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.

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  • Thomas_L_Holaday

    What are some promising ways to reduce pilfering taxes?

    • See my link. But basically: enforce wills as written.

      • Thomas_L_Holaday

        I see a link to If More Now, Less Later. Is that the link you mean for {promising ways to reduce pilfering taxes | enforce wills as written} ? If so, is it correct for me to infer that a way of reducing pilfering taxes is to allow for very long term trusts? If that inference is correct, it is not clear to me how the duration of the trust reduces the pilfering tax.

      • A trust that is instructed to keep investing and not spend is far more likely to actually do that than handing the money to a next of kin.

  • Lawrence D’Anna

    Would the government allow you to set up a nonprofit whose only goal was to grow the size of its own endowment? Has anyone ever seriously tried?

    • Yes people have tried, and no it isn’t easily allowed.

      • Lawrence D’Anna

        What does “not allowed” consist of? What happens if you try? They never let you incorporate in the first place? At some point they just confiscate the assets? They tax it so much it can’t really grow?

      • Jess Riedel

        That document discusses the rule requiring foundations to make “charitable expenditures” of at least 5% of their assets each year. The penalty is 30% of the additional amount that should have been spent, which is assessed against only the foundation and is not considered a crime by its members. Could the foundation simply pay the penalty, which would amount to a 1.5% yearly tax on the endowment, and continue to grow?

      • I expect that if a foundation successfully grew via blatantly and consistently violating this rule, the penalty would be increased.

  • VV

    It seems to me that those that you call “hidden taxes” are actually deadweight losses, and they would affect the poor at least as much as the rich, and historically in practice much more.

  • Radford Neal

    The analysis seems to ignore that as a “family” becomes dominant financially, it may also get bigger – with more and more descendents, perhaps encompassing every member of society after many generations. The family might avoid this by encouraging its members to have only one child, but this would increase the possibility that the whole family will disappear due to some disaster.

    • The usual asset returns quoted are quite a bit larger than the usual growth rates for family population.

    • IMASBA

      I think that problem is often circumvented by locking the wealth into companies and real estate that mostly don’t get divided but all go to a single heir. A noticeable exception would be the Saudi royal family that keeps handing out money to more and more people.

  • lump1

    Isn’t Krugman assuming that g is roughly homogenous across the social classes? Couldn’t there be a society with a reasonably high g which is almost entirely based on gains of the very wealthy families (and stagnation or even impoverishment of everyone else)? If so, their relative wealth will grow fast, even though g and r for the society are fairly close. (Disclosure: I’ve been thinking about Greg Clark’s new book recently.)

    • IMASBA

      r did outpace g most of the time since the invention of agriculture, but that was indeed only the case on average, periodic resets did happen. Still, inequality had grown to huge proportions in some civilizations like the Roman Empire and Tsarist Russia. If there are less wars and major catastrophes in the future then the resets may not happen often enough anymore to keep dynastic wealthfrom running off. In addition we may see something like a genetic divide increase r relative to g as well.

    • Jonas Feit

      That is one of the chief points of the book. R generally outpaces g, but, in the 20th century, events like you describe allowed g to dominate.

  • Alexei Sadeski

    Given the fact that rich dynastic families have considerably less power now than perhaps any other time since the dawn of civilization, it seems puzzling that this would be a concern.

    • S.C. Schwarz

      Some families have lots of dynastic power. Think of the Clintons and the Bushes. But that’s not a problem Piketty want to worry about, especially with Hillary about to run for president.

      In the end people like Piketty want more government and the taxes to pay for it. All their “research” is to find, or make up, reasons for what the want initially.

    • lump1

      I think the idea behind the article acknowledges just what you said, but suggests that this is an anomaly and that we shouldn’t get used to it.

  • Doug

    A technical note, r and g are actually random distributions that we’re using shorthand to denote Mean(r) and Mean(g). It’s possible that Mean(r) > Mean(g), yet dynastic wealth still not outpace growth. A simple example, assume g reliably was 50% every century. And r was either a doubling or halving with equal probability every century. Mean(r) = 75%/century > Mean(g) = 50%/century. Yet over the long run dynastic wealth will stay static and the economy will grow.

    In financial parlance this is called volatility drag. And I don’t think it’s a trivial contribution to the problem. Dynastic wealth really probably is much more volatile than overall global economic growth. This is true for a multitude of reasons, including dynasties being overly aggressive in risk-taking (which is probably how they got rich in the first place), dynasties being more subject to local economic conditions and not globally diversified, as well as real returns to capital being much more volatile than economic growth rates.

    • it makes more sense to talk about ln(r) and ln(g). The long run outcomes do track the means of those quantities, without volatility drag.

  • consider

    I have problems with Piketty’s graph. First, it is odd distorting the x-axis by having one unit represent 1000 years then 500 years, then 200 years, shrinking to 90 years and eventually 50 years. And does Piketty really have reliable data to show the slight increase in growth going back 2000 years? I know that Greg Clark has said Agnus Maddison’s data prior to 1800 isn’t worth anything.

  • Sam Dangremond

    Aka “No, you can’t take over the world by compound interest. No matter how low your time preference.”

  • Aren’t you ignoring the demand side in your assumption that the correct policy will maximize investment?

  • Evelyn Mitchell

    Family may be too small a concept here.
    Sovereign Wealth Funds are the country-level equivalent of dynasties:

    As are multinational corporations:

    If the issue is concentration of wealth in the hands of a few, does it matter if those few are related by blood and marriage, or contract, or geography?

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  • Joshua Toon

    Whatever it takes to make sure that the accepted wisdom is correct…

  • Whitespiral

    Dear all,

    Why are we all implicitly assuming that “dynasties” is a static and homogeneous blob when in fact experience and data indicate that it is not just volatile at the aggregate level (“dynasties”), but extremely volatile at the individual level (“dynasty”)?

    Doesn’t matter if it’s families, corporations or countries we’re talking about, the general rule is that what goes up, probably will come down.

    Just my 2c.

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