In the United States, there has been talk of implementing a wealth tax in order to generate revenue off of wealthier individuals. While the politics of a wealth tax are beyond the scope of this post, we can still examine the effects of wealth based taxation on a quantitative basis.
The future value interest factor formula that accounts for an annual tax on wealth is as follows:
Where:
Assume that an individuals portfolio which comprises their entire net worth will grow at a required rate of 7% for 10 years and the tax rate on wealth is 1% annually, plugging those values into the formula will yield the following:
An individual with an initial net worth of $1,000,000 would be worth $1,779,100 in ten years.
On the surface, a 1% tax on wealth doesn’t seem like much when this individual’s portfolio is now worth $1.7mm dollars; however, let’s quantify the tax-drag that wealth based taxation has on net worth.
Recall that the formula used to calculate tax-drag is as follows:
where:
In order to calculate the tax-drag we need to compute the value of the portfolio without taxes as follows:
We can now plug the ending values of the tax-free and taxable accounts into the tax-drag formula:
The tax-drag in this particular scenario is 19.44%. In other words, a 1% tax on wealth every ten years eroded 19.44% of the appreciation relative to the tax-free account.
Constructing a tax-drag table that quantifies the effect wealth based taxation has over time will illustrate how destructive wealth taxes are even if wealth taxes are in the low single digits per annum.
First let’s construct the future value table for the tax-free account:
| Rate | ||||||
| 2% | 3% | 4% | 5% | 6% | 7% | |
| Year | ($ 000s) | |||||
| 1 | $ 1,020.00 | $ 1,030.00 | $ 1,040.00 | $ 1,050.00 | $ 1,060.00 | $ 1,070.00 |
| 2 | $ 1,040.40 | $ 1,060.90 | $ 1,081.60 | $ 1,102.50 | $ 1,123.60 | $ 1,144.90 |
| 3 | $ 1,061.21 | $ 1,092.73 | $ 1,124.86 | $ 1,157.63 | $ 1,191.02 | $ 1,225.04 |
| 4 | $ 1,082.43 | $ 1,125.51 | $ 1,169.86 | $ 1,215.51 | $ 1,262.48 | $ 1,310.80 |
| 5 | $ 1,104.08 | $ 1,159.27 | $ 1,216.65 | $ 1,276.28 | $ 1,338.23 | $ 1,402.55 |
| 6 | $ 1,126.16 | $ 1,194.05 | $ 1,265.32 | $ 1,340.10 | $ 1,418.52 | $ 1,500.73 |
| 7 | $ 1,148.69 | $ 1,229.87 | $ 1,315.93 | $ 1,407.10 | $ 1,503.63 | $ 1,605.78 |
| 8 | $ 1,171.66 | $ 1,266.77 | $ 1,368.57 | $ 1,477.46 | $ 1,593.85 | $ 1,718.19 |
| 9 | $ 1,195.09 | $ 1,304.77 | $ 1,423.31 | $ 1,551.33 | $ 1,689.48 | $ 1,838.46 |
| 10 | $ 1,218.99 | $ 1,343.92 | $ 1,480.24 | $ 1,628.89 | $ 1,790.85 | $ 1,967.15 |
We’ll do the same for the taxable account assuming an annual wealth tax of 1%:
| Rate | ||||||
| 2% | 3% | 4% | 5% | 6% | 7% | |
| Year | ($ 000s) | |||||
| 1 | $ 1,009.80 | $ 1,019.70 | $ 1,029.60 | $ 1,039.50 | $ 1,049.40 | $ 1,059.30 |
| 2 | $ 1,019.70 | $ 1,039.79 | $ 1,060.08 | $ 1,080.56 | $ 1,101.24 | $ 1,122.12 |
| 3 | $ 1,029.69 | $ 1,060.27 | $ 1,091.45 | $ 1,123.24 | $ 1,155.64 | $ 1,188.66 |
| 4 | $ 1,039.78 | $ 1,081.16 | $ 1,123.76 | $ 1,167.61 | $ 1,212.73 | $ 1,259.15 |
| 5 | $ 1,049.97 | $ 1,102.46 | $ 1,157.02 | $ 1,213.73 | $ 1,272.64 | $ 1,333.81 |
| 6 | $ 1,060.26 | $ 1,124.18 | $ 1,191.27 | $ 1,261.67 | $ 1,335.51 | $ 1,412.91 |
| 7 | $ 1,070.65 | $ 1,146.32 | $ 1,226.53 | $ 1,311.51 | $ 1,401.48 | $ 1,496.69 |
| 8 | $ 1,081.14 | $ 1,168.91 | $ 1,262.84 | $ 1,363.31 | $ 1,470.71 | $ 1,585.45 |
| 9 | $ 1,091.74 | $ 1,191.93 | $ 1,300.22 | $ 1,417.17 | $ 1,543.37 | $ 1,679.46 |
| 10 | $ 1,102.44 | $ 1,215.41 | $ 1,338.71 | $ 1,473.14 | $ 1,619.61 | $ 1,779.06 |
Now we can calculate the tax-drag table using the two tables above:
| Rate | ||||||
| 2% | 3% | 4% | 5% | 6% | 7% | |
| Year | ||||||
| 1 | 51.00% | 34.33% | 26.00% | 21.00% | 17.67% | 15.29% |
| 2 | 51.25% | 34.67% | 26.38% | 21.40% | 18.09% | 15.72% |
| 3 | 51.49% | 35.00% | 26.76% | 21.81% | 18.52% | 16.17% |
| 4 | 51.74% | 35.34% | 27.14% | 22.22% | 18.95% | 16.62% |
| 5 | 51.99% | 35.67% | 27.52% | 22.64% | 19.39% | 17.08% |
| 6 | 52.24% | 36.01% | 27.91% | 23.06% | 19.83% | 17.54% |
| 7 | 52.48% | 36.35% | 28.30% | 23.48% | 20.28% | 18.01% |
| 8 | 52.73% | 36.69% | 28.69% | 23.91% | 20.73% | 18.48% |
| 9 | 52.98% | 37.02% | 29.08% | 24.33% | 21.19% | 18.96% |
| 10 | 53.22% | 37.36% | 29.47% | 24.77% | 21.65% | 19.45% |
Notice how the tax-drag is much higher if your net worth grows at a lower assumed rate of return. Higher rates can somewhat offset the tax-drag; however, a 2% rate of return over ten years has a tax-drag of over 53.22%, and that’s if the annual wealth tax is “only” 1%. Imagine having a tax-drag of 53.22% over ten years before adjusting for inflation. Can you say, “Capital flight”?
The Excel model used to calculate the tax-drag of annual wealth taxes can be found here.