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What is a good way to encourage entrepreneurs to start a business or grow their existing business? Reduce their taxes, of course! This is also likely to increases their demand for labor, reduces unemployment, and increases wages, which benefit workers. But, reducing taxes on businesses is costly to the government. How can the government recover the lost tax revenue?
In a recent paper, I show that increasing the residential real estate tax above the currently prevailing tax of roughly 1%, is an efficient way to raise government revenues to subsidize business income (I show this for the U.S. economy). This capital income subsidy is intended to help productive but credit constrained entrepreneurs who are trying to start or grow their business, not the already large and very profitable corporations. My scheme raises the median household’s income by $17,386 per year! In contrast, the average rent rises only by $265 per month. As a result, the median household should expect to enjoy $14,200 per year in net gain.
So, how does this scheme work? While the tax on residential real estate raises housing costs and rents, it enables the government to reduce the capital income tax. This, in turn, encourages productive entrepreneurs to increase their business investments and demand more labor. As a result, workers are paid higher wages. Quantitatively, wages rise more quickly than rents and housing costs, and thus, people are better off overall.
There are several important points pertaining to this suggested policy change that should be discussed and explained. First, some of you might be worried that I am overstating the benefit accrued to workers from the low capital income tax. In other words, will wages really increase as a result of business owners’ increased profits? To help put your mind at ease, I should emphasize that in my analysis I “down-play” the size of the pie going to labor. To be precise, the data show that 66%-70% of GDP (i.e. the pie) goes to labor (through wages). In contrast, in my model only 60% of GDP goes to labor (through wages). In other words, in my model the benefit to business owners is higher than the data suggest. Second, I show in the paper that even small increases in the property tax (such as 1%) can generate roughly 50% of the societal gains the full policy generates. As well, I show in my paper that small increases in property taxes (like 1% or 2%) have negligible effects on housing prices and home-ownership rates. Thus, it seems that small increases in property taxes have few down-sides. Third, while some of you may be thinking about the meaning of raising property taxes in the context of your country’s housing market, you must remember that the tax scheme I suggest is for the U.S. where the average house price is about 250,000 dollars (the model I use is calibrated to U.S. data – but it would be interesting to also test the model on other countries’ data). Fourth, although society is better off substantially as a result of my proposed tax scheme, wealth inequality rises substantially (the Gini coefficient rises by 17%, from 0.63 to 0.74). Therefore, if policy makers decide to adopt (part of) my tax scheme, they should take this into consideration and be transparent about the policy’s effect on inequality. Fifth, some might be worried that my proposed tax scheme will hurt the unemployed since they do not enjoy the higher income but pay higher rents. This is true but only if a person is unemployed most of their life. Otherwise, they would eventually find a job, be better paid, and be better off overall. Sixth, there may be a concern about retired people (or those close to retirement) who do not earn an income but already own expensive homes on which higher taxes will have to be paid. Therefore, they will suffer from the increase in property taxes due to their inability to financially secure themselves against the increasing costs of living. One way to deal with this problem is to not apply the increase in property taxes to retired households who own a house, and for renters who are in the age of retirement, rebate the increased cost in rent arising from the higher property tax. Another option is to only gradually increase property taxes over many years. This will ensure that older individuals can better plan for the future.
In my paper I also present other interesting findings: While some economists argue for the use of a wealth tax, it turns out that subsidizing capital income is better than using a wealth tax. Why is that? A wealth tax is based on wealth rather than productivity. However, wealth and rates-of-return on investment are not always correlated, especially for entrepreneurs who are very successful but did not inherit much from their parents. In contrast, a capital income subsidy helps productive entrepreneurs based on the rates-of-return on their investments.
My results agree with many other economists before me who suggested to tax real estate (see The Henry George Theorem, for example). Furthermore, in January 2018, France switched away from taxing wealth to taxing real estate. It will be interesting to evaluate the outcome of their policy change and contrast it with my quantitative findings. We’ll have to wait and see if the French have really done it this time! Will their croissants be extra buttery this year?!
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