Why taxing the rich is hard?
First, there is an important distinction between the net worth and income. The term “the rich” usually refers to those people with high net worth, i.e, the total asset value net of liabilities. A rich person may only have a modest income; conversely a person with high income may not be rich yet. For example, a lawyer who just started his practice may not have much net worth despite his high income, especially if he still carries a large student loan balance. In principle, “tax the rich” means taxing those with a lot of net worth rather than those with high income; for example, a billionaire with no income should be paying more taxes than a doctor who is still struggling with his student loans by all fairness.
However, today’s government taxes are almost exclusively assessed on a person’s income rather than the net worth. There are many reasons, the most fundamental one is that taxing the net worth is a form of property confiscation that violates the private property rights, which is one of the sacred founding principles of the free world. Even if we are willing to ignore the problem with the private property rights, there are still many technical difficulties in taxing the net worth. First, it is difficult to measure a person’s net worth, especially if he owns illiquid assets such as real estate and art collections; it is too much of a burden if the taxpayer has to hire accountant to audit his net worth every year. Secondly taxing the net worth may force the taxpayer to liquidate their assets prematurely if he does not have enough liquid assets to cover his tax liability. Thirdly, a person’s net worth may go up and down, and it is only fair for the government to refund part of his previous year’s tax if the taxpayer suffers a net worth loss. However, the requirement to refund the past taxes makes it difficult for the government to budget and plan its spending because its tax revenue may disappear or even go negative during a recession when the tax revenues are most needed. The last point is not a problem for income taxation because it is unusual for a person’s to have negative net income. Therefore, directly taxing the net worth can be objected on the grounds of the fundamental principle and the practicality.
If we accept that the taxation has to be income based, what’s wrong with simply raising the income tax rate? The problem is that the rich can easily evade income tax, and there are many ways to do so. Moving out of the country is one of the obvious means to evade income tax; another way is to hide the income as property value appreciation, which is usually not taxable. Let’s take the owner of a company as an example, and assume that all his wealth is in the company for the sake of the argument. If the income tax rate is raised very high, all he needs to do to evade the income tax is to suspend the dividend payments from his company. Since all his wealth is in the company, no dividend payments means he no longer has any income thus no taxes. However his wealth continues to grow as the company becomes more valuable with all the trapped earnings that would have been paid out as dividend otherwise. The salaried employees of the company would be paying more taxes than the owner, which is clearly not the intention of ‘taxing the rich’. This rather stylized example shows that it is easy for the rich to enjoy the uninterrupted accumulation of wealth without reporting much income. Therefore, the attempt to tax the rich by raising the income tax rate is not going to work.
The estate tax is the only legitimate tax on the net worth without violating the private property rights, as the estate is the heir’s income. However, there are ways to evade the estate tax as well. For example, the heirs can set up trusts or charitable organizations, allowing them to evade the estate tax while retaining the control of the assets. Therefore, increasing estate tax rate is not likely to succeed either.
The senior ownership
So the big question is how to tax the rich successfully. By success, we mean collecting a lot of tax revenue, and ideally the rich should voluntarily foot the large tax bill without governments’ coercion. How can we design a taxation scheme that can tap into the rich’s net worth without violating the private property rights, and how can we do so easily, effectively and fairly in practice, so that the rich will pay their share voluntarily?
The only way to achieve this is for the government to establish a legitimate co-ownership of a person’s net worth, in return for the government services. Such an arrangement is very common in private sectors, for example, people invest money to a private company in exchange for some ownership stake. However, regular ownership comes with the responsibility of managing the assets; the government clearly does not have the resources, expertise or the right incentives to manage individuals’ assets properly. The solution is to structure the government’s stake as a form of senior ownership, similar to the preferred stocks or debt of a private company.
In a private company, the common equity investors are the junior owners, they are junior in relative to the investors in preferred shares, convertible bonds and debts. The equity investors own all the residue value of the company after paying off all the senior owners; therefore they benefit the most if the company is successful; however if the company goes bankrupt, the senior owners have to be paid before junior owners once the company is liquidated, so that the junior owners lose the most under such an event. Given that the junior owner’s interests are the most aligned with the company’s success, the junior owners are usually entrusted to run the company’s day to day business through its board of directors. The senior owners usually do not interfere with the company’s management, and only get involved under extraordinary circumstance such as bankruptcy and ownership changes (as in merger & acquisitions).
A senior ownership in individuals’ assets, like the preferred stock or callable bond holders of a company, is an appropriate form to protect the government’s interests because it does not come with any responsibility to manage individual’s assets; and the government’s stake has to be paid off first before the individual can transfer the ownership of his assets, as in his death or donations to trusts or charities.
Let’s consider a concrete example of how the senior ownership can be used to tax the rich fairly and effectively. Suppose that a state uses the public money to fund affordable and high quality education to its local residents. The benefit of education materializes throughout the life time of the graduates via better earning powers; however some state residents may choose to move to other states thus will not pay back the state government’s education subsidy via the state taxes. Also, today’s higher educations are commonly funded by student loans, which often become a heavy burden for most graduates. A creative way to fund the public education is for the state to claims a senior ownership to the college graduates’ future income and estate, in return for the subsidized education. The beneficiary of the public education has to pay the state a fixed percentage of his annual income over his lifetime and the same percentage of his estate upon his death. This form of ownership is very similar to the preferred share commonly found in private companies.
The important differences between the senior ownership and traditional state taxes are, first the senior ownership can be collected no matter where the student chooses to live; secondly it is tied to the overall net worth of the graduate by claiming the same percentage on the estate upon his death, thus there is no incentive for the graduate to hide his income in the form of asset appreciation because eventually the same percentage goes to the government upon his death; thirdly the senior ownership has to be paid off first before the graduate can transfer the ownership of his assets, thus donating the assets to trusts or charities won’t relieve the graduates’ liabilities. The senior ownership does not violate the private property rights either because the ownership belongs to the government in the first place.
To most students, the senior ownership is going to be much more cost effective to fund their education than student loans. The reason is that out of a large pool of young students, it is almost certain that some of them will become very successful and wealthy over time; therefore the future rich will end up with paying a lot more and effectively subsidizing those less fortunate.
Under some stylized assumptions, we estimated that the government only need to claim roughly 1% of students’ future income and estate to fund 4 years of college education, if the un-subsidized tuition is $40,000/year. The left pie chart above is a distribution of American’s net worth, if we assume that the final net worth distribution among college graduates are similar, then the 80% of the graduates will collectively pay 11% of the total tuition, ie, equivalent to $5,500/year for each student; while each of the richest 1% of the student will end up with effectively paying $1,400,000/year for the same education.
The senior ownership can also be used to fund other government programs, let’s take the social security as an example. The current social security tax rate is 6.2% on the first $113,700 of individuals’ income. If we fund the social security using senior ownership and apply the same net worth distribution above, then the 80% of people’s equivalent social tax rate would be effectively 0.85% for the same social security benefits, while the richest 1%’s equivalent social security tax would be 217% on their first $113,700 income. As you can see, the senior ownership is dramatically more progressive than any of the existing tax code, but it is also fairer and morally superior because it has the rich people’s prior consent, before they become rich. In another word, the rich is willingly paying much more.
Therefore, the key to successfully tax the rich is to obtain their consent to give up a percentage of their future income and estate before they become rich. The senior ownership works in the opposite way as insurance policies, where the insurance buyers pay a small premium before the accidents occurs, and the premiums are pooled together to cover the rare but costly accidents. The senior ownership is for a group of people to agree that they will evenly re-distribute a percentage of their collective future wealth before any of them becomes rich. Becoming rich has a lot of similarities to an accident, in that it only happen to very few people, and the impact to those affected is disproportionately large.
The human capital market
The senior ownership sounds great, but there are several technical issues worth careful considerations, the first is how to prevent the rich from hiding the assets or underestimating their net worth. For example, a rich person could directly pass valuables to his heirs without paying off the senior ownership. The other problem is that it takes a very long time for the government to cash out its senior ownership, but the government certainly need short term funding. Both these problems can be solved by creating a market to trade governments’ senior ownership in individuals’ income and estate, we call it the human capital market.
Interesting financial products can be created by pooling senior ownership of a cohort of people together and trade them as a whole. For example, the pool of senior ownership of Harvard graduates (think Zuckerberg) would worth a lot more than the pools of community college graduates. The human capital market also let a person buy back the government’s senior ownership on himself to effectively pay off the government’s interests. The government can raise cash by selling its senior ownership to the market, which relieves the government from the burden of having to audit and value individuals’ net worth. The history has taught us that market force is extremely effective in price discovery, we therefore have strong reasons to believe that the same market force will discover the fair and accurate valuation of the senior ownership of individuals’ future income and estate. The investors who bought the rights to individual’s senior interests from the government would have the right incentive and resources to police and fight the fraud, and ensure that the person’s asset value is reported correctly.
A senior ownership market on people’s future earning and net worth has other interesting benefits, one of them is to put a market price on the value of higher education. For example, the same senior ownership on a Ph.D. degree holder should be more valuable on average than a Bachelor degree holder; we can even directly observe which university and majors offer the best value.
The senior ownership can offer some interesting solutions to fund retirement, what’s better for retirees than an income stream that is tied to the income and net worth of a group of highly educated workers? Such an income stream is automatically adjusted for inflation and economic growth. The retirement funding is a very interesting subject and I will elaborate more in future blogs.
How govlet helps
The senior ownership is an innovative scheme to fund government services. However, it is not feasible under the current legal system, because the senior ownership can only be legally established on corporations but not on a natural person. Fundamental legislative measures need to be created in order to treat a natural person as a corporation, and allowing him to give up a senior stake in exchange for government services. The senior ownership is admittedly more complicated than the current income based taxation, therefore it is destined to meet much skepticism thus is unlikely to be adopted under the current political system due to the legislative and legal difficulties. However, the govlet system allows small group of people to experiment such ideas, and hopefully more people will adopt once they observe the benefits.
