Can well designed tax systems help redistribute wealth?
As OECD statistics confirm the growing inequality between the world’s richest and poorest, how far can a well-designed tax system be used to redress the balance?
This article was first published in the July/August 2019 International edition of Accounting and Business magazine.
Taxing the wealthy is back on the agenda in many parts of the world, reflecting rising concerns over inequality. In the US, several high-profile Democrats have expressed support for measures to raise extra revenue from the rich.
Member of Congress Alexandria Ocasio-Cortez wants to hike the rate of income tax to 70% for those earning over US$10m a year, while presidential contender Elizabeth Warren has proposed a ‘wealth tax’ for people with assets of more than US$50m. Across the Atlantic, the UK Labour Party’s platform includes a proposed rise in income tax on top earnings, higher taxes on capital gains and tightening the inheritance tax regime.
The average disposable income of the richest 10% of the population is now around 9.5 times that of the poorest 10% across the Organisation for Economic Co-operation and Development (OECD) nations, up from seven times 25 years ago.
The disparity in the stock of wealth is even more pronounced, with the top 10% holding half the wealth and the bottom 40% holding just 3%. ‘Such inequalities risk entrenching privilege among the rich, reducing social mobility and corroding the political system,’ says Robert Palmer, executive director of Tax Justice. ‘A fair tax system can help redress the balance.’
Yet designing a tax system that redresses inequality in wealth poses both political and economic difficulties. ‘It is not easy to forge a consensus on how much of the burden should fall on the rich and how to give to the poor,’ says Dan Powers, global head of tax at Grant Thornton International. ‘The challenge is to raise revenue with the greatest efficiency, while minimising adverse economic side effects – like discouraging work or investment.’
Balance is the key to achieving this goal, he adds, since all forms of taxation have different drawbacks. Governments seeking to raise contributions from the well-off have four main options to choose from: taxes on high earnings, taxes on the stock of wealth, taxes on the transfer of wealth through generations, and taxes on the returns on wealth – such as capital gains, dividends or corporation tax.
So, what are the pros and cons of various ways of taking from the rich to give to the poor?
Raise income taxes on high earners. This can be the easiest form of redistribution to explain politically, since most people pay income tax. However, it is not typically the best way of extracting more revenue from the rich. ‘This is because much of the reason for rising inequality has come through increases in wealth through investments, not earnings,’ explains Michael Förster, an OECD economist who focuses on inequality. For example, in the UK, the stock of wealth is now seven times larger than the annual income of workers – up from three times in the 1970s. The distribution of wealth is now significantly more unequal than the distribution of income. This point was recently underlined by Microsoft founder Bill Gates, who argued that raising marginal income tax rates was a ‘misfocus’, since returns on investment were a bigger generator of wealth. OECD governments have tended to agree; the average marginal rate of tax on high earners has fallen from about 65% in the 1980s to 42%.
Wealth tax. The idea of taxing the stock of wealth through a ‘wealth tax’ has been declining in popularity. The main reason is that assessing individuals’ net worth is not straightforward, says Chris Morgan, head of tax policy at KPMG. ‘The wealthy often hold illiquid assets that can be complicated to value – from art and antiques to private equity stakes and land,’ he says. Auditing such estates can be a bureaucratic headache, with tax returns reaching several feet high and valuations subject to endless debate. As a result, only three of the 36 OECD nations now levy a wealth tax, down from 12 in 1990. France eliminated its wealth tax in 2017. But there are forms of taxation on the stock of wealth that are more efficient. Taxes on property and land are less burdensome to collect and less susceptible to avoidance strategies. Unlike capital, this form of wealth is immovable. Morgan sees particular merit in taxation on land, since it does not penalise owners who make improvements to their property – thus boosting its taxable value.
Inheritance tax. Inheritance taxes (IHT) are much maligned. A 2015 poll in the UK found that 59% of respondents opposed levying an inheritance tax, making it the nation’s most hated tax. This is despite the fact that only 4% of estates in the country were subject to IHT last year. A wide range of exemptions – including assets on agricultural land and unlisted shares – mean that the very richest generally end up paying little. But inheritance tax can be a highly effective means of limiting the power of wealthy dynasties. David Willetts, executive chair of the Resolution Foundation, argues for replacing inheritance tax with a ‘lifetime receipts tax’ – with each person getting a £125,000 (US$158,722) lifetime tax-free allowance for gifts and inheritances and paying a relatively low rate on anything above that.
Taxes on the generation of wealth. These tax capital gains, dividends and other investment income. ‘Rates of taxation on capital in particular have declined since the 1990s in rich nations, which has contributed to making tax systems less redistributive,’ says Förster. This has partly been driven by a desire to encourage investment, along with the fact that capital can flee high tax countries. The wealthy have also benefited disproportionately from a fall in the average corporate income tax rate across the OECD from 32.5% in 2000 to 23.9% in 2018, since they typically have more extensive investments. But the balance may now have shifted too far away from taxes on wealth creation, argues Palmer.
While taxing the rich involves tough choices, so does boosting the income of low earners. Simply cutting taxes is usually not the answer. The simplest approach is cash transfers. This appears to have worked well in Brazil, through the Bolsa Família Program, which was introduced by President Luiz Inácio Lula da Silva in 2003 and contributed to a 27% fall in poverty. And despite criticism that it discourages work, studies by the World Bank found no evidence that this is the case.
This approach, however, would be unlikely to gain political traction in many richer countries. ‘A key challenge for governments is to assist lower income groups without discouraging them from work,’ says Förster. This can often be best achieved through in-work benefits – refundable tax credits that can be gradually phased out as wages rise.
A well-designed tax system does have the potential to reduce inequalities. But it is not the only tool that governments should use to foster a fairer society, argues KPMG’s Morgan.
‘Inequality can be exacerbated by a range of problems, from flaws in employment law and union representation, to poor lifetime training opportunities for displaced workers,’ he says. ‘Redesigning the tax system should not be a substitute for asking tough questions about how the broader economy is working.’
Dijana Suljovic, journalist