By Guillaume Allègre, Mathieu Plane and Xavier Timbeau
Why and how should wealth be taxed? Are France’s wealth taxes fair and efficient? In an article entitled, “Reforming the taxation of wealth?”, published in the special Tax Reform issue of the Revue de l’OFCE [in French], we examine these issues and propose some possible ways to reform the taxation of wealth.
We show that in recent years real economic income from capital has been very substantial. The visible income from capital (interest, dividend, rents received, etc.) exists alongside less visible income (capital gains net of the consumption of fixed capital and inflationary tax). As only a portion of potential capital gains are realized, this less visible income forms a significant part of average personal income. Between 1998 and 2010, despite two financial crises, capital gains increased real per capita income by an annual average of 12% (33% on average from 2004 to 2007). This growth was due in large part to the sharp rise in property prices.
We also show that the actual tax rate on income from wealth is low, even though the nominal interest rates on capital income are high, and the tax rate on income that is actually taxed is even higher due to not taking into account inflationary tax in the calculation of taxes [1]. After taking into account all taxation based on household wealth, including wealth which is held (“ISF” wealth tax, property tax) or which is passed on (property transaction taxes i.e. “stamp duty”) and income from wealth (income tax, “CSG” wealth tax, etc.), the actual rate of taxation on economic income from capital [2] comes to an average of 11.1%. This low rate for the actual taxation of capital income is due to the fact that a large portion of this income fully or partially escapes taxation: real property gains on principal residences are totally exempt, and secondary residences are partly exempt; the housing enjoyed by owner-occupiers (“imputed rent”) is not taxable, even though, net of interest, it constitutes income; gifts serve to “purge” any capital gains, even when these are not taxed (there is a tax allowance of 159,000 euros per child for gifts to direct heirs, which is renewable every ten years); and some financial income avoids income tax (life insurance, tax-exempt bank accounts, etc.).
Next we discuss possibilities for reform that would lead to taxing all income from wealth. We believe that income from wealth (net increased income from wealth) should be taxed in the same way as labour income. This principle is fair (in the sense that households are then taxed on their contributory capacity, regardless of the source of their income), and it would also help to combat tax avoidance. In an increasingly financialized economy, the interface between labour income and capital income has become porous. Taxing capital income differently opens the door to tax schemes. Any reform of wealth taxation should make it a priority to tax all real capital gains, in particular real property gains, which currently are subject to specific rules. In addition, since property is a fixed asset, the existing rules cannot be justified as due to tax competition in Europe. They are occasionally defended based on the need to take account of inflation or due to the unique character of the principal residence. But taking inflation into account cannot justify the total exemption of real property gains on secondary residences after they have been held for a certain time (currently 30 years, previously 22 years): not only does the exemption on capital gains seem unfair, but it can also prompt some households to keep their property, in particular during speculative bubbles. Furthermore, the specific character of property cannot be invoked once there has been a definitive withdrawal from the market. The taxation of realized capital gains, net of inflation, of the consumption of fixed capital and of renovation costs, would thus be preferable to a system of allowances based on the period of ownership. This could take place when the sale is not followed by another purchase – so as not to penalize mobility – and during inheritance (taxation of unrealized gains, before calculating inheritance tax). The taxation of real property gains upon a definitive withdrawal from the market could gradually replace the system of property transaction taxes or “stamp duty”, which would promote mobility and greater horizontal fairness.
In light of these arguments, what do we make of the proposals by the new French President François Hollande with regard to the taxation of wealth? He proposes (1) to tax capital income at the same rate as labour income is taxed; (2) to roll back the tax breaks on the ISF wealth tax and to raise the rate of taxation on the top income brackets; and (3) to reduce the inheritance tax allowance from 159,000 euros per child to 100,000 euros (it was raised from 50,000 euros to 150,000 euros in 2007).
(1) The first point would also involve eliminating the flat-rate withholding tax and the various tax loopholes that permit tax avoidance. It is similar to our proposals, so long as the income subject to tax takes into account inflationary tax and the consumption of fixed capital. This kind of proposal would involve taxing imputed rent, which constitutes an imputed income from capital. Nevertheless, given the difficulty of estimating the tax base, imputed rent has not been taxed since 1965 (see the article by Briant and Jacquot). One solution to this difficulty is to permit renters and first-time buyers to deduct their rent or loan interest payments from their taxable income, while increasing the average income tax rate to offset this.
(2) The second point departs from our proposals, but the ISF tax offers one solution for taxing large estates bit by bit, even when they do not procure any taxable income (when there are unrealized capital gains but an absence of dividends or earned rent, for example). In a situation like this, the ISF tax makes sense only if it is not capped based on the taxable income (or a similar notion). The ISF tax on wealth makes even more sense when the actual yields, including the unrealized gains on the assets, are not very heterogeneous (but it is then equivalent to a tax on the income from the assets) or when the supervision of the asset owners can improve their yields (taxation based on holding the wealth, and not on income, then serves as an additional incentive “to owners to ‘activate’ their estate,” in the words of Maurice Allais). In contrast, if the asset yields are heterogeneous and strong incentives to optimize the wealth already exist, then a tax on the income from the wealth is preferable from the viewpoint of fairness and not undermining economic efficiency.
(3) Higher inheritance taxes seem legitimate from the perspective of equal opportunity. We feel, however, that this should go further, at least by eliminating the purge of capital gains, in particular when the goods have been exempted from inheritance tax.
* This text is taken from the article Reforming the taxation of wealth? published in the special Tax Reform issue of the Revue de l’OFCE, available on the OFCE website.
[1] As Henri Sterdyniak points out: “It is thus erroneous to claim that capital income is taxed at a lower rate. When it is actually taxed, this is at higher rates.”
[2] Defined as the ratio between the sum of taxes based on wealth and the net increased income from the wealth after having subtracted the consumption of fixed capital and inflationary tax.