This is important because the majority of the super-rich consume only a small fraction of their income. This implies that we are taxing away funds that would otherwise be recycled into proven business enterprises. This is important. Not all investments are created the same. In nerd speak there are heterogeneous non-reproducible inputs to production.
An income tax on the wealthy explicitly takes more from those who have shown the best skill at employing resources. This doesn’t matter for consumption, because there is no reason to value one person’s consumption over another. However, it does matter for investment because some people are clearly better entrepreneurs than others. For uber-nerds I’ll address Modigliani-Miller at the bottom.
So, what do we do instead. The goal is to have a progressive consumption tax. That is we weight the burden tax system towards the wealthy, but only in terms of consumption.
The immediate concern obviously is that because the super wealthy consume so little of their income we won’t be able to achieve the progressivity we want. But lets think about where the money has to flow.
When we tax consumption instead of income we are basically exempting savings from taxation. What happens then. Well, one thing that could happen is that the wealthy save less. That is they have a specific savings goal in mind and now its easier to reach that goal. In that case the consumption of the wealthy rises and we retrieve some of our lost progressivity.
On the other hand, the net savings of the wealthy could rise. This would mean that in the first step we are loosing some progressivity. But, what happens next?
In a healthy economy – that is outside of recession – that savings is transformed into investment. That investment then drives up the demand for labor which drives up wages. So, even though we are loosing some progressivity by only taxing income we are driving up wages for working people.
Now, not all of the returns from investment go to higher wages. Some of them go right back to the investor. However, again we ask: what will she do with them? If she saves them again we go through the same loop as before and drive up wages even further. If she consumes them then they go into the tax base and we retrieve some our progressivity.
In short, the results of reducing the tax on savings can only be parsed out to two sources. Either an increase in the total amount of investment, which will raise wages or an increase in the consumption of the saver which will then be taxed.
Now we will probably have to end up with higher tax rates in order to retain the same end level of progressivity. However, taxing consumption doesn’t create a fundamental loophole through which the wealthy can escape. One way or another it all comes back to investment or consumption.
So where do we start. A good jumping off place would be the Bradford X tax which is a progressive consumption tax. There are other approaches including combining a VAT with a wage subsidy, my preferred choice.
However, this is the direction we should all be looking to move towards. Again, not because we don’t care about the poor, but because we do. A stronger economy, with a optimally designed progressive tax system is the best way to alleviate suffering.
So Modigliani-Miller says that it doesn’t matter that the most successful entrepreneurs pay the most tax because financial markets will direct capital to its most productive uses regardless. However, considerable evidence exists that the there is a significant external finance premium. That is, its cheaper to reinvest your own profits than borrow from the market. The source of this premium is assumed to be information asymmetries. And such asymmetries are likely to be most pronounced in the case of heterogeneous entrepreneurial skill, as I am discussing here.
Thus, we should expect the strongest failure of Modigliani-Miller precisely in the cases of extreme wealth accumulation. Indeed, in some sense it is the failure of MM that allows extreme wealth accumulation through an interaction effect of entrepreneurial skill with the cost of capital. That is, being good gives you excess profits, which by virtue of lower financing costs give you an even further advantage over your competitors.