Let’s Talk About Elizabeth Warren’s Proposed Wealth Tax

As many of you know, Elizabeth Warren has been getting a lot of press lately after proposing a wealth tax equal to 2.00% on fortunes above $50 million and 3.00% on fortunes above $1 billion. As an academic exercise, it’s useful to consider what that would mean for the United States.

Before we begin, though, there are two things I feel need to be acknowledged.

Two Important Facts That Should Be Acknowledged When Discussing a Federal Wealth Tax

Firstly, national wealth taxes, particularly on financial assets, have proven to be disastrous to the point that nearly every country that has ever attempted to put them into place has abandoned them. Even having this conversation to those who have looked at the economics is a bit like saying, “Why don’t we spike the drinking water with arsenic?” or, to allude to a sentiment I shared in a recent post, “How about we improve this paint by adding lead to it?”. France abandoned them after tens of thousands of wealthy citizens left the country, resulting in hundreds of billions of lost wealth and hundreds of thousands of jobs that would have been created not materializing. Sweden abandoned them after watching $200 billion in assets flee for greener pastures. Long-term, the result is the middle class ends up paying more in taxes because the rich move money around or, in many cases, leave, causing the tax burden to shift downward onto the typical family. It is difficult to overstate how badly wealth taxes have failed in the real world.

Secondly, leaving that aside entirely, it is my strong belief that it is irrefutably beyond question that a direct Federal wealth tax would be blatantly, offensively unconstitutional due to its outright violation of both Article I, §9, Clause IV and the 16th Amendment. To say otherwise is lawlessness; to turn the nation’s most important legal bedrock into toilet paper. Going further, I believe this is one of those extraordinarily rare areas where reasonable disagreements are not possible; that anyone who argues otherwise is either:

Blinded by their own policy goals to the point they have ceased to care about the integrity of the constitution itself and/or are willing to lie to voters in an effort to pander; Are lying to themselves; or Are stupid.

Full stop. That’s it. Game over. Even if a person thinks a wealth tax is a good idea – and actual experience have shown how disastrous they are – there is no getting around this in any honest way. It requires a person to look at the drafting and jurisprudence history of the Constitution and completely disregard the meaning of words because he or she doesn’t like them. In some cases this is painful for me to say. For example, there is one recent paper in a law journal by a practicing attorney for whom I have a good deal of gratitude due to his work in fighting for equality but that argues the limitations in the Constitution aren’t workable because they would burden residents of poorer states – e.g., California vs. Mississippi. Any right-thinking person should immediately respond, “So what? Too bad! If you don’t like it, amend the Constitution!” That – amending the Constitution – is the only acceptable solution. Disregarding what it plainly states, turning into the legal equivalent of religious scholars fighting over how many angels can fit on the head of a pin, is intellectual and professional malpractice. It degrades both academia and law.

Put bluntly, the United States Congress has the authority to levy proportional taxes based on population, import duties, excise taxes, and income taxes. It has no authority – none – to levy taxes based upon the net surplus of a given balance sheet. It will only gain that authority of the people of the United States, using the democratic process, decide to grant it such power by amending the Constitution. If by some miracle Congress passes a bill that includes it (it won’t) and the President of the United States signs it into law (he won’t), the courts would strike it down before the ink dried on the page. With the current composition of the court, I think there is effectively a zero chance it would survive, which is the right call given that this is so clearly in the middle lane there is no other reasonable interpretation.

A Look at How the Mechanics of the Wealth Tax Might Work

Imagine you are single, 50 years old, and have no children. You live in California. You grow tired of your job and decide to follow your lifelong dream of being a writer. After honing your craft, and toiling for years, you write a series of bestsellers. You can’t believe how fortunate you are; you’re finally doing what you love and people reward you by sending you a few dollars every time they buy one of your works. You have no employees. Many of your sales are electronic (profits are ordinarily higher on e-book sales because you don’t have to pay for cutting down a tree, the gasoline to ship the finished book to warehouses, and all of the other related expenses involved with creating a physical product).

This entire empire consists of you sitting at a desk in California and publishing. Your financial life is extremely simple – no complex tax shelters, no retirement plans, nothing. You’re a self-employed writer, like E.L. James when she first released Fifty Shades of Grey.

You awake one day to find that your royalty income is exactly $20,000,000 per annum before taxes. This is still meaningfully below the amounts earned by society’s super-star authors like J.K. Rowling, Steven King, and James Patterson, but you’d be a household name. Your success would be well-deserved. Furthermore, this is not a terribly unusual situation. Every year, new artists, musicians, authors, software programmers, designers, and inventors catapult to the rank of outsize economic successes because they create something that causes men, women, and children to transfer small amounts of money to them, which, in the aggregate, adds up to a lot.

Depending upon how the terms of your contract were structured, or whether you self-published your work (using the economic model pioneered by the aforementioned E.L. James when she initially released Fifty Shades of Grey is a good example), it is likely that your combined Federal and state income taxes, including self-employment taxes, would have been somewhere around $10,387,046. That means out of your $20,000,000 in income, you would be left with roughly $9,612,954.

There are several assumptions and rounding adjustments that need to go into this estimate but, stated another way, we get pretty close to the actual tax liability if you look at it this way: the government has decided that it effectively owns a majority stake in your labor. For every $100 you generate from your labor, it keeps $52, you are left with the remaining $48.

This is the status quo. This is where we are now, today, under the current tax laws. Of course, after a few years of this nonsense, you might decide to get serious about trying to lower your tax bill. You might move to a state like Washington, Florida, or Texas. That’d save you some money. You might setup a pension plan combined with a 401(k). That might allow you to reduce your tax bill by a few hundred thousand dollars per annum; still a rounding error of your income but it’s not insignificant.

Follow me so far?

Good.

What Would Elizabeth Warren’s Proposed Wealth Tax Do In This Scenario?

Now, let’s look at what would happen if a 2.00% tax on net worth above $50,000,000 were implemented.

A lot of people don’t realize that net worth for highly successful people usually does not consist of cash or cash equivalents. In this simplified example, recall that you, our author, earned $20,000,000, paid $10,387,046 to the government, and were left with $9,612,954. That is money sitting in your checking account at, say, Bank of America or Wells Fargo. It is not your net worth.

Assuming you held no other assets, what do you think your net worth is?

It depends on a number of factors, with interest rates playing an enormous role, but you’re probably looking at an estimated net worth of anywhere from $100,000,000 to $200,000,000; possibly even much higher if the books are part of a series that is in development and promises substantially more income in the future. That is because your net worth includes the legal right to the copyrights you created out of thin air. Those copyrights have no physical form. You can’t go down to the local McDonald’s and use them to buy a cheeseburger. They are an idea – a legal concept – that entitles you to a stream of earnings. Putting a value on them requires estimating what you might be able to get if you were to sell, giving up creative control and ownership of the characters and world you invented. There’s also movie rights. And merchandising rights. You’re much wealthier than you think.

Let’s say you successfully argue to the IRS that a 5x pre-tax profit valuation is acceptable – something that might be hard to do in today’s interest rate environment but we’ll err on the side of caution. That means your intellectual property is worth $100,000,000.

In this case, Elizabeth Warren’s proposed 2.00% net worth tax would would be:

$100,000,000 capitalized value of royalties + $9,612,954 cash on hand = $109,612,954 net worth

– $50,000,000 exemption

——————————————————————————

= $59,612,954 net worth subject to 2.00% net worth tax

= $1,192,259 net worth tax

At this point, of course, you have to pay for that $1,192,259, meaning you’ll need to spend some of the $9,612,954 you had left over after paying your other taxes. Your final take-home pay will be reduced to $8,420,695. For all intents and purposes, the government has now decided that for every $100 you generate from your labor, it is entitled to $58. You get the $42 that remains.

If you were unsuccessful in your appeal to the IRS, and they insisted that a 10x pre-tax income valuation was required, the math would change. You would be looking at:

$200,000,000 capitalized value of royalties + $9,612,954 = $209,612,954 net worth

– $50,000,000 exemption

——————————————————————————

= $159,612,954 net worth subject to 2.00% net worth tax

= $3,192,259 net worth tax

Under this scenario, you’d have to still pay that $3,192,259 out of your other tax-home income of $9,612,954. This would reduce your final take-home pay to $6,420,695. For all intents and purposes, the government has now decided that for every $100 you generate from your labor, it is entitled to $68. You get the $32 that remains.

This means those in the creative fields – the men and women who create music, art, software, products, and services – are going to be taxed at vastly disproportional rates as the by-product of their labor and ingenuity is transferred to politicians, who think they should be able to allocate it. Even worse, that money won’t just go to politicians with whom you, our author, agree. Imagine you are a liberal. In this case, someone like Donald Trump will be using the money you’re sending to enact his policy objectives. When you reduce individual freedom by expanding the power of the state, you cannot always predict who is going to be sitting in the seats of authority. That is one of the reasons it is essential that you design a system in which you would be happy to live even if your political party were out of power.

A Look at Some of the Non-Intended Consequences

The introduction of a wealth tax would shift incentives massively. Nearly every successful member of society would have an incentive to influence the economy in a way that prioritized higher-than-necessary interest rates, permitting lower carrying valuations. What does that do to the cost of borrowing? To getting a mortgage? For taking on student loans to get a degree? To buy a car? The poor and the middle class would wonder why they were getting screwed.

(On this note, people outside of finance don’t realize how sensitive valuation estimates are to interest rates fluctuations in the so-called “risk-free rate”, which is currently U.S. Treasury bills, notes, and bonds. When interest rates increase, valuations decline. When interest rates decline, valuations increase. It’s a basic function of discounting cash flow; the rational system upon which the entire global financial system rests akin to discovering how to measure energy or inventing calculus. Imagine a real estate investor. He or she has the same number of units, the same number of tenants, and the same rental revenue. If Cap Rates, which are influenced by interest rates, are 5.00% or 15.00%, the tax he or she would owe under such a convoluted system would vary wildly in any given year despite nothing changing about his or her holdings, cash flow, and profit. There’d be almost no way to plan for it, creating the need to restrict investment and hoard cash as a countermeasure.)

How about the logistics? The IRS would have to balloon into a staggeringly large bureaucracy with untold power as it now faces the daunting task of regularly valuing all non-traded assets in the world’s largest economy; valuations that are inevitably going to be challenged in courts given the huge incentives. The entire tax court system would need to be drastically expanded, as well. What kind of liquidity discounts should be used for non-control stakes? What about securities or derivatives with contingent cash flow provisions? For example, we recently had several retired private clients at our asset management firm who received a buyout on a pharmaceutical stake that involved the initial merger consideration plus the right to receive future payouts based upon the results of FDA clinical trials down the road. How should those rights – which are worth somewhere between $0 and quite a lot – be valued? And what if they are valued on the higher end of the spectrum, while generating no cash at all, creating a liquidity crisis for the recipient? You could end up paying substantial taxes on an asset that never actually produces any income for you or your family before expiring worthless.

And, for a moment, let’s revisit interest rates. People are complaining a great deal about wealth inequality these days but quoted net worth estimates are based upon interest rates, as we just discussed. What happens if we go back to the interest rates experienced in the 1970s or 1980s? You guessed it – magically, quoted net worth would plummet, reducing inequality despite the wealthy owning the exact same assets they did prior to the shift in interest rates. You cannot reasonably talk about wealth inequality without acknowledging we are in a bizarre period in which interest rates have been among the lowest in recorded history. That matters. It creates distortions and illusions.

In the worst cases, company founders would be forced to sell off illiquid stakes in their businesses, triggering more taxes, and slowly losing control. It would be all but impossible for a successful individual to maintain power over his or her company for 25 years at a 2% or 3% wealth tax rate especially when you consider that the IRS is likely to apply a “control premium” to any valuation of equity stakes – another thing the typical voter doesn’t realize. Some of the most amazing advances from civilization have resulted from such controlling personalities creating an enterprise from scratch. Assets would end up in the hands of bureaucrats and investors, both domestic and foreign, as visionary leaders were forced out of their own start-ups. It begs the question: what would the world look like if Walt Disney hadn’t been able to control and mold his studio, especially in the early years after the success of Snow White when it was rich on paper but nowhere near permanently established? What would Pixar had looked like if, after Toy Story, Steve Jobs couldn’t have maintained control? If he had to pay dividends or sell ownership to ship of money to Washington, D.C. instead of reinvesting future movie franchises? What amount Microsoft? People take for granted the massive productivity gains society enjoyed due to standardized technology systems, which produced more net positives than drawbacks.

Mobility matters, too. Of the 91 new start-ups in the United States that reached a $1 billion valuation, 50 of them, or 55%, had at least one immigrant founder. Why would a talented person want to come here and start a company if he or she faced a tax that wasn’t levied in such an economically destructive way anywhere else in the world? As a result of the Trump administration’s signaling to the world, foreign student enrollment in America’s university has been declining at accelerating rates. Do you think entrepreneurs are going to behave any differently?

The United States people are acting like spoiled, rich teenagers who take their family’s success for granted – that, somehow, we can do whatever we want, however we want, and all of the historical advantages we’ve enjoyed will continue because we’re entitled to living better than everyone else. We can’t. After World War II, the rest of the developed planet had been bombed into oblivion, leaving us the dominant economic and military power. We’re in the midst of a century where we will have to compete with other countries to attract the best and the brightest, nurture talent, and win. Reducing inequality is a nice goal but what really counts is creating a system that delivers ever-rising standards of living for the most number of citizens. Trying to reduce inequality using a tool that has failed everywhere else and is bound to harm the poor and middle classes is like cutting off your arm because you need to diet. Sure, you’ll have lost weight on the scale but you’ve done yourself more harm than good without achieving what you were hoping to achieve.

Final Thoughts on the Topic

As a consequence, the plan is so unbelievably stupid that if Elizabeth Warren were to become the Democratic nominee for President in 2020, I wouldn’t be able to vote for her in good conscience. Prior to her entering Congress, I regarded her as one of the more honest academics working in finance-related fields and was a fan of her work. That work focused not on demonizing groups of people using policies that won’t succeed in the real world but, rather, actual pragmatic proposals to make the economy and Wall Street function better for society – e.g., breaking apart the investment banks and commercial banks, breaking apart “too big to fail” institutions, and a host of other reforms. Seeing her lower herself, to pander to crowds the same way Donald Trump does as he stands at those rallies and blatantly lies, is disheartening. I’d rather watch the DNC fail during this election cycle than support this kind of madness, which is a sentiment I’m hearing a lot from people who have the means and influence to make it happen. The Democrats should hope and pray they don’t end up nominating a far-left candidate from the fringe wing of the party’s echo chamber because if they do, it’s going to be a long, cold winter during which they watch their achievements over the past decade slip away. In fact, from a purely strategic standpoint, as devious as it would be, I think the GOP would be behaving intelligently if it were to make that happen by attacking potential centrist Democratic candidates like Bloomberg, astro-turfing online comment sections and social media.