How effective is the wealth tax in tackling inequality

The UK champions merit, backed by the belief that hard work and persistence changes destiny. However, our system does not work for most people. Some have proposed a wealth tax to fight inequality. In what follows, I will explore the relative merits of the wealth tax, which is a percentage charge levied on the total market value of a person’s assets. One potential implementation for the wealth tax was proposed by the Wealth Tax Commission [BBC, ‘Tax the wealthy to pay for coronavirus’, 2020], which will be used as a model for this essay. This policy is a progressive tax as it involves an increasing tax rate as a function of wealth after an allowance of £500,000, as illustrated by Figure 1.

[Figure 1]

However, it will ultimately be argued that the wealth tax is ineffective in fighting inequality due to two main reasons: tax avoidance and how the tax would disproportionately affect asset-rich pensioners. Inequality is characterised as the bridging of the gap of wealth and quality of life between the most and least well-off in society.

In theory, if we assume perfect adherence to the tax, we should observe a reduction in wealth inequality in the UK. Firstly, ceteris paribus, the wealth levels of high-wealth households go down, while that of low-wealth households stay the same. The Wealth Tax Commission concluded that a one-off tax of 5% on household net wealth per person of £500,000 or above could raise £260 billion. This revenue generated from the tax can be reinvested in society by introducing welfare services such as free meals for school children, improving the NHS, improving unemployment pay and household subsidies. This would tackle inequality by raising the standards of living of the least well-off, so as to reduce the gap between the richest and the poorest. Secondly, since the wealth tax is spent on lowering the national debt, then it may reduce future tax hikes on low-wealth households. For example, in wake of the 2008 financial crisis, the UK saw an increase in VAT and reduction in exemptions as part of austerity measures to decrease national debt, resulting in greater decrease in lower households’ disposable incomes due to the regressive nature of the tax [HM Treasury, 2008]. As a result, the reduction of national debt financed by this one-off wealth tax may also help to prevent a decrease in future low-wealth household disposable income. Therefore, theoretically, under the assumption of compliance and adherence to the tax, a wealth tax should be effective in reducing inequality in terms of both wealth and standards of living.

However, the prescribed effects of the wealth tax, under the assumption of ceteris paribus, is often not observed in society. The wealth tax may be ineffective in reducing inequality because of aggressive, yet legal, tax avoidance strategies, as well as the disproportionate negative effects on middle-class pensioners.

Firstly, tax avoidance strategies mean that the wealth tax might not target the top 1% and redistribute it to the least well-off as well as we want it to. Most of the top 1% in the UK are non-domiciled UK residents: UK residents with their ‘permanent homes’ outside of the UK. They are only taxed on UK income but not non-UK income. A wealth tax would incentivize them to transfer wealth and assets to non-UK tax havens. They are not taxed on non-UK wealth and most have done the transfers already. [Morgan-Bentley, 2019]. While medium-wealth households tend to keep most of their wealth in the UK, high-wealth households tend to transfer their wealth overseas. This is because of two factors: the ability to pay for the lump-sum cost needed to employ expertise to exploit legal tax loopholes and the type of assets owned by each class of households. Firstly, the lump-sum cost (as a function of wealth) needed for avoiding taxes and offshoring assets becomes a smaller percentage of wealth when the person in mind is wealthier. This means that it is considerably harder for the middle class to afford such a transfer than it is for the top 1%. Secondly, as suggested by Thomas Piketty in “Capital and Ideology”, the middle class and the top 1% own different type of assets. The majority of assets owned by the middle class are either immovable assets like houses or self-owned businesses; on the other hand, the 1% tend to own mobile and liquid financial assets like stocks and bonds. [Figure 2] Ultimately, the wealth tax may not be as effective as expected to raise money from the top 1% in order to reduce inequality.

[Figure 2] [Piketty, 2017]

The effectiveness of the wealth tax in tackling inequality can also be disputed because it has too low of a threshold such that the tax burden is raised for those who are savings-dependent, when actually the policy should be tackling the top 1%. It is important to consider the difference in sources of income between households that rely on wages (labour income) and households that rely on interests and the sale of assets (capital income). The wealth tax would disproportionately affect those who rely on savings, such as retirees and pensioners. For example, a retiree at the age of 65 with total net asset value of £600,000 would already have a disposable income of only £30,000 a year (assuming interest rate of savings is close to zero, inflation is very small and retiree has 20 years of life expectancy), but would have to pay 5,000 in the wealth tax. At the same time, a middle-aged high-income earner, such as a banker earning 200,000 per year, can simply consume the majority of their labour income without acquiring enough wealth to pay a significant amount of wealth tax. This can be illustrated with the following model of consumption smoothing.

Figure 3 considers a simple 2-period model of consumption explaining the difference between how savings-dependents and income-dependents are affected. We can model a household’s disposable income as the following: income from wages + change in assets - taxes. The green curves represent their initial consumption possibility frontier, while the black curves are the utility curves of the households. Since it is convex, this implies that they prefer to smooth their consumption (i.e. consume a similar amount in both periods). The diagram on the left represents the savings-dependent household, and a wealth tax decreases their total disposable income, as represented by the shift from the green to the blue curve. As a result, the new optimal consumption decreases. This is because, according to Milton Friedman’s permanent income hypothesis, savings-dependent households would have to save (and pay the wealth tax) in order to be able to smooth out their consumption, since they expect their long term average income to decrease. Contrastingly, the diagram on the right represents wage-dependent households. A wealth tax only decreases their total income slightly if they spend more and accumulate less wealth. Thus, they are not necessarily worse off and they are not necessarily paying as much of the wealth tax. The retiree is hence forced to pay the full amount of the tax from their savings, whereas the well-off banker can afford to spend instead and maintain a generally affluent lifestyle.

[Figure3 – consumption possibility frontier]

Furthermore, taking into account the life cycle hypothesis, even if the bankers were capital-rich, the pensioners would still be more adversely affected by the wealth tax because they have to smooth out their income over a shorter period. This can be illustrated in the same two-period model if we assume that the pensioners do not consume in period 2. The immediate drop in income suffered by the pensioner in period 1 is thus considerably higher than that suffered by the banker, since the former cannot smooth their income across two periods.

[Figure 4]

Consequently, the wealth tax would not necessarily reduce inequality as a function of disposable income, as some relatively low income (but savings-dependent) households would pay the wealth tax and be adversely affected by it, while other high income (but wage-dependent) households would not.

In conclusion, theoretically, the wealth tax is effective because it taxes the rich in accordance to their entire wealth, and the revenue generated can be redistributed to the poor, reducing the inequality gap. However, the problem with the wealth tax in practice is that it allows the wealthiest to exploit legal loopholes at the expense of hard-working middle class pensioners, who are affected due to the low threshold. It is important to take into account that tax compliance is rarely observed amongst the wealthiest individuals, given that politicians are reluctant to risk alienating their wealthy backers by properly enforcing the tax and closing the loopholes. Hence, the effective tax rate may eventually be low or zero for low or ultra-high wealth earners, and high for medium-wealth households. This would not be substantial in reducing inequality since the gap between the top and the bottom is not bridged, and the middle is treated as expendable.

References

• BBC News. 2020. 'Tax the wealthy to pay for coronavirus'. [online] Available at: <https://www.bbc.com/news/business-55236851>.

• HM Treasury, 2008. Pre-Budget Report November 2008, Facing global challenges: Supporting people through difficult times. London: The Stationery Office, p.200.

• Morgan-Bentley, P., 2019. A third of British billionaires have moved to a tax haven. The Sunday Times, [online] Available at: <https://www.thetimes.co.uk/article/a-third-of-british-billionaires-have-moved-to-a-tax-haven-zk6q53rtd>.

• Piketty, T., 2017. Suppression of the wealth tax: an historical error. LeMonde.fr, [online] Available at: <https://www.lemonde.fr/blog/piketty/2017/10/10/suppression-of-the-wealth-tax-an-historical-error/>.