How to tax wealth

A credible one-off wealth tax

A few weeks ago The Wealth Tax Commission published a report making the case for a one-off wealth tax post-covid in the UK.

Specifically, they would impose a one-off wealth tax payable on all individual wealth above £500,000 and charged at 1% a year for five years to raise £260 billion.

Most taxes distort behaviour. If you tax work, people work less. If you tax investment, people invest less. And if you tax windows, people brick them up. It’s a trade-off every government must make.

In theory, a one-off wealth tax is a great way to raise revenue. As the commission notes: “Since it is based on wealth at a (past) point in time, a one-off wealth tax does not distort behaviour.” The wealthy have many tools for avoiding taxation, but time travel is not one of them.

But as they note the efficiency relies “on the wealth tax being credibly one-off”. If you don’t believe it when the Government says “Just this once”, then the Government is hit with a double whammy. The wealthy act as if you passed an annual wealth tax, but you only raise the revenue once.

The Commission points to the UK’s record of windfall taxes and Ireland’s financial crisis era tax on pensions as proof that governments can credibly commit to one-off taxes. They also argue the scale and once-in-a-century nature of the coronavirus crisis would provide a compelling rationale that it would truly be one-off.

But I’m not so sure a credibly one-off wealth tax is possible.

Just three years ago, the British electorate nearly made John McDonnell Chancellor of the Exchequer. Last year, the Government seriously discussed breaking international law. While in July Shadow Chancellor Anneliese Dodds expressed support for a wealth tax. There were no hints this would be one-off.

When the top rate of income tax was hiked to 50p, Labour said it’d be temporary. It was eventually abolished, but it never returned to its original 40p rate. It became a wedge issue and Labour campaigned to bring it back after the Tories scrapped it.

It is easy to imagine a one-off wealth tax being made permanent after a change of government.

There are many problems with a one-off wealth tax (some are covered here), but a key problem is public choice.

There may be a case for an ideal wealth tax, but in practice, wealth taxes will exempt many forms of wealth, creating avoidance opportunities and distorting behaviour.

As a matter of electoral survival, certain carve outs and exemptions are inevitable. A primary residence exemption is inevitable. We already have one for our other taxes that hit unearned income e.g. inheritance and capital gains tax.

A recent poll of Sunday Times readers found a plurality (45%) supported a wealth tax provided it excluded their main residence. There was even less support for taxing ISAs or pensions. Readers were also not keen on taxing inheritances.

There was support for taxing second homes but second homes, when used as buy to let investments, already face a significantly higher tax burden. As Stuart Adam of the Institute of Fiscal Studies notes: “Rental housing [is] now the most heavily taxed major asset class, whereas owner-occupied housing subsidised.” It may be a hard political sell, but we should really tax buy-to-let landlords less rather than more. The status quo discourages investment in rental property, which I suspect makes it harder for models such as build to rent to work.

But it is possible to impose a credible one-off wealth tax without ending up with a complex distortionary annual wealth tax. It’s called taxing consumption.

All wealth will, at some point, be consumed, either today or by some distant heir. And if the wealthy never consume their wealth, then it is a great deal for society. We get investment, while the super-rich make no claim on society’s resources. 

Mentally, you can break consumption taxes up into two taxes. A tax on consumption from existing wealth and a tax on consumption from future wealth.

Consumption taxes like VAT or David Bradford’s Progressive X Tax have a key advantage over wealth taxes. The forward looking part of the tax is time-neutral. By contrast, under an annual wealth tax, you are incentivised to spend more today and less tomorrow. This is because wealth taxes hit the return to saving. Money has a time value. We have to be paid interest in order to defer gratification. Taxes on wealth and income create an intertemporal distortion. Under an annual wealth tax, consumption tomorrow is, in effect, taxed at a higher rate than consumption today is. By contrast, consumption taxes do not discriminate.

The main objection to taxing consumption is its regressiveness, but I think this objection is over-egged. It is true that poorer people consume a greater share of their annual income than the better-off. But this only looks at one side of the coin. We raise taxes to pay for spending. For a VAT to be on-net progressive, the revenue does not even need to be spent particularly progressively. If the money simply went on universal benefits, poorer households would win out significantly (see this blog from Matt Bruenig for a worked example).

Consumption taxes can be made more progressive too. Our current method for doing this, zero-rating or exempting ‘essential’ goods, isn’t very efficient. For example, the 0% VAT rate on children’s shoes creates larger savings for parents who buy their children multiple pairs of £100 designer shoes compared to a single parent who buys one pair from Matalan for £10. Worse still, zero-rating introduces unnecessary complexity into the tax system (see the table below for some maddening examples).

There’s a better alternative. By definition income minus saving is consumption. To create a progressive consumption tax without getting into the fraught business of defining what is and isn’t essential, simply tax income progressively but exempt saving by creating an unlimited ISA.

If your aim is to tax wealth, but you want to avoid the long-term investment disincentives and avoidance opportunities created by an annual wealth tax, then a progressive consumption tax might just be a better option.