Estate taxes are back in a big way.
In a coordinated effort, legislators in seven states that collectively house about 60 percent of the nation’s wealth—California, Connecticut, Hawaii, Illinois, Maryland, New York and Washington—will introduce wealth tax legislation on Thursday.
The campaign is part of a broader national focus on new investment, entrepreneurship and wealth taxes. For example, a pending proposal in New York would result in a nearly 30 percent capital gains tax on wealthy New York City residents, twice the federal 20 percent long-term capital gains tax. term. Elsewhere, lower estate tax thresholds would tax the upper middle class and not just the very wealthy, including small businesses and farms. And the estate taxes themselves would vary among the seven states, in part because of different state constitutional restrictions.
Not that constitutions will always get in the way of legislative proposals. A wealth tax is transparent in conflict with the Washington state constitution, but that hasn’t stymied previous proposals and doesn’t stand in the way of a new effort due to be unveiled Thursday. California’s proposals have tended to include exit taxes—designed to continue to tax responders leaving the state—implying a number of federal constitutional provisions, a reality that has caused little consternation among supporters. And most of the above proposals would tax Worldwide net worth for state residents, with all the constitutional issues it raises.
The constant across all seven states, or wherever such taxes are proposed: Estate taxes are economically destructive, their base is nearly impossible to measure precisely, and they create perverse incentives and promote costly evasion strategies. too few contributors refer estate taxes, but many more would pay the price.
Proponents sometimes argue that estate taxes are small and that the wealthy can afford them. But because the rates are based on net worth, not income, they cut deeply into investment returns, to the detriment of the broader economy. Average taxpayers may not care if the ultra-rich have lower net worths. But they will certainly care if innovation slows and investment dwindles.
We are not used to thinking of taxes in terms of stocks (accumulated wealth) rather than flows (streams of income). For most people, it’s not intuitive how a wealth tax rate compares to something we understand better, like income tax rates.
Imagine a $50 million investment, held for 10 years and earning a 10 percent nominal annual rate of return in a 3 percent annual inflation environment. Without an estate tax, that investment would produce $46.5 million in investment returns, in current dollars, after 10 years. With a 1 percent estate tax, it would yield $37.3 million. The wealth tax would wipe out nearly 20 percent of profits. If the gains had been realized at the end of 10 years, a 1 percent estate tax would have generated almost as much as the 20 percent federal capital gains tax.
In current dollars (valued at the beginning, not the end, of the investment period), that 1 percent annual wealth tax is converted into a 14.5 percent effective tax on net income ($6.3 million in $43.6 million in pre-tax earnings). But because each year there was less capital to invest than there would have been without the annual tax, another $2.9 million is lost not as tax revenue but as investment gains that never materialized. The result: a 1 percent wealth tax erodes 19.8 percent of investment income.
If past efforts are any indication, some of these proposals (like the one in Washington) will have a base of fairly liquid publicly traded investments, for which there is a known market value. But others, potentially including California’s, would tax all assets of the wealthy, many of which have no known market value. This could include tangible assets, such as artwork, as well as non-financial intangible assets, such as trademarks or goodwill, which can be nearly impossible to value. Worst of all, it can include ownership stakes in closely held corporations and corporations, which often defy assessment.
A promising tech startup might briefly be valued at hundreds of millions of dollars, but close without a profit. Another might go under the radar until suddenly bought for billions of dollars. Owners of the former could face insurmountable wealth tax burdens on a hypothetical net worth that never generates actual income and eventually disappears, while owners of the latter could avoid any wealth tax on a business that presumably had significant value. before its price tag was set by its acquisition.
Taxing wealth consisting of unrealized gains from publicly traded assets is relatively straightforward, since a portion of the shares could be sold to satisfy the tax liability. (Of course, this would still have consequences for some wealthy investors who are trying to maintain a controlling interest, and the conflicting treatment of capital gains at the federal and state levels would create confusing incentives.) But with private business assets, the tax can be much more consequential: a portion of the business or its assets may have to be sold to pay taxes on gains that only exist on paper. Owners are asset rich but cash poor.
For even the most public public figures, net worth is not only difficult to assess, but also difficult to project. And estate taxes are imposed regardless of whether there is any income and whether net worth is increasing or decreasing.
In current dollars, Elon Musk lost $226 billion between November 2021 and December 2022. Sixty-two percent of his wealth was wasted, not to say vanished. And at least he had investments to liquidate if he had to pay estate taxes on the much higher November 2021 valuation. For many early-stage entrepreneurs, it’s not just their net worth that can be highly volatile (and difficult to to assess), but they may also have few ways to generate the cash flow needed to pay the tax.
At either end of that spectrum, of course, there is the prospect of exit: Those subject to an estate tax could move to another state, a move that is much easier at the state level than at the national level. In fact, the economic consequences of both emigration and reduced economic activity are so significant that even at the national level, most countries have abandoned the wealth taxes they once had.
Thirteen OECD countries have imposed wealth taxes since 1965, but the number has dropped to three (in Norway, Spain and Switzerland) by 2022, and governments are increasingly recognizing the intrinsic economic harm of such taxes. However, the new left-wing government of Colombia restored a wealth tax for the beginning of the current calendar year. That is the only recent example for states to follow, amid a general trend of repudiation and repeal. (France has a tax on luxury real estate, but no longer on other sources of wealth.)
From thirteen to four, in the national level, where the exit is comparatively difficult. However, seven states want to try this experiment in the United States?
California has previously considered a 0.4 percent state estate tax, which proponents estimated would have raised about $7.5 billion a year—equal to 4.2 percent of state revenue at the time, and just under 1.1 percent of California’s combined federal and state tax revenue, more than the tax share in three of the four national wealth taxes in OECD countries.
People will move. California knows that people will move. His answer: a departure tax and estate taxes owed for years after leaving the state. this almost sure it works bad of the Commerce Clause of the US Constitution and interferes with the constitutionally protected right to travel.
But that’s where the economic illogic of estate taxes leaves states: contemplating constitutionally dubious taxes of nonresidents to counter the simple reality that estate taxes undermine investment and drive out entrepreneurs and innovators. of the state.
