California Billionaire Tax: Risks, Myths, and Growth Impact

The "All Else Equal" podcast, hosted by Jules Van Binsbergen and Jonathan Burke, recently delved into the controversial topic of California's proposed billionaire tax. This initiative, which will be put to a vote in November, suggests a one-time 5% wealth tax on billionaires. While the proposal is specific to California, the underlying principles and motivations, as the hosts noted, are relevant globally.

The Billionaire Tax: A Closer Look

Jonathan Burke initiated the discussion by playing "devil's advocate," questioning why taxing billionaires, who possess wealth far exceeding their lifetime needs, would be problematic. Jules Van Binsbergen responded by highlighting the core theme of the podcast: examining the side effects of such taxation and whether it truly achieves its stated goals.

The primary goals of a billionaire tax could be to increase government revenue or to foster a fairer society. Focusing on the former, Van Binsbergen introduced the concept of the Laffer Curve, an economic principle suggesting that there's a limit to how much revenue can be extracted through taxation. Beyond a certain point, higher tax rates can lead to lower tax revenues because they incentivize tax avoidance and disincentivize productive activity.

Burke elaborated on behavioral responses to high taxes, noting that individuals might hire accountants to find loopholes or, more significantly, choose leisure over labor if the marginal tax rate on additional earnings is too high. In the U.S. context, where labor is mobile, high taxes in one state can prompt individuals to relocate to states with lower tax burdens.

The Financial Implications for California

The hosts presented a stark calculation regarding the potential impact of billionaires leaving California. With an estimated $2 trillion in total billionaire wealth in the state and a top income tax rate of approximately 14% (which includes capital gains), California stands to collect around $270 billion in income tax over time. However, if just 20% of billionaires were to leave the state in response to the wealth tax, California would actually lose money.

The "Fair Share" Argument and Economic Reality

The discussion then shifted to the common argument that billionaires are not paying their "fair share" of taxes. Van Binsbergen presented data challenging this notion:

• Top 0.1%: Pays approximately 20% of total U.S. income tax revenue.
• Top 1%: Pays 38.4% of total taxes.
• Top 10%: Pays 71% of total taxes.
• Top 50%: Pays 97% of total taxes.

This data suggests that the bottom 50% of earners pay very little in income taxes, making the statement "rich people don't pay taxes" inaccurate. The hosts questioned what constitutes a "fair share," pointing out that the top 0.1% effectively pays taxes for 200 other people.

Burke drew a parallel to the Soviet Union, a system that eliminated billionaires and, consequently, economic growth. He argued that billionaires often achieve their wealth by providing valuable services and products that consumers willingly purchase, creating immense consumer surplus and economic value. While acknowledging that some billionaires in other countries might acquire wealth through illicit means, the hosts emphasized that many in California, like Steve Jobs, built their fortunes by innovating and creating products that significantly benefited society.

The Implicit Contract and Economic Growth

The hosts argued that a wealth tax violates an "implicit contract" that encourages individuals to work hard and innovate by allowing them to retain the benefits of their efforts. This contract is crucial for economic growth. If future innovators believe their wealth will be confiscated, their incentive to create and invest in California, or even the U.S., could diminish.

Van Binsbergen used a sports analogy: taxing Michael Jordan's earnings to equalize pay among all basketball players would be detrimental to the team's success. Similarly, a country or state should strive to retain its "star athletes" (innovators and wealth creators) to ensure continued prosperity.

Expert Insight: Josh Rauh on the California Billionaire Tax

The podcast then welcomed Josh Rauh, the Omen Family Professor of Finance at the Stanford Graduate School of Business and a Senior Fellow at the Hoover Institution. Rauh, an expert on taxation in California, provided a critical perspective on the proposed tax.

Rauh outlined several issues with the billionaire tax:

1. Revenue Generation: He believes the tax will not generate the revenue proponents claim.
2. Economic Damage: It will cause significant economic harm and is unlikely to improve inequality, potentially even worsening it if billionaires leave the state.
3. Spending Problem: California has a spending problem, not a revenue problem, with public services like health and education seeing increased costs without commensurate quality improvements.
4. Property Rights: The tax infringes on individuals' property rights.
5. Countermeasures: There are other ballot measures aimed at preventing the state from taxing retirement savings and assets, indicating public concern about such taxation.

Rauh specifically addressed the estimate by University of Berkeley professor Emanuel Saez and Gabriel Zucman (now at the Paris School of Economics), who projected the tax would raise $100 billion. Rauh's research, however, suggests this estimate fails to account for behavioral responses, particularly billionaires leaving the state.

He noted that six billionaires had already publicly left California, and even if their departures were challenged by tax authorities, their legal teams are likely well-prepared. Accounting for these known departures reduces the projected revenue to $67 billion. Furthermore, many other billionaires, not household names, may have quietly relocated. Considering these factors and the loss of annual income tax revenue from these individuals (estimated at $4-5 billion per year), Rauh concluded that it's difficult to envision California achieving a net positive outcome from this tax.

The Arbitrary Nature of the Tax and its Broader Implications

Van Binsbergen questioned the arbitrary nature of targeting billionaires with a 5% wealth tax, especially when individuals with slightly less wealth are not subject to it. Rauh acknowledged that California has a history of arbitrary cutoffs, such as the millionaire income tax, but highlighted the political appeal of "demonizing" billionaires. He stressed that these individuals and their companies have been massive job creators and economic drivers in California. The assumption that the tech industry would thrive even if its founders left is, in Rauh's view, incorrect.

Rauh also discussed the proponents' argument that billionaires hold significant unrealized capital gains, which they view as untaxed income. He warned that taxing unrealized capital gains would have severely negative impacts on the incentive to invest and take risks, particularly in volatile startup environments.

The Flawed Focus on Revenue Maximization

Rauh criticized the field of public economics for its "laser focus" on maximizing government revenue, arguing that this should not be the primary objective of a government. Instead, governments should aim to optimize social welfare. He pointed out that the proponents of the wealth tax, like Emanuel Saez, have suggested that even if 80% of billionaires left California, the state budget would still be better off. Rauh found this perspective deeply flawed, arguing that liquidating Silicon Valley for a relatively small revenue gain would have devastating consequences for jobs and prosperity.

Burke reinforced this point, stating that people often fail to see how billionaires create wealth, mistakenly assuming that economic growth would continue even without them.

Towards a Better Tax System

When asked about an optimal tax system, Rauh suggested moving away from income and wealth taxes, which create significant distortions, towards consumption taxes like a value-added tax. More practically, he advocated for lower income tax rates, a broader tax base, and the elimination of the corporate tax (with shareholder-level taxes as an offset). He also recommended simplifying the system by removing deductions and loopholes, including those for employer-provided health insurance and mortgage interest.

The "All Else Equal" Mistake in Taxation

The discussion concluded by reiterating that taxation is a prime example of an "all else equal" mistake, where policymakers often fail to account for how people will react to tax changes. Rauh emphasized that while a basic social safety net is necessary, the current scale of government spending often leads to increasing distortions and makes everyone poorer. He cited Margaret Thatcher's quote: "You would rather that the poor were poorer so long as the rich are less rich. That is your policy."

Rauh also highlighted the issue of high marginal tax rates for lower-income individuals, particularly those transitioning from Medicaid. He noted that someone at the 25th percentile of earnings in states with Medicaid expansion could face a marginal tax rate over 100% if they double their income, effectively removing any incentive to work harder. This, he argued, is a significant problem that needs to be addressed when considering the overall impact of redistribution policies.