Hidden Asset Taxes Must Be Huge

Paul Krugman:

Piketty’s big idea is that we are in the early stages of returning to a society dominated by great dynastic fortunes, by inherited wealth. … Imagine a wealthy family that has managed, somehow or other, to guarantee that a large fraction of its income is used to accumulate more wealth. Can this family thereby acquire a dominant position in society?

The answer depends on the relationship between r, the rate of return on assets, and g, the overall rate of economic growth. If r is less than g, dynasties are doomed to erode: even if all income from a very large fortune is devoted to accumulation, the family’s wealth will grow more slowly than the economy, and it will slowly slide into obscurity. But if r is greater than g, dynastic wealth can indeed grow to gigantic size. …

Piketty tells us something remarkable: historically, r has almost always exceeded g – but there was an exceptional period in the 20th century, a period of rapid labor force growth and technological progress, when r was less than g. And he asserts that the kind of society we consider normal, in which high incomes reflect personal achievement rather than inherited wealth, is in fact an aberration driven by this exceptional period. … A couple of questions:

1. How much of the decline in r relative to g in the 20th century reflected fast growth, and how much reflected policies that either taxed or in effect confiscated inherited wealth? In other words, how much was destiny, how much wars and political upheaval? Piketty stresses both factors, but never gives us a relative quantitative assessment. (more from Piketty here, here)

This rate of return on assets r that Krugman and Piketty discuss is something like the ratio of rental to purchase price of land. I don’t have access to Piketty’s book, but I’ve been pondering this question for a few months, and I’ve concluded that the usual estimates of asset returns r must fail to include many taxes that in practice reduce the actual rate of return r that growing dynasties can achieve. And I think that once we include all hidden taxes, the actual rate of return r that dynasties could achieve in practice must have usually be no more than the economic growth rate g. Let me explain.

Some taxes are explicit, like property taxes. Other taxes are implicit in the property destruction and transfer that result from wars, political upheavals, and legal corruption, and in the costs of reasonable efforts to prevent such losses. Finally, there are implicit taxes resulting from local legal limits on who one may use to manage a dynastic fund. For example, if a dynasty must give its eldest living male wide discretion over spending and investment choices, and if such males often turn out to be spent-thrift fools, this will greatly limit this dynasty’s ability to grow over the long run. An ideal might be to delegate dynasty management to a reputed professional trust that is legally obligated to follow explicit instructions to grow the fund as fast as possible over the long run. But, as I’ve discussed before, most societies have put substantial legal obstacles before solutions like this.

I argue that the net effect of all these hidden taxes on dynastic funds must have been to usually reduce asset returns to below growth rates. My argument is simple: If asset returns had typically been above growth rates, then if any dynastic funds had chosen to grow at the maximum possible rate, then even if those funds had started small they would have come to dominate investments worldwide. And they would have done so on a timescale short compared to the time period over which historical records suggest that asset returns have exceeded growth rates. By competing with each other, such dominating dynastic funds would then have increased the supply of investment so much as to drive down asset returns to or below the sustainable level, which is the economic growth rate.

I conclude that consistently across space and time, the net effects of all forms of taxes on dynastic investment funds, including taxes implicit in limiting who one may trust not to pilfer those funds, has been to reduce real assets returns to below growth rates. Perhaps well below.

Of course, if the main hidden tax in history has been pilfering by dynasty managers, that can result in a world where such pilferers spend a large fraction of world income, without much social value to show for it. One might easily dislike such a scenario, and want to prevent it. But instead of adding more explicit taxes to prevent the growth of dynastic funds, it seems to me better to cut the pilfering tax. Because this should encourage much more investment overall, which seems a good thing. This includes investment in helping and protecting the future, including protection from disasters, including existential risks. Which also seem like good things.