Much has been written about the dramatic increase in income and wealth inequality in the United States over the last four decades. This volume of literature not only warns about the injustice of our current system, but also raises alarm that extreme inequality poses a serious risk to our democracy.
Concern about inequality is at least as old as the United States itself. Writing in 1792 about the necessity and dangers of political parties, James Madison made the connection between excessive wealth and its political influence:
The great object should be to combat the evil: 1. By establishing a political equality among all. 2. By withholding unnecessary opportunities from a few, to increase the inequality of property, by an immoderate, and especially an unmerited, accumulation of riches. 3. By the silent operation of laws, which, without violating the rights of property, reduce extreme wealth towards a state of mediocrity, and raise extreme indigence towards a state of comfort.
Excessive wealth concentration, in Madison’s view, was as poisonous for democracy as war. “In war,” he continued, “the discretionary power of the executive is extended; its influence in dealing out offices, honors, and emoluments is multiplied. . . . The same malignant aspect in republicanism may be traced in the inequality of fortunes.”
Wealth is power. An extreme concentration of wealth means an extreme concentration of power: the power to influence government policy, the power to stifle competition, the power to shape ideology. Together, these amount to the power to tilt the distribution of income to one’s advantage. This is the core reason why the extreme wealth of some can reduce what remains for the rest—why part of the income of today’s superrich can be earned at the expense of the rest of society. That’s what earned John Astor, Andrew Carnegie, John Rockefeller, and other Gilded Age industrialists their epithet of “Robber Barons.”
An extreme concentration of wealth means an extreme concentration of power: the power to influence government policy, the power to stifle competition, the power to shape ideology.
In much of the twentieth century, the U.S. tax system protected against such extreme disparities. But far from curbing this trend, the tax system in the last four decades has instead reinforced it. The three traditional progressive taxes—the individual income tax, the corporate income tax, and the estate tax—have all weakened. The top marginal federal income tax rate has fallen dramatically, from more than 70 percent every year between 1936 and 1980—in fact, often higher, peaking at 94 percent during the final years of World War II—to 37 percent in 2018. (The income threshold at which this rate kicked was several million of today’s dollars.) Corporate taxes—which are progressive in the sense that they tax corporate profits, a highly concentrated source of income—have declined from about 50 percent in the 1950s and 1960s to 16 percent in 2019. And estate taxes on large bequests are now almost negligible due to a high exemption threshold, many deductions, and weak enforcement.
A renewed political demand calls for progressive taxation to reverse these trends—to achieve greater tax justice, raise revenue to pay for important public goods, and curb the rise of inequality. Indeed, two major presidential candidates have proposed wealth taxes. In January 2019 Elizabeth Warren proposed a progressive wealth tax on families or individuals with net worth above $50 million with a 2 percent marginal tax rate and 3 percent above $1 billion (she revised that to 6 percent rate for billionaires in the fall). And in September 2019 Bernie Sanders proposed a similar wealth tax starting at $32 million with a 1 percent marginal tax rate, rising to 5 percent for billionaires and 8 percent for deca-billionaires. The key difference between these proposals and earlier proposals, for instance the one made by Edward Wolff in these pages (as well as existing or past wealth taxes in other countries), is the high exemption thresholds: fewer than 0.1 percent of U.S. families would be liable for the Warren or Sanders wealth tax.
Both presidential candidates rightly believe that a wealth tax of the sort they have proposed would fill a critical gap in the U.S. tax system: it would ensure greater tax justice by requiring that the ultra-wealthy pay taxes commensurate with their ability to pay. But in the long run, an ambitious wealth tax—with marginal tax rates high enough for billionaires—could also help address the threat that extreme inequality poses for democracy.
A wealth tax: the proper way to tax the ultrarich
Why isn’t the income tax sufficient for taxing the superrich? Because many of the most advantaged members of society possess substantial wealth but low taxable income. Maybe they own a valuable business that does not make much in profits, but which, everybody anticipates, will be immensely profitable in the future (think Amazon, before 2016). Or, as is more frequently the case, they may structure their already profitable business so that they generate little taxable income. Consider Warren Buffett. According to Forbes, Buffett owned $62 billion in wealth in 2015. We don’t know the exact rate of return on his wealth, but let’s assume it was 5 percent. On this conservative assumption, Buffett’s real pre-tax income—his share of his company Berkshire Hathaway’s profits—was $3.1 billion. That year Buffet paid federal income taxes of about $1.8 million, corresponding to an effective income tax rate of around . . . 0.058 percent.
In much of the twentieth century, the U.S. tax system protected against extreme disparities in wealth. Far from curbing this trend, the tax system in the last four decades has only reinforced it.
Buffett’s effective income tax rate is so low because his wealth primarily consists of shares in his company Berkshire Hathaway, which does not pay dividends. When Berkshire Hathaway buys other corporations, Buffett forces them to stop paying dividends too. As a result, Buffett’s wealth has been accumulating for decades, free of individual income taxes, within his firm. Eliminating dividends and perpetually reinvesting profits boosts Berkshire Hathaway’s share price, year after year. One share now costs some $330,000, thirty times more than it cost in 1992. To finance any spending, Buffett need only sell a few shares. By selling forty shares, for example, he can move $13 million to his personal bank account. He then pays tax—a modest one—on the small amount of capital gains he just realized. And that’s the limit of his tax liability. Raising the top marginal income tax rate wouldn’t affect the tax bill of Buffett or Bezos notably, since neither of them has much taxable income in the first place.
That’s how billionaires such as Buffett, Jeff Bezos, and Mark Zuckerberg can live almost tax-free today. And that’s how the top 400 richest Americans have come to pay the lowest tax rate of any income group. When we combine all taxes at all levels of government (federal, state, and local), we find the U.S. tax system indeed now resembles a giant flat tax that becomes regressive at the very top. All groups of the population pay effective tax rates of roughly 28 percent, with mild progressivity up to the top 0.1 percent and a significant drop at the top—where effective tax rates fall to 23 percent for the 400 richest Americans.
What about corporate taxes? The 1950s U.S. tax system was highly progressive in large part thanks to very high effective corporate tax rates of about 50 percent. Those rates applied to profitable companies, which, at the time, had relatively few owners, typically individuals rather than institutional investors. Now, however, more than 20 percent of listed U.S. equities are owned by foreigners and 30 percent by pension funds, who accumulate assets on behalf not only of the…