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Once And For All—Why Capital Levies Are Not The Answer

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Holy grail

Last night, when you went to bed, you left $40 on the kitchen table. When you woke up this morning, you found only $30—and a note from the government saying, “Thank you very much, we took $10 as a tax payment.” This is, of course, extremely irritating. To an economist, however, it’s close to an ideal form of taxation, since there is nothing you can now do to reduce, avoid, or evade it—the holy grail of what economists call a non-distorting tax.

(This doesn’t mean that you won’t react in some way. Being worse off, you may now work a bit more, or save a bit less. But any other tax raising $1 would make you even worse off, because it would change relative prices (a tax on your earnings would make working less attractive, for instance), and so take your choices even further from those you would make in the absence of taxation.)

What was just described is the essential idea of a “capital levy,” the passing discussion of which in Box 6 of the recent Fiscal Monitor attracted much attention. (To be clear, there is no such proposal from the IMF; the box simply contains an analytical description of the issue and experiences, which had already been the subject of some public discussion). Such a levy would entail a one-off charge on capital assets, the precise base being a matter for choice, but generally larger than cash left on kitchen tables. Added to the efficiency advantage of such a tax, many see an equity appeal in that such a charge would naturally fall most heavily on those with the most assets.

So it is not surprising that the idea of a capital levy has at times risen high in public debate, especially after wars in which extraordinary means are sought to reduce high levels of debt—whether of the winners (Britain after the Napoleonic and First World Wars, for instance) or losers (Germany after the First World War, Japan after the Second World War). But, as the review by Berkeley economist Barry Eichengreen makes clear, governments have rarely implemented capital levies, and they have almost never succeeded. And there are very good reasons for that.

Or poisoned chalice?

The homey analogy also points to a pretty fundamental flaw in this basic case for a capital levy. Tonight, fearing that the government will do the same again, you may choose not to leave your cash on the table, or perhaps you will spend it. Looking closer at the note that the government left on the table, you find “P.S. We promise not to do this again.”

But do you believe it? What if the government finds itself in trouble again? Now you are likely to search for ways to reduce, avoid or evade possible future levies—and the tax may become highly distortionary.

The point is that to be non-distorting the tax must be both unanticipated and believed certain not to be repeated. These are both very hard things to achieve.

Introducing and implementing any new tax takes time, and governments can rarely do it in entire secrecy (even leaving aside transparency issues). And that gives time for assets to be moved abroad, run down, or concealed. The risk of future levies can be even more damaging; they discourage the saving and investment that generate future capital assets. More generally still, the credibility of all government tax policy can be jeopardized by unanticipated taxes of this sort. If the government can do this, what’s to stop them from, say, suddenly deciding that the depreciation of past investments and interest incurred on old loans will no longer be deductible against tax?

Effective taxation requires a degree of confidence in future tax policies that goes beyond any legal restrictions governments may face on their ability to tax. So the point is not simply that in practice, any capital levy will be distorting: it is that it is likely to be very distorting.

The experience of capital levies bears out these warnings. Where they have been tried, they have rarely raised much revenue, being preceded by lengthy public debate and capital flight (associated with an inflation that eroded the underlying debt problem). Eichengreen finds only one successful example: Japan after the Second World War, where the tax was imposed by an occupying power and so was largely unconstrained by democratic norms and did not taint for future governments. This was the exception—emphatically not the rule.

A wealth of wealth taxes 

A capital levy is one form of wealth tax. It should not be confused, as it sometimes has been, with the many other possible types of tax on wealth and its transfer: taxes on estates left at death, on inheritance and gifts, on real estate, on transactions in capital assets, to name but a few. The economics of these are quite different and, in some cases, much more attractive. We also discussed this in the Fiscal Monitor, and it deserves a blog of its own.