Capital in the Twenty-First Century (91 page)

To date, the most thoroughgoing attempt to end these practices is the Foreign Account
Tax Compliance Act (FATCA) adopted in the United States in 2010 and scheduled to be
phased in by stages in 2014 and 2015. It requires all foreign banks to inform the
Treasury Department about bank accounts and investments held abroad by US taxpayers,
along with any other sources of revenue from which they might benefit. This is a far
more ambitious law than the 2003 EU directive on foreign savings, which concerns only
interest-bearing deposit accounts (equity portfolios are not covered, which is unfortunate,
since large fortunes are held primarily in the form of stocks, which are fully covered
by FATCA) and applies only to European banks and not worldwide (again unlike FATCA).
Even though the European directive is timid and almost meaningless, it is not enforced,
since, despite numerous discussions and proposed amendments since 2008, Luxembourg
and Austria managed to win from other EU member states an agreement to extend their
exemption from automatic data reporting and retain their right to share information
only on formal request. This system, which also applies to Switzerland and other territories
outside the European Union,
⁸
means that a government must already possess something close to proof of fraud in
order to obtain information about the foreign bank accounts of one of its citizens.
This obviously limits drastically the ability to detect and control fraud. In 2013,
after Luxembourg and Switzerland announced their intention to abide by the provisions
of FATCA, discussions in Europe resumed with the intention of incorporating some or
all of these in a new EU directive. It is impossible to know when these discussions
will conclude or whether they will lead to a legally binding agreement.

Note, moreover, that in this realm there is often a chasm between the triumphant declarations
of political leaders and the reality of what they accomplish. This is extremely worrisome
for the future equilibrium of our democratic societies. It is particularly striking
to discover that the countries that are most dependent on substantial tax revenues
to pay for their social programs, namely the European countries, are also the ones
that have accomplished the least, even though the technical challenges are quite simple.
This is a good example of the difficult situation that smaller countries face in dealing
with globalization. Nation-states built over centuries find that they are too small
to impose and enforce rules on today’s globalized patrimonial capitalism. The countries
of Europe were able to unite around a single currency (to be discussed more extensively
in the next chapter), but they have accomplished almost nothing in the area of taxation.
The leaders of the largest countries in the European Union, who naturally bear primary
responsibility for this failure and for the gaping chasm between their words and their
actions, nevertheless continue to blame other countries and the institutions of the
European Union itself. There is no reason to think that things will change anytime
soon.

Furthermore, although FATCA is far more ambitious than any EU directive in this realm,
it, too, is insufficient. For one thing, its language is not sufficiently precise
or comprehensive, so that there is good reason to believe that certain trust funds
and foundations can legally avoid any obligation to report their assets. For another,
the sanction envisioned by the law (a 30 percent surtax on income that noncompliant
banks derive from their US operations) is insufficient. It may be enough to persuade
certain banks (such as the big Swiss and Luxembourgian institutions that need to do
business in the United States) to abide by the law, but there may well be a resurgence
of smaller banks that specialize in managing overseas portfolios and do not operate
on US soil. Such institutions, whether located in Switzerland, Luxembourg, London,
or more exotic locales, can continue to manage the assets of US (or European) taxpayers
without conveying any information to the authorities, with complete impunity.

Very likely the only way to obtain tangible results is to impose automatic sanctions
not only on banks but also on countries that refuse to require their financial institutions
to provide the required information. One might contemplate, for example, a tariff
of 30 percent or more on the exports of offending states. To be clear, the goal is
not to impose a general embargo on tax havens or engage in an endless trade war with
Switzerland or Luxembourg. Protectionism does not produce wealth, and free trade and
economic openness are ultimately in everyone’s interest, provided that some countries
do not take advantage of their neighbors by siphoning off their tax base. The requirement
to provide comprehensive banking data automatically should have been part of the free
trade and capital liberalization agreements negotiated since 1980. It was not, but
that is not a good reason to stick with the status quo forever. Countries that have
thrived on financial opacity may find it difficult to accept reform, especially since
a legitimate financial services industry often develops alongside illicit (or questionable)
banking activities. The financial services industry responds to genuine needs of the
real international economy and will obviously continue to exist no matter what regulations
are adopted. Nevertheless, the tax havens will undoubtedly suffer significant losses
if financial transparency becomes the norm.
⁹
Such countries would be unlikely to agree to reform without sanctions, especially
since other countries, and in particular the largest countries in the European Union,
have not for the moment shown much determination to deal with the problem. Note, moreover,
that the construction of the European Union has thus far rested on the idea that each
country could have a single market and free capital flows without paying any price
(or much of one). Reform is necessary, even indispensable, but it would be naïve to
think that it will happen without a fight. Because it moves the debate away from the
realm of abstractions and high-flown rhetoric and toward concrete sanctions, which
are important, especially in Europe, FATCA is useful.

Finally, note that neither FATCA nor the EU directives were intended to support a
progressive tax on global wealth. Their purpose was primarily to provide the tax authorities
with information about taxpayer assets to be used for internal purposes such as identifying
omissions in income tax returns. The information can also be used to identify possible
evasion of the estate tax or wealth tax (in countries that have one), but the primary
emphasis is on enforcement of the income tax. Clearly, these various issues are closely
related, and international financial transparency is a crucial matter for the modern
fiscal state across the board.

Suppose next that the tax authorities are fully informed about the net asset position
of each citizen. Should they be content to tax wealth at a very low rate (of, say,
0.1 percent, in keeping with the logic of compulsory reporting), or should a more
substantial tax be assessed, and if so, why? The key question can be reformulated
as follows. Since a progressive income tax exists and, in most countries, a progressive
estate tax as well, what is the purpose of a progressive tax on capital? In fact,
these three progressive taxes play distinct and complementary roles. Each is an essential
pillar of an ideal tax system.
¹⁰
There are two distinct justifications of a capital tax: a contributive justification
and an incentive justification.

The contributive logic is quite simple: income is often not a well-defined concept
for very wealthy individuals, and only a direct tax on capital can correctly gauge
the contributive capacity of the wealthy. Concretely, imagine a person with a fortune
of 10 billion euros. As we saw in our examination of the
Forbes
rankings, fortunes of this magnitude have increased very rapidly over the past three
decades, with real growth rates of 6–7 percent a year or even higher for the wealthiest
individuals (such as Liliane Bettencourt and Bill Gates).
¹¹
By definition, this means that income in the economic sense, including dividends,
capital gains, and all other new resources capable of financing consumption and increasing
the capital stock, amounted to at least 6–7 percent of the individual’s capital (assuming
that virtually none of this is consumed).
¹²
To simplify things, imagine that the individual in question enjoys an economic income
of 5 percent of her fortune of 10 billion euros, which would be 500 million a year.
Now, it is unlikely that such an individual would declare an income of 500 million
euros on her income tax return. In France, the United States, and all other countries
we have studied, the largest incomes declared on income tax returns are generally
no more than a few tens of millions of euros or dollars. Take Liliane Bettencourt,
the L’Oréal heiress and the wealthiest person in France. According to information
published in the press and revealed by Bettencourt herself, her declared income was
never more than 5 million a year, or little more than one ten-thousandth of her wealth
(which is currently more than 30 billion euros). Uncertainties about individual cases
aside (they are of little importance), the income declared for tax purposes in a case
like this is less than a hundredth of the taxpayer’s economic income.
¹³

The crucial point here is that no tax evasion or undeclared Swiss bank account is
involved (as far as we know). Even a person of the most refined taste and elegance
cannot easily spend 500 million euros a year on current expenses. It is generally
enough to take a few million a year in dividends (or some other type of payout) while
leaving the remainder of the return on one’s capital to accumulate in a family trust
or other ad hoc legal entity created for the sole purpose of managing a fortune of
this magnitude, just as university endowments are managed.

This is perfectly legal and not inherently problematic.
¹⁴
Nevertheless, it does present a challenge to the tax system. If some people are taxed
on the basis of declared incomes that are only 1 percent of their economic incomes,
or even 10 percent, then nothing is accomplished by taxing that income at a rate of
50 percent or even 98 percent. The problem is that this is how the tax system works
in practice in the developed countries. Effective tax rates (expressed as a percentage
of economic income) are extremely low at the top of the wealth hierarchy, which is
problematic, since it accentuates the explosive dynamic of wealth inequality, especially
when larger fortunes are able to garner larger returns. In fact, the tax system ought
to attenuate this dynamic, not accentuate it.

There are several ways to deal with this problem. One would be to tax all of a person’s
income, including the part that accumulates in trusts, holding companies, and partnerships.
A simpler solution is to compute the tax due on the basis of wealth rather than income.
One could then assume a flat yield (of, say, 5 percent a year) to estimate the income
on the capital and include that amount in the income subject to a progressive income
tax. Some countries, such as the Netherlands, have tried this but have run into a
number of difficulties having to do with the range of assets covered and the choice
of a return on capital.
¹⁵
Another solution is to apply a progressive tax directly to an individual’s total
wealth. The important advantage of this approach is that one can vary the tax rate
with the size of the fortune, since we know that in practice larger fortunes earn
larger returns.

In view of the finding that fortunes at the top of the wealth hierarchy are earning
very high returns, this contributive argument is the most important justification
of a progressive tax on capital. According to this reasoning, capital is a better
indicator of the contributive capacity of very wealthy individuals than is income,
which is often difficult to measure. A tax on capital is thus needed in addition to
the income tax for those individuals whose taxable income is clearly too low in light
of their wealth.
¹⁶

Nevertheless, another classic argument in favor of a capital tax should not be neglected.
It relies on a logic of incentives. The basic idea is that a tax on capital is an
incentive to seek the best possible return on one’s capital stock. Concretely, a tax
of 1 or 2 percent on wealth is relatively light for an entrepreneur who manages to
earn 10 percent a year on her capital. By contrast, it is quite heavy for a person
who is content to park her wealth in investments returning at most 2 or 3 percent
a year. According to this logic, the purpose of the tax on capital is thus to force
people who use their wealth inefficiently to sell assets in order to pay their taxes,
thus ensuring that those assets wind up in the hands of more dynamic investors.

There is some validity to this argument, but it should not be overstated.
¹⁷
In practice, the return on capital does not depend solely on the talent and effort
supplied by the capitalist. For one thing, the average return varies systematically
with the size of the initial fortune. For another, individual returns are largely
unpredictable and chaotic and are affected by all sorts of economic shocks. For example,
there are many reasons why a firm might be losing money at any given point in time.
A tax system based solely on the capital stock (and not on realized profits) would
put disproportionate pressure on companies in the red, because their taxes would be
as high when they were losing money as when they were earning high profits, and this
could plunge them into bankruptcy.
¹⁸
The ideal tax system is therefore a compromise between the incentive logic (which
favors a tax on the capital stock) and an insurance logic (which favors a tax on the
revenue stream stemming from capital).
¹⁹
The unpredictability of the return on capital explains, moreover, why it is more
efficient to tax heirs not once and for all, at the moment of inheritance (by way
of the estate tax), but throughout their lives, via taxes based on both capital income
and the value of the capital stock.
²⁰
In other words, all three types of tax—on inheritance, income, and capital—play useful
and complementary roles (even if income is perfectly observable for all taxpayers,
no matter how wealthy).
²¹