Liz Warren’s wealth tax would take entire asset classes off the table for billionaires and destabilize corporate strategy. A 70% income tax wouldn’t be as bad.
A lot of people have focused on whether Senator Liz Warren can get elected if she’s eager to tax the rich and whether her proposal is constitutional as described.
We’ll just have to see if she gets any electoral traction to answer the first question. As for the second, she’s rounded up a lot of her fellow law professors who back her up.
In the meantime, planning is all about weighing the impact of possible futures and making sure you know how to position them if anything actually happens.
Warren has put one future on the table. Alexandria Ocasio-Cortez in the House has floated another proposal.
Even though they probably won’t won’t happen, let’s see what’s actually on the table.
Start with the real estate
Tax policy has degenerated into floating a big picture idea and then letting the numbers take care of themselves if and when the core concept gets traction.
That means that we haven’t heard about any adjustments to the income tax, estate tax or capital gains treatment. Warren’s people simply say the existing rules will continue.
But with no adjustments, her plan to let the IRS take 2% of all standing wealth above $50 million every year and another 1% for everything beyond $1 billion will dramatically change the way rich families invest.
For one thing, that annual 2-3% drag creates a strong incentive to keep huge pools of wealth working. Even a single $80 million New York penthouse needs to appreciate at least that much or generate income in order to resist the undertow.
And even a collection of little mansions can hit the $50 million barrier fast. “Surplus” real estate gets penalized and isn’t liquid while you own it.
The IRS will still want its 2% in cash, year in and year out. Unless you rent out the extra houses, you’re going to need to slim down the property profile or make sure there’s a lot of outside cash to cover the taxes.
Effectively the cost of collecting mansions would go up at least 2%. Whether you account for it as a higher property tax assessment or maintenance inflation, the result is the same. Get those houses working or start raiding the equity.
In theory, more “working” mansions can depress the high end of the housing market by expanding real inventory. Naturally any houses that need to be sold to raise cash will have a similar effect.
A wealth tax doesn’t necessarily force anyone to dump an extra condo, but even a few families downsizing — especially in states where the tax burden is already high — can create a significant drag.
Warren’s team has evidently put a little thought into illiquid assets because there’s some chatter about giving people a few years to raise cash. Unfortunately, it can take that long even under ideal market conditions to unload that $80 million penthouse.
Either way, trophy real estate allocations need to shrink to make room for bigger annual bills. After all, if the properties aren’t pulling their weight, every other dollar needs to work harder.
Naturally, I ran the numbers. Again, assuming that nothing else changes in the tax code, a passive wealth tax acts like a separate form of inflation, a drag on your clients’ buying power.
Someone with $60 million would get a pass on the first $50 million and owe the Warren IRS 2% of everything else. If none of the money is invested, $60 million turns into $59.8 million in the first year, $59.6 million after that and so on.
But if that money is working, effective investment returns decline. If $60 million generates 10% in a typical year in the market and that’s roughly 30% dividends, you’re already paying the IRS $1.5 million a year, assuming of course that the advisors only harvest long-term gains.
In that scenario, the Warren proposal basically amounts to taking the capital gains tax to 25% and praying that the market cooperates. Remember, the wealth tax would be due whether people are liquid or not. No cash? You need to sell something or go into debt.
And if you’re nervous about the market like a lot of truly wealthy people, bonds are still an option at this level. Sink everything in Treasury paper and live on the interest. After all the taxes on interest and principal, you can squeeze $800,000 a year out of $60 million at current yields.
Munis actually do better here. I don’t think that’s Warren’s plan but she’d probably appreciate “motivating” mega-millionaires to park their money in local government debt instead of the Treasury market.
Run all the numbers and munis will deliver a higher after-tax return, keeping overall net worth positive even after paying the wealth tax.
As you travel up the wealth scale, Treasury yields need to rise in order to cover the annual IRS bill. In a post-Warren world, a bona fide billionaire can never preserve wealth in the Treasury market at rates below 2.9%.
It’s hard to say where those rates will go but odds are good that retail and UHNW demand for government bonds will go down, giving yields a bit of a boost until they hit the sweet spot.
Don’t forget bond investors are already swallowing 2% inflation. In Warren’s world, any investment return under 4% will erode the value of every large fortune sooner or later.
That’s munis and Treasuries alike at this point.
The Bezos solution
Finally, let’s take an example from the top end, a Jeff Bezos type. Split his net worth in divorce court and you’re looking at $70 billion here, mostly in Amazon stock.
Currently he’s only taxed on that wealth when he realizes a capital gain. Say he liquidates $1 billion a year to fund his modest living expenses and gets $800 million back after taxes.
The wealth tax would force him to sell or at least borrow another $2.27 billion a year. Maybe he starts trading around the stock with derivatives (if he isn’t already) in order to raise that cash. But if he can’t cover the IRS bill, he’s still got to sell.
As long as the stock keeps rising more than 3% a year, every year, his wealth keeps increasing. What’s his ideal strategy? Let the gains ride as long as possible.
It’s in his interest to never pay himself dividends, which increase the tax drag at ordinary income rates. Of course that’s always been the case, but as the overall drag increases, the motive gets sharper.
And for everyone, trusts start to look extremely attractive. It’s not about passing on the assets to another generation at that point — Warren is quiet on the estate tax front.
It’s all about getting personal wealth down to that $50 million mark as fast as you can. Presumably trusts and other corporate entities are exempt from the wealth tax as she envisions it. Maybe she just hasn’t given it much thought.
Imagine a $900 billion company. That market capitalization is technically “wealth.” The equity certainly is. The owners would get taxed under her scheme.
A trust owns its own assets. It files tax returns. Would there be a new 2-3% surcharge on its assets? Unclear.
Savvy advisors will keep up with all of this, as a mental exercise if nothing else.
Either way, a 70% income tax would almost be preferable. We know what happens then. Maximize pre-tax spending and capital gains. Dividends and interest become even less attractive.
None of this is good for bonds. But the yield curve doesn't need any more pain right now.