Rebalancing the Tax Burden

Already started on this year’s tax return? The deadline is looming. Taxes might not be everyone’s favorite subject, but there’s no downplaying their importance. “Fiscal policy and taxes are what drives society. They’re a means of negotiating crucial aspects of our co-existence, such as wealth and income redistribution, and fairness,” historian Matthieu Leimgruber declares. Yet he also says there’s no such thing as an objectively fair tax. Economist Florian Scheuer couldn’t agree more: “There’s no conclusive scientific answer to the ‘fair tax’ question. It depends too much on political preference. How much redistribution does a society want, and how much inequality will it accept?”

There’s one thing that many tax-related debates around the world have in common, however. Most of today’s taxation systems are progressive in nature, at least on paper. That means that richer people pay tax on a higher percentage of their incomes than poorer people or the middle classes. The tax debate has been a feature of modern society since the French Revolution, Leimgruber says. Many of the core ideas that now seem self-evident – progressive income tax being a good example – were being discussed as long ago as the 18th century, even if it took over a century for some of them to enter practice.

There is a growing paradox in that practice today: it is the super-rich who often bear a surprisingly low effective tax burden. The reason lies in how their income is structured. For ordinary mortals, the largest share of the total comes from earned income, salary. That is taxed progressively in most countries. The income of the average billionaire, on the other hand, is derived almost exclusively from capital. The biggest element of this is capital gains, in other words increases in the value of stocks or ownership interests. Scheuer explains: “Jeff Bezos and Elon Musk, for example, hold large equity stakes in the companies they founded. They take little if any salary, and in some cases no dividends are paid out.”

In many places, capital gains become taxable only when they are realized, meaning when those stocks or interests are sold. What’s more, in many countries the rate of tax due on those gains is lower than the income tax rate. One lever to achieve greater fairness would then be to align these tax rates and thus reduce incentives to declare income as capital instead.

But how do billionaires finance their lifestyles on zero income? They use a strategy that has become increasingly visible in recent years, known as “buy, borrow, die.” The super-rich take out loans with their equity holdings as collateral, without ever realizing capital gains.

In the US, one particular rule is exacerbating the problem. Anyone inheriting stocks and later selling them only has to pay tax on the capital gains accrued after the point of inheritance. It is called the step-up in basis, and means that the increase in value during the lifetime of the original owner frequently remains entirely untaxed. In a research paper authored with US economist Joel Slemrod, Sheuer estimated that no tax is ever paid on around half of all capital gains in the USA.

“An obvious first step would be to abolish the step-up rule and replace it with a better one,” Scheuer says. An option here might be the carry-over principle that Germany applies. Here, when inherited assets are sold, tax is payable on the full increase in value since they were originally purchased. Some object that this is too complicated administratively, but Scheuer puts the argument into context: “Banks have the documents stating the original price, after all.” The Canadian approach is another possibility: inherited stocks are subject to inheritance tax at the time of death, and unrealized capital gains are treated as if they had been realized. Both models require patience from the taxman, however. In many cases the revenue comes in much – sometimes decades – later when subsequent generations sell their inherited shares.

The debate has repeatedly prompted initiatives in the USA and in some European countries to levy tax on unrealized capital gains. “If Amazon stock rises five percent, Jeff Bezos would have to pay tax on the gain, even if he doesn’t sell his shares,” Scheuer points out. Yet his research identified two issues with a tax like this. Firstly, it could cause problems for start-ups and get in the way of innovation because the market valuations of young, fast-growing companies often appreciate long before they are turning a profit or have cash to play with. An annual asset or value growth tax might force founders to sell stock just to pay their tax bill, causing them to lose control over their own company. Switzerland is seen as pragmatic in this regard, because start-ups can enjoy de facto relief until the founder(s) sell or go public, and can then access liquidity.

In Scheuer’s eyes, the second problem lies in unrealized gains that exist on paper only. “In their first semester, we teach our students how the value of a company can be determined. Anticipated future cash flows are taken back – discounted – to their present value because the value of money can change over time,” he says. However, asset values rise not only because companies earn more in the future, but also because this discount rate falls. The long period of low interest rates has considerably amplified this effect.

As a result, the value of assets can multiply without any increase in their income return right now. Owner-occupied property is a good example here. Falling interest rates might suddenly make it worth more, but that increase generates no immediate income return unless and until the home is sold. A tax on unrealized gains or assets would then place a greater burden on people who have no additional cashflow at all in real terms. A tax on gains actually realized, however, would be levied right at the point when the gain becomes money. That is why Scheuer recommends this approach to taxation, although loopholes such as the buy-borrow-die strategy would have to be closed.

Switzerland does not levy capital gains tax on private individuals, but on the other hand we have the wealth tax. “That makes Switzerland an exception internationally nowadays, because many European countries have been abolishing taxes like it since the 1990s,” Scheuer states. He describes Swiss wealth tax as “astonishingly non-progressive.” With his co-authors he analyzed the relationship between the wealth tax and the distribution of wealth in Switzerland. Over time the average top cantonal tax rate has fallen significantly. Meanwhile, the gap between the haves and have-nots has become wider. In the 1980s, the richest one percent of taxpayers held 33 percent of all the wealth in Switzerland. In 2018, they held 42 percent. That said, there are differences between the cantons: while patterns in Zurich are relatively stable, wealth is now distributed much more unequally in cantons such as Schwyz or Nidwalden, in other words those that have slashed their wealth tax rates.

Another factor contributes to growing inequality in the way wealth is distributed: the abolition of inheritance tax in many cantons. “Inheritance tax could help achieve a fairer system because it adjusts the balance between well-off and less well-off families,” Matthieu Leimgruber explains. Admittedly, it’s a hard sell politically. In the debate it is often suggested that inheritance tax ultimately affects the entire population. Leimgruber sees this fear as part of a repeated pattern. There were arguments against inheritance tax a century ago, much the same as today. That a broader section of the population can expect to inherit anything at all is a recent phenomenon, he points out. While under the ancien régime only a very few privileged individuals had assets to pass on, the 20th century gave rise to a middle class with a certain level of wealth, in the form of home ownership and pension funds, for example. This was accompanied by fears of losing that wealth, or not being able to leave it to the next generation.

In Switzerland, the question of fairness also arises in relation to lump-sum taxation, the simplified process for foreign nationals who are not in gainful employment. Leimgruber explains this in the historical context as the product of tourist regions in Western Switzerland, such as the cantons of Geneva or Vaud, wanting to make themselves more attractive to wealthy individuals of independent means. The system was later exported to other cantons, despite criticism from the federal government. “Often, the moralistic finger-pointing about unfairness only comes from cantons where lump-sum taxation doesn’t exist at all,” Leimgruber says. Where it is important, such as the Valais, Ticino, Vaud or Geneva, it is frequently a political taboo. “Nobody dares touch the subject.”

In many cases lump-sum taxation doesn’t even bring in all that much tax revenue. Rather than financial, the benefits lie elsewhere, as an indirect subsidy for high-end tourism and as a magnet for wealth managers, banks and financial services providers. In effect, lump-sum taxation is part of a strategy to position Switzerland as a particularly stable and predictable wealth management platform.

To sum up in very general terms, anyone engaged in making taxes “fairer” will not happen upon a single perfect solution, but a whole bundle of pragmatic measures instead. These close tax loopholes, do not allow the rates of tax on work and capital to drift apart, and set a tax policy framework that minimizes false incentives. Fairness remains a political issue. Whether a system has a progressive effect or becomes regressive for the one percent is a matter of influence.