A Capitalist’s View on Why US Capitalism Must Be Fixed

Elizabeth Warren’s net worth tax proposal has problems, but she’s right that US capitalism must be fixed. Here’s how we should do that (and what we shouldn’t do).

In 1924, my dad was born in Berlin. By the time he was 9, the Nazis had won a series of elections and Hitler was appointed Chancellor. My dad’s family moved to Paris that year, and two years later moved again, to Palestine. Two bullets dodged in a row. The 6 million Jews murdered in the Holocaust included many of my relatives. Thankfully, my dad’s immediate family was safely in Palestine.

Along with all those Jews, the Nazis murdered 5 million others — gays, priests, gypsies, the mentally or physically handicapped, communists, and others deemed to be undesirable, subhuman, “untermenschen” in Nazi terms.

What does this snippet of personal and general history have to do with US capitalism?

Bear with me for a bit and I’ll make that clear.

First, another question. How could the Germans, among the most civilized of nations in 1930s Europe, have supported such a heinous regime?

The humiliation and crushing economic sanctions levied against Germany in the Treaty of Versailles led to extreme economic hardship. That made them very susceptible to Hitler’s oratorical abilities.

Back to the US today…

It’s no secret that inequality in the US has been rising for decades, becoming a major social justice issue. Tens of millions of Americans are forced to give up on the American Dream, and on any possibility that their kids will have a better future than their present.

Things have gotten so bad that even avowed capitalists and some very wealthy people say that something needs to be done for ethical and national interest reasons.

• Ethical considerations: e.g. Disney heiress Abigail Disney said recently, “If your CEO salary is at the 700, 600, 500 times your median worker’s pay, there is nobody on Earth … Jesus Christ himself isn’t worth 500 times his median worker’s pay.”
• National interest considerations: e.g. Ray Dalio says, “Low incomes, poorly funded schools, and weak family support for children lead to poor academic achievement, which leads to low productivity and low incomes of people who become economic burdens on the society… The previously described income/wealth/opportunity gap and its manifestations pose existential threats to the USbecause these conditions weaken the US economically, threaten to bring about painful and counterproductive domestic conflict, and undermine the United States’ strength relative to that of its global competitors…” (bold emphasis is mine). Among other issues, Dalio points out that economic mobility plummeted from a 23% chance in 1990 of someone from the bottom 1/5 of the wealth distribution escaping that 1/5 within a decade, to only 14% in 2011.

(See further discussion by The Financial Times here).

If we want to avoid painful domestic conflict, as stated by Mr. Dalio, and potentially devastating, populist-driven international conflict like World War II, we must address the excesses and unfair impacts of our current version of corporate capitalism.

First, some stats.

Income inequality grew:

• From 1979 to 2015, the average after-tax income of the top 1% increased by 242%, while the income of the bottom 20% increased less than 1/3 as quickly, by only 79%.
• The top 1% of earners earn 21% of our total income.
• The average earning of the top 0.1% was 188 times the average income of the bottom 90%.
• In 33 corporations, including Weight Watchers, McDonald’s, and Walmart, 2018 CEO compensation was >1000x higher than median employee pay.

Wealth inequality increased:

• The richest three people in the US, Jeff Bezos, Bill Gates, and Warren Buffet, jointly have more wealth (over $345 billion as of 2018) than the bottom 50% of Americans ($255 billion as of 2016). That’s three people who together have more than the combined net worth of over 160 million Americans!
• As of 2016, the top 1% held 39.6% of the national wealth; the top 5% held 66.7%; the top 10% held nearly 80%; meanwhile, the bottom 90% held only 21.2% of the nation’s wealth!

Jeff Bezos, Bill gates, and Warren Buffet jointly have more wealth than over 160 million Americans!

Democratic hopefuls vying for their party’s nomination as 2020 presidential candidate made this inequality a central issue. They offer several ideas, but are these ideas feasible, and are they ethical?

As of 2016, the top 1% held nearly 40% of our national wealth, and the top 5% held two thirds of it!

Since a large part of the problem is caused by how the federal tax code has gradually tilted the playing field ever more in favor of the wealthy, let’s see how that tax system looks now, and then consider how it should and shouldn’t be changed.

Where Does the Federal Government Get Its Revenue Now?

The federal government needs money to provide for national defense, infrastructure, social safety networks, etc. However, since the government doesn’t earn money, it has to collect it in the form of taxes. According to the Center on Budget and Policy Priorities, in 2018 the federal government collected $3.3 trillion (that’s $3,300,000,000,000), broken down as follows.

Individual Income Taxes (51% of federal revenue)

One of the more progressive forms of taxation in the US. However, the system is legendary in its complexity, and over the decades many loopholes and unintended consequences have burrowed into it.

For example, the wealthy among us make most of their income from investments, with capital gains tax rates maxing out at 20%, significantly lower than the 37% maximum rate on money earned for work.

Worse, capital gains aren’t taxed until assets are sold, allowing the wealthy to defer taxes on much of their income.

And worst, when the wealthy pass away, their heirs benefit from “stepped-up basis” so unrealized gains that happened before that death will never be taxed — the main highway to dynastic wealth.

Payroll Taxes (35%)

Social Security taxes apply only to wage income, and even that only up to a certain level ($128,400 in 2018). This structure makes payroll taxes very regressive, with high earners paying less as a fraction of their income than low earners. In fact, if you’re wealthy enough to make all your income from investments, you pay no Social Security taxes at all.

Medicare taxes aren’t capped, but also apply only to wage income.

Corporate Income Taxes (6%)

These were cut by the Tax Cuts and Jobs Act (TCJA) of 2017, from a rate of 35% to 21%, reducing their slice of the revenue pie from 9% to today’s 6%.

Excise Taxes on Fuel, Alcohol, Tobacco, etc. (~3%)

It’s a very good thing that cars have become more fuel-efficient (e.g., hybrids and all-electric vehicles), and that the national rate of tobacco use has dropped so much over the decades. However, as a result, these sources bring in less and less revenue.

Estate Tax (< 1%)

This is possibly the most progressive tax on the books. The TCJA doubled the exemption amount to $11.4 million per individual, so a couple can bequeath $22.8 million tax-free. In 2018, only 1890 estates nationwide (the largest 0.06%) were subject to this tax.

Despite how few are affected by this tax, and that they are the ones who can best afford it at that, conservatives fight tooth and nail to abolish the estate tax, deriding it as a “death tax.” They argue that it double-taxes money that has already been taxed and that it can force families to sell e.g. family farms to pay the tax.

In reality, such claims are arguable, given that the recipient of the estate gets a windfall on which s/he never paid any taxes, that the majority of wealth in large estates is in the form of unrealized capital gain that was never taxed, and that conservatives have been unable to point to any instance of a family farm being sold as a result of estate taxes.

(If you’re wondering about the remaining 4% of revenues, those came from a range of other taxes, customs duties, etc.).

Despite collecting a near-imaginary revenue of $3.3 trillion in 2018, the federal budget was significantly higher than even that number, $4.1 trillion in fact, causing a $779 billion deficit. To put this in perspective, if the federal government was a family earning $100,000, this would have been the equivalent of spending $123,600 by putting $23,600 on credit cards.

If the federal government was a family earning $100,000, the 2018 budget would have been the equivalent of spending $123,600 by putting $23,600 on credit cards.

How Can We Reduce Budget Deficits and Inequality?

The Congressional Budget Office (CBO) periodically publishes a report on possible ways to reduce the deficit. The most recent, from Dec. 2018, outlines 121 ways the government could reduce spending and/or increase revenues.

Borrowing from the CBO and from Democratic candidates, here are some ways the federal government could bring us closer to a balanced budget, along with an assessment of whether these would also address the extent and the problematic “stickiness” of inequality.

Changing the Payroll Tax System

The Social Security Trust Fund is currently estimated to run dry in 2035, and if Congress makes no changes, benefits will need to be cut by an average of 20%. Imagine someone living on the average monthly benefit of $1461, and suddenly being informed that her benefit is dropping to $1169.

Do you think your landlord would accept a 20% reduction in your rent payments, or your lender a similar cut in your mortgage payments?

Didn’t think so. Neither will that senior’s.

That’s why Congress will almost certainly increase revenues, decrease benefits for at least some seniors, and/or delay full retirement age. According to the CBO:

• Increasing the fraction of wages subject to payroll taxes would increase revenue collection by $785 billion over the next decade; while subjecting wages above $250,000 a year to payroll taxes would raise an extra $1.22 trillion over the next decade (see here).
• Increasing the tax rate by 1%, split evenly between employees and employers, would raise an extra $715 billion over the next decade; increasing that rate by 2% would increase revenue by ~$1.42 trillion over the next decade (see here).

Either or both changes would deal with the looming Social Security funding crisis, and help the federal deficit. Especially the first would also make the system less regressive. However, the burden would mostly fall on the working poor and the middle class. The wealthy get most of their income from investments, and would not be affected.

Imposing a Federal Value-Added Tax (VAT)

Currently, there is no VAT in the US, and sales taxes are imposed by states, not the federal government.

• According to the CBO, Adding a 5% federal VAT would raise between $1.92 trillion and $2.97 trillion over the next decade.

However, like all other consumption-based taxes, a VAT is regressive. Since poor families spend 100% (if not more) of their income, they’d bear the full brunt of the 5% tax. Middle class families who spend say 90% of their income would feel a 4.5% bite. The wealthy, who spend a small fraction of their income would hardly feel it. For example, someone earning $10 million and spending $2 million would only pay an extra 1% of their income.

Net Worth Tax

This sort of tax plays well especially on the left, as the party’s base trends away from capitalism and toward “democratic socialism.” The leading example, proposed by Elizabeth Warren, suggests taxing families with a net worth above $50 million at 2% a year, with an extra 1% tax on those who have over billion.

• This is projected to bring in $2.75 trillion over ten years.
• Constitutionally, it may have some problems.
• Valuation of closely-held companies can be manipulated to avoid this tax.

Because it affects so few people, a net worth tax is more politically tenable than a tax that affects a large number of Americans. However, there’s a “slippery slope” problem. Say someone has a net worth of $70 million and pays $1.4 million in net worth taxes. Then, we hit a bad stretch for the market, as we did in the early 1970s, the dot-com bubble burst in the early “aughts,” the 2008 Great Recession, or worst, the Great Depression. Soon, that taxpayer’s net worth drops below the taxable threshold.

As the pool of taxable fortunes shrinks, tax collections suffer. Since the government is much better at collecting taxes than at reducing spending, Congress increases the tax rate, reduces the taxable threshold, or both. In effect, this becomes a creeping nationalization of private wealth, which is ethically challenged.

In effect, a net worth tax could become a creeping nationalization of private wealth, which is ethically challenged.

For these reasons, improved taxation of high income would seem to be the better choice, especially if it doesn’t require the near-confiscatory 70% top rate favored by Rep. Alexandra Ocasio-Cortez (see below), as that would likely encourage creative ways for high-income earners to avoid that tax.

Taxing Investment Transactions

This seems to be on solid ethical ground since investors benefit from regulatory oversight of US exchanges and investor behavior. Such a tax creates minute “friction” on trading, affecting day traders most, and buy-and-hold investors least.

• The CBO estimatesa 0.1% tax per transaction would raise $777 billion over the next decade.
• Such a tax might reduce volatility caused by trading algorithms that led to several short-term crashes but might slow down market reactions to the news, potentially causing short-term mispricing of securities.
• This tax would immediately reduce (somewhat) the value of securities across the board.

Because the overwhelming majority of investments are held by the wealthiest Americans, with almost none held by the bottom 50% of earners, such a tax would be highly progressive. Exempting transactions from retirement accounts would shield the middle class much more than it would the truly wealthy, who hold most of their assets outside retirement accounts.

Repeal Special Tax Treatment of Capital Gains

Since wages result from the earner spending his time to help create value, whereas the same is not true for passive investments, it seems ethically sound to tax wages at a lower rate than capital gains. However, taxing both at the same rate (as was done by Ronald Reagan) would at least not tilt the playing field against the poor as much as it is currently.

Since wages result from the earner spending his time to help create value, which isn’t true for passive investments, it seems ethically sound to tax wages at a lower rate than capital gains.

• This will reduce the ability of the wealthy to pay lower rates than what middle-class employees pay for much lower income (the lowest 44% of earners already pay no federal income tax).
• The Institute on Taxation and Economic Policy (ITEP) estimatesthis would bring in an extra $1.54 trillion over a decade. To prevent the very wealthy from avoiding this by simply holding on to assets until their death and using the step-up basis prevent their heirs from paying the capital gains tax, they suggest repealing the step-up basis, bringing in another $780 billion. Other changes to prevent manipulation of capital gains to avoid taxation are estimated by ITEP to bring in another $152 billion. Altogether, this could add $2.47 trillion in new revenue over a decade.
• In some cases, such as closely-held businesses, unrealized capital gains aren’t easy to assess. In such cases, the tax could be deferred until the business is sold or the owner dies. To prevent this from being abused, such deferral could come hand-in-hand with a higher tax rate.

Since this change doesn’t tax wealth but rather increases in wealth through the income of various sorts, it sits on the same ethical ground as income taxes in general.

However, since the richest 1% gain about 78% of the benefit from the lower capital gains tax rates currently in the US tax code, and the richest 5% gain 90% of that benefit, such a change would be extremely progressive.

The Bottom Line

As a naturalized citizen, I chose to become an American, and am a great believer in this country and what it stands for. I’m also what could be described as a success story, having come to the US with negative net worth, and through decades of hard work and prudent choices have done very well.

Despite my success under the current system, I would like to see things changed in a way that levels the playing field in an ethical and constitutional way. This is crucial for moral reasons, but also to ensure the continued survival and prosperity of this great American experiment.

Despite my success under the current system, I would like to see things changed in a way that levels the playing field in an ethical and constitutional way. This is crucial for moral reasons, but also to ensure the continued survival and prosperity of this great American experiment.

While the net worth tax is promoted by several Democratic candidates, that option appears to be constitutionally challenged, and at least somewhat ethically questionable. Combining the last two changes above (a 0.1% tax on investment transactions, and repealing special tax treatment of capital gains) is estimated to raise $3.25 trillion over the next decade, 18% more than Warren’s net worth tax proposal. Further, neither of these two changes appears to have constitutional challenges or ethical problems.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.