous implementation problems, however, it is unclear whether the capital losses correspond to an actual welfare loss at all. If they are due to a higher interest rate and are not realised, the owner may even be able to afford more future consumption thanks to the higher returns.
The capital gains tax avoids both disadvantages, as it also covers extraordinary gains or relabelled labour income. This points to reforming the taxation of capital gains instead of a wealth tax. Besides a higher tax rate, the fundamental issue is when capital gains become taxable. US Treasury Secretary Janet Yellen, for example, is currently considering ways to tax the book profits of billionaires annually, even if they have not yet been realised. However, as with the wealth tax, the question arises as to what causes the increases in value. In the case of company shares, there are essentially two possibilities: firstly, higher (current or expected future) company profits or, secondly, a lower interest rate, which also discounts a constant flow of future profits into a higher present value and thus increases the value of the company.
In fact, globally real interest rates have fallen significantly in the past decades, which, to a significant extent, explains the increase in asset values to a significant extent. While the first possibility, i.e. increased corporate profits, goes hand in hand with an actual increase in wealth for the owners, the second possibility, i.e. valuation gains due to falling interest rates, are merely "paper gains".
Holding out until inheritance
All in all, these arguments speak in favour of staying with a tax system based on realised capital gains. However, it should be ensured that the tax burden cannot be avoided entirely by not realising the capital gains until death. This is currently the case in the USA, for example, and represents one of the most important tax loopholes for the superrich: If, for example, one bequeaths shares in a company to one's children and they sell them later, only the capital gains accrued from the time of the transfer are taxable; the increase in value during one's own lifetime, on the other hand, escapes taxation completely. This is not only problematic from the point of view of tax fairness, but also has distorting effects, such as the incentive not to sell company shares as one grows older (the so-called "lock-in" effect). Last year, the Biden administration tried to abolish this regulation, but failed due to opposition in the US Congress.
The situation is different in Germany: There, inheritors would, for example, have to pay the final withholding tax on the entire capital gains when they sell the inherited assets, including those that arose during the lifetime of the deceased. An alternative would be to tax the accumulated but unrealised capital gains no later than at the time of the deceased's death. This could be well combined with the inheritance tax, which requires a valuation of the assets at that time in any case.
All in all, these arguments speak in favour of staying with a tax system based on realised capital gains. However, it should be ensured that the tax burden cannot be avoided entirely by not realising the capital gains until death. This is currently the case in the USA, for example, and represents one of the most important tax loopholes for the superrich: If, for example, one bequeaths shares in a company to one's children and they sell them later, only the capital gains accrued from the time of the transfer are taxable; the increase in value during one's own lifetime, on the other hand, escapes taxation completely. This is not only problematic from the point of view of tax fairness, but also has distorting effects, such as the incentive not to sell company shares as one grows older (the so-called "lock-in" effect). Last year, the Biden administration tried to abolish this regulation, but failed due to opposition in the US Congress.
The situation is different in Germany: There, inheritors would, for example, have to pay the final withholding tax on the entire capital gains when they sell the inherited assets, including those that arose during the lifetime of the deceased. An alternative would be to tax the accumulated but unrealised capital gains no later than at the time of the deceased's death. This could be well combined with the inheritance tax, which requires a valuation of the assets at that time in any case.
The unpopular inheritance tax
In the view of many economists, inheritance tax is how the distribution of wealth can be prevented from widening in the long term. Yet worldwide it is in retreat: many countries have abolished it or further eroded the tax base. In Germany, for example, it can be largely avoided by many of the superrich thanks to generous exemption rules for business assets.
In the public debate, inheritance tax is often unpopular because of the double taxation of previously taxed, saved earned income or liquidity problems when inheriting private companies. It is also perceived as invasive by many opponents and in the USA, for example, it is derided as a "death tax". However, less attention is typically paid to its significance for the next generation, who receive the inheritances. Which family we are born into is by far the greatest economic risk in life, without us having the slightest influence over it. From this perspective, a certain redistribution of inherited (or given away) wealth is an essential instrument for taking at least one step towards equal opportunities. Inheritance tax therefore also corresponds to fundamental liberal principles.
In the view of many economists, inheritance tax is how the distribution of wealth can be prevented from widening in the long term. Yet worldwide it is in retreat: many countries have abolished it or further eroded the tax base. In Germany, for example, it can be largely avoided by many of the superrich thanks to generous exemption rules for business assets.
In the public debate, inheritance tax is often unpopular because of the double taxation of previously taxed, saved earned income or liquidity problems when inheriting private companies. It is also perceived as invasive by many opponents and in the USA, for example, it is derided as a "death tax". However, less attention is typically paid to its significance for the next generation, who receive the inheritances. Which family we are born into is by far the greatest economic risk in life, without us having the slightest influence over it. From this perspective, a certain redistribution of inherited (or given away) wealth is an essential instrument for taking at least one step towards equal opportunities. Inheritance tax therefore also corresponds to fundamental liberal principles.
Conceivable deferral over decades
From this perspective, a system based entirely on the inheriting generation would be thinkable. Instead of taxing each inheritance individually, the tax burden would depend on the total amount of inheritances and gifts received over the course of a lifetime, including capital gains. In addition to tax-free allowances that focus the tax burden on inheritors with millions to inherit, it would also be important to broaden the tax base and close the loopholes that currently benefit the top estates in particular. For example, potential difficulties in transferring illiquid assets, such as companies, could be mitigated by spreading the tax liability over several years or even decades. The fact of double taxation is not a valid counter-argument in any case; it applies equally to many other widely accepted taxes, such as consumption taxes.
However, a reform of inheritance tax that consistently focuses on the recipient generation would require better data collection than is currently available, so that it is at best a long-term solution. Generally, comprehensive data on the distribution of wealth transfers from generation to generation over the life cycle would also have the welcome side effect of giving the public a more accurate picture of the development of wealth inequality and possible tax policy responses. One can only hope that this would also boost political support for a workable inheritance tax.
From this perspective, a system based entirely on the inheriting generation would be thinkable. Instead of taxing each inheritance individually, the tax burden would depend on the total amount of inheritances and gifts received over the course of a lifetime, including capital gains. In addition to tax-free allowances that focus the tax burden on inheritors with millions to inherit, it would also be important to broaden the tax base and close the loopholes that currently benefit the top estates in particular. For example, potential difficulties in transferring illiquid assets, such as companies, could be mitigated by spreading the tax liability over several years or even decades. The fact of double taxation is not a valid counter-argument in any case; it applies equally to many other widely accepted taxes, such as consumption taxes.
However, a reform of inheritance tax that consistently focuses on the recipient generation would require better data collection than is currently available, so that it is at best a long-term solution. Generally, comprehensive data on the distribution of wealth transfers from generation to generation over the life cycle would also have the welcome side effect of giving the public a more accurate picture of the development of wealth inequality and possible tax policy responses. One can only hope that this would also boost political support for a workable inheritance tax.
Contact
UBS Foundation Professor of Economics of Institutions
Florian Scheuer received his PhD from MIT in 2010. He is interested in the policy implications of rising inequality, with a focus on tax policy. In particular, he has worked on incorporating important features of real-world labor markets into the design of optimal income and wealth taxes. These include economies with rent-seeking, superstar effects or an important entrepreneurial sector, frictional financial markets, as well as political constraints on tax policy and the resulting inequality. His work has been published in the American Economic Review, the Journal of Political Economy, the Quarterly Journal of Economics and the Review of Economic Studies, among other journals. In 2017, he received an ERC starting grant for his research on “Inequality - Public Policy and Political Economy.” Before joining Zurich, he was on the faculty at Stanford, held visiting positions at Harvard and UC Berkeley and was a National Fellow at the Hoover Institution. He is Co-Editor of Theoretical Economics and Member of the Board of Editors of the Review of Economic Studies. He is also a Co-Director of the working group on Macro Public Finance at the NBER. He has commented on tax policy in various US and Swiss media outlets.
UBS Foundation Professor of Economics of Institutions
Florian Scheuer received his PhD from MIT in 2010. He is interested in the policy implications of rising inequality, with a focus on tax policy. In particular, he has worked on incorporating important features of real-world labor markets into the design of optimal income and wealth taxes. These include economies with rent-seeking, superstar effects or an important entrepreneurial sector, frictional financial markets, as well as political constraints on tax policy and the resulting inequality. His work has been published in the American Economic Review, the Journal of Political Economy, the Quarterly Journal of Economics and the Review of Economic Studies, among other journals. In 2017, he received an ERC starting grant for his research on “Inequality - Public Policy and Political Economy.” Before joining Zurich, he was on the faculty at Stanford, held visiting positions at Harvard and UC Berkeley and was a National Fellow at the Hoover Institution. He is Co-Editor of Theoretical Economics and Member of the Board of Editors of the Review of Economic Studies. He is also a Co-Director of the working group on Macro Public Finance at the NBER. He has commented on tax policy in various US and Swiss media outlets.