Want a Flat Tax? I Got a Flat Tax for You

Crossposted at Angry Bear.

One percent of financial assets. Personal and corporate. Annually.

With somewhere north of $55 trillion in U.S. financial assets out there (2009, down from $63 trillion in 2007), a Financial Assets Tax would generate more than $550 billion in annual revenue.

What could we do with that revenue? Here are some options:

• Eradicate taxes on corporate profits, dividends, and capital gains, and cut income taxes by between 22% and 51%. (Depends on which tax year you’re looking at; this for 2007-09. NIPA Table 3.2.)

• Pay off some of our national debt, invest in productive infrastructure to build true national wealth, greatly expand the EITC (and index it to unemployment) to turbocharge the real economy, or…

• Some equitable and economically efficient combination of the above

Why should we do this? Simple: greater prosperity and greater equality. Both.

This idea seems to have far greater upsides than downsides. But I’ve undoubtedly missed some things, which I hope my gentle readers will fill in.

Here are some of the issues involved:

Innovation and growth. Naysayers (mostly — surprise! — large holders of financial assets) will scream that THIS PROPOSAL TAXES SAVINGS!!!, which for not-very-well-hidden and supposedly moralistic reasons is seen as BAD!!! (As my friend Gabriel in England said to me once, “Yes, well, we shipped all our Puritans over to you, now didn’t we?”)

Their post-hoc rationalization for that faux moralizing: savings are (more accurately: can be) used for investment, by which they mean (in this instance) fixed investment in productive assets — structures, equipment, software, etc. We want to encourage fixed investment, right? It drives growth (and long term, employment), and builds national wealth and prosperity, right?

The answer to those questions is “Yes.” But when they start objecting to the tax because it “will hut poor people,” raise at least one eyebrow.

First — as usual — they’re confusing flows with stocks. Savings is a flow. Money from savings goes into the stock of financial assets — cash in mattresses, bank account balances, CDs, stocks, bonds, collateralized debt obligations, etc.

But that misconception aside, talk about being wrong by 180 degrees. This proposal does indeed discourage saving — in favor of real investment.

Remember: there are only five things a person or company can do with a dollar of income:

1. Spend it on consumption (buy food or office supplies, pay wages for ongoing operations, etc.)

2. Invest it (to create or purchase — hence spur creation of — real assets)

3. Save it (“invest”/store it in financial assets — effectively or actually lending it out)

4. Pay off loans (basically saving, but on the other side of the balance sheet)

5. Pay taxes

If a dollar is “saved,” it is by definition not invested. (Though it or an identical, fungible equivalent might flow back out of the pool of financial assets to be spent on real investment — or on consumption, loan payoffs, or taxes.)

If people and companies sock away their income in financial “investments” (save it) and just enjoy the returns, one percent of those returns will be skimmed off every year. (Not terribly onerous, given that hedge-fund “investors” pay large multiples of that and still make piles of money for doing nothing.)

If, on the other hand, people and companies use that money to build houses, apartment buildings, malls, office buildings, amusement parks, and factories, invest in new equipment and software, or spend it on those deucedly hard-to-measure but massive contributors to our national asset base — education, training, research, and development — the assets they create won’t be hit by this tax.

And the ongoing income generated by those real assets will be taxed at a far lower rate.

Alternatively, the income that isn’t saved might be spent on consumption — increasing monetary velocity and aggregate demand, and making the whole swirling pie that is the economy, bigger.

If you think collateralized debt obligations are valuable national assets, you should hate this tax. If you think — correctly — that as Kuznets and many others have pointed out, real assets constitute true national wealth (though many of the most important real assets, like ideas, knowledge, skills, and “organizational capital,” are intangible and unmeasurable), you should love this tax.

What do we mean by financial assets? There are some gray areas that would need to be sorted out (insurance, pensions, etc.), but most financial assets quack like ducks. For a quick list, take a look at the column headings in Table 2A the of the Fed’s analysis of the Census’s 2009 Panel Survey of Consumer Finances (XLS):

Transaction accounts
Certificates of deposit
Savings bonds
Bonds
Stocks
Pooled investment funds
Retirement  accounts
Cash value life insurance
Other managed assets
Other

We might even want to include cash (actual dollar or euro bills). Why should we encourage cash in mattresses? TBD.

My friend Steve tentatively suggested “anything that’s traded on an exchange,” which seems like a good idea except it would encourage Wall Streeters to move towards assets that are traded off-exchange, over the counter. We’ve seen the effects of that.

What about incentives and economic distortions? How much would this tax distort economic decisions? Think: Nobody, ever, says “I’m not going to get wealthy because I’d have to pay taxes.” Why? Ask any of Jane Austen’s heroines: because there’s no substitute for wealth.

Earned income? Quite otherwise, because there’s a very good substitute for working to earn money: leisure. Spending time with the kids, playing golf, writing overly long and abstruse economic blog posts, watching NASCAR, assembling intricate miniatures of Civil War battle scenes.

In economic terms, the demand for employment is quite elastic because there’s an attractive substitue. The demand for wealth is quite inelastic, because there just ain’t no substitute for being rich.

The Financial Assets Tax would provide a very slightly lower incentive to earn money every year (anyone care to do the arithmetic?), but nothing like the disincentive that results (in theory, to some greater or lesser degree) from high marginal income tax rates, corporate profit and dividend taxes, etc.

The biggest incentive — arguably an economic “distortion,” but every tax except maybe land value taxes is distortionary — would be to spend on real investment (and consumption) instead of saving.

But that incentive would actually compensate for an inherent distortion resulting from the nature of financial assets, which are at root an artificial creation: Financial assets don’t decay and depreciate like real assets do. After ten years (or whatever), you still have the initial capital, plus the returns, which is not true with fixed investments. So fixed investments have a big disadvantage when they’re competing for “investment” dollars. A Financial Assets Tax would to some degree correct for that inherent market distortion/inefficiency.

Too big to fail. I’ve pointed out that the financial economy — the trade in financial assets — is many time larger (40x, 50x?) than the real economy — trade in goods and services. And it’s arguably many times larger than is necessary to lubricate and intermediate the real economy. And innumerable wise voices have pointed out the negative externalities of this excessive size: systemic risk of financial-market meltdowns that trash the real economy, gross misallocation of financial and human resources, etc.

There have been some salutary if rather timid proposals to address this via taxes on financial transactions — the flows — to compensate for those externalities and shrink the sector. But this proposal for taxing the stock of financial assets could be a superior alternative. I’ll leave it to others, for now, to analyze the pros and cons of those two alternatives.

What about private residences? This is both a large segment of fixed investment, and kind of a special case — different from business investments because the value derived isn’t in the ability to produce more, saleable goods and services, but having a roof over your head.

Here’s the functional scenario: you’ve got half a million dollars in financial assets, and you want to build a half-million-dollar house. Here are the two ends of the spectrum — you can land anywhere in between:

1. Sell all your financial assets and spend the money to build the house.

2. Sell $50,000 of financial assets for the 10% down payment on a loan, and borrow the rest.

Your taxes on the house asset are the same either way. But in scenario 2, under the Financial Asset Tax proposal you also pay tax every year on the $450,000 in financial assets you’re still holding. So it’s less attractive. It effectively increases the interest rate on your loan by 1%.

Putting aside for the moment all the other factors you personally consider (liquidity, risk, return, peace of mind, etc.): which of these scenarios — if repeated by millions of people over decades — contributes more to national wealth and prosperity? Which should the tax system encourage? (Because every tax system encourages something.)

The first scenario reduces the value of financial assets by reducing demand for them; the second increases it. As Dirk Bezemer has explained, borrowing-driven booms in financial asset values drain resources from the real economy, and so are associated with slower real-sector growth. The second scenario also effectively prints $450,000 in new money, causing more inflation pressure, which puts pressure on the Fed to raise interest rates, which discourages real-sector investment.

Which one should we encourage — borrowing or real investment? You decide. (And yes: we should also eradicate the insanely economically inefficient — and regressive — mortgage interest deduction, which makes the second scenario so much more attractive.)

What about volatility? The value of U.S. financial assets (nominal — not inflation-adjusted) fell by 13% from 2007 to 2009 (assets held by U.S. households, nonprofits, and nonfarm, nonfinancial businesses — Fed Flow of Funds TFAABSNNCB + TFAABSHNO).  Under this proposal, that would result in a huge hole in the Federal budget.

Personal income went up by 2% (nominal) over that period (NIPA Table 2.1). This tells you: the revenues from a Financial Assets Tax would be much more volatile than from income taxes, because asset values are far more volatile than incomes.

But let’s step back: Every reasonable person (this excludes large portions of the Republican and Tea Parties) agrees that it’s smart for government to spend more in the bad times (causing a government deficit), and less in the good times (causing a surplus). It’s intuitively obvious (thanks to Keynes), we’ve seen it work (1939 passim), and all sorts of old and new economic theory, notably Modern Monetary Theory, supports it in spades.

The problem, of course, is politicians. When bad times hit and government revenues are down, they panic like scared children. They don’t remember (or look forward to) the good times, like when the federal debt was plummeting during the Clinton boom/tax-increase/surplus years. So they do exactly the opposite of what common sense and prudent wisdom prescribe: they cut spending. The volatility of the Financial Asset Tax could contribute greatly to this panic-driven policymaking.

My only reply: it is to be hoped that the economic efficiency of the Financial Assets Tax — the growth and prosperity it engenders, especially in the real sector of the economy — would over the long term overwhelm the negative effects of political mismanagement. Other suggestions to overcome this difficulty, much appreciated.

What about evasion and offshoring? Stocks of financial assets are easier to track and harder to hide than flows of income. They have to be stored somewhere. Since they’re not ongoing flows, they can’t be laundered and hidden as easily through multiple international pipelines and entities.

People will still use secret accounts in the Bahamas to hide their money (as long as we allow the Bahamas bankers to get away with it; the Swiss can’t anymore…). And yes, people and businesses will figure out new schemes to evade this tax. People will always figure out ways to commit fraud. A simple tax on an easier-to-track item will make it harder for them to do so.

Since we’ll tax domestic entities’ financial assets no matter what country those assets happen to be stored in (just as we tax worldwide income now — at least of natural humans) — people and businesses will have less incentive to keep piling up their treasure in financial (and real) assets overseas. They can bring it home at no cost (they’re paying taxes on it in either place) hopefully investing it in real assets here.

Why not a consumption tax or VAT instead? I don’t actually know much about these, so take this for what you will.

Those taxes are good because they don’t penalize or kill incentives for work, innovation, and real earnings (personal earned income and real — nonfinancial — corporate profits). But both of them, as I understand the proposals and real-world examples I know of, tax investment spending at the same rate as consumption spending. So they’re not really just consumption taxes. They’re also investment taxes. That’s not good. I assume there are carve-outs to correct for that, but the more carve-outs you put in place for various and sundry reasons, the more messed up, gamed, and inefficient tax regimes become. The Financial Assets Tax makes things much more clear and simple. That’s one value of a flat tax.

Also: to make consumption taxes reasonably progressive, the top marginal rates have to be high, maybe even greater than 100%. Imagine a million-dollar consumer paying two million dollars in taxes on that consumption. You think that’s gonna happen?

How do you phase it in? This would be a big change in the rules of the game. It’s both fair and efficient to give people time to adapt. I would do it based on: 1. person versus company, 2. age, and 3. quantity of financial assets.

For people: Give a few year’s warning, then in the first year, people 30 and under with more than $5 million in financial assets would be subject to the tax. (I am rather unconcerned with these people’s well-being, or with their ability to adapt to the new regime over the course of their lives.) Increase the age and reduce the cutoff — perhaps ending at around  four to six times median income — over ten or fifteen years. Other personal tax rates should decline in concert.

For companies: Give two or three years warning, then replace the tax on C-corp profits with the Financial Assets Tax. They’ll adapt just fine — mainly by shifting from financial investment to real investment, but also probably by increasing dividends, putting the money back out there where it can be intelligently allocated by the wisdom of the crowds rather than by CEOs’ purported omniscience. Maybe this will also encourage corporations to hire CEOs who are real business managers, rather than practitioners of financial prestidigitation.

Oh yeah: equity! Don’t change the channel, America. It matters. It especially matters to those who don’t have it. (Few of whom are reading this.) But excessive inequity hurts the rich too, in the long run, because it kills long-term national prosperity. Economically efficient policies that deliver greater equity also deliver greater long-term prosperity. Even the rich get richer under progressive policies (except maybe the very, very rich). The poor and the middle class get far richer.

What do we mean by equity and inequity? Are we talking about income inequality? Feh.

Our world in pictures (regular readers will recognize some of these, but some are all new):

Source (pdf). The tax info here is just an added bonus feature, showing that above about $60K or 80K in income, our tax system (local, state, federal combined) isn’t progressive at all. The people making $160K pay the same share of their income pool as the people making $160 million.

Sources (PDF): Sylvia A. Allegretto, Economic Policy Institute; Edward Wolff, unpublished 2010 analysis of the U.S. Federal Reserve Board, Survey of Consumer Finances and Federal Reserve Flow of Funds, prepared for the Economic Policy Institute. Another hat tip to Catherine Rampell.

Figure 2. The actual United States wealth distribution plotted against the estimated and ideal distributions across all respondents. Ariely and Norton, 2010 (PDF).

The bottom 80% gets about 40% of the income.

The bottom 80% owns about 15% of the wealth.

You want freedom? Look to your bank balance. You want opportunity? Look to your bank balance. You want time and space enough to innovate and be an entrepreneur, without the disincentive (not to mention embarrassment and inconvenience) of potential financial catastrophe?  You want to buy birthday presents for your kids, get their teeth fixed, or put them through good colleges, maybe take a family vacation every year or two? You know where to look.

But if you’re not in the top 20%, you’re not looking at shit.

So who pays the tax? You can see the ownership breakout for financial assets sliced various ways in the aforementioned Fed/Census Bureau table (XLS). Here’s the breakout for personal holdings, by levels of income:

This would be a very progressive tax, because the the distribution of wealth is very regressive. It would compensate quite effectively for all our country’s regressive taxes, like payroll taxes, sales taxes, property taxes, and cut-rate taxes on financial investments.

I don’t have the wherewithal to calculate the total resulting progressivity. Perhaps it would be excessive, to the point of economic inefficiency (though I doubt it). If we thought that was the case, we could reduce the rate from 1% to .75% or .5%, and continue income and other taxes at higher rates. Subject to discussion.

Bottom line: If we want widespread freedom, opportunity, innovation, entrepreneurship, and healthy, happy living, all feeding on itself in a virtuous, self-perpetuating cycle, then broadly based wealth distribution is at least one necessary condition. A tax on financial assets would be an (economicaly) efficient and effective means to move towards that goal.

Oh, and not that this matters, but in the short and medium term, while pies are growing and boats are rising, tens of millions of people get to suffer less.

But maybe it does matter, because in the long run, you know…

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