Give this man a break.

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Designing a Tax That Doesn't Reward Failure

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Most of us haven’t seen Donald Trump’s tax returns, and we may never get that chance. But one thing we do know, thanks to the New York Times, is that Trump declared a $916 million loss in 1995, mostly likely from his troubled casinos and other businesses.

The revelation has sparked a lot of controversy, as many people are looking for ways that Trump might have exploited loopholes in the system. John Hempton, the chief investment officer of hedge fund Bronte Capital, suggests that Trump may have taken losses that he didn’t really deserve, using a probably legal but ethically dubious technique known as debt parking, in which a shell company created by Trump holds all his debt and never collects it.

But regardless of the ethics of Trump’s tax-avoidance strategies, the question is: How can the U.S. and other developed countries improve their tax systems to avoid this sort of thing? It’s obviously bad for the government to give incentives for businesspeople to embark on ill-advised ventures, and giving rich people credits for spending lavishly on their own consumption seems unfair. But what’s the policy solution here?

One bad idea would be to eliminate tax-loss carry-forwards, in which taxpayers use losses in one year to offset income in others. The ability of businesses to write off losses against future profits is an essential piece of the corporate tax system. It allows companies with highly variable profits to avoid over-taxation, and it encourages young startups and fast-growing companies to stay in high-growth mode for longer.

A better idea is wealth taxation. This has been suggested by economists Thomas Piketty, Emmanuel Saez and Gabriel Zucman, and independently by another team including Daphne Chen, Fatih Guvenen, Gueorgui Kambourov and Burhanettin Kuruscu.

Piketty et al.’s rationale is primarily a moral one -- wealth taxation, they say, is fair. The modern tax system, they point out, gives rich people many ways of hiding their true income:

Owners of very large fortunes typically receive personal, taxable income [that is] much smaller than their full economic income. Their wealth portfolio is generally managed through a holding company, a private foundation … and most of the return is being accumulated within this vehicle. They then choose to receive an annual personal income … to pay for their private consumption - which can be a very small fraction of their wealth.

So Piketty and Zucman advocate wealth taxes as a way to make rich people pay their fair share. If a person like Donald Trump uses clever tax-avoidance strategies like debt parking to hide his true income, a wealth tax would still catch some of it.

They also advocate a progressive inheritance tax -- basically a souped-up version of the U.S.’s current estate tax. The moral argument here is clear -- inherited wealth is widely seen as less deserved than money one makes for oneself. Inheritance taxes also help prevent the creation of a permanent, ossified upper class.

Chen et al. have a very different rationale for wealth taxation -- they say it improves productivity. Basically, a wealth tax would take money away from all investors. The ones who are good at business can make money in spite of that tax, and therefore they survive and even thrive, while the incompetent investors go out of business. As a result, the skilled investors end up managing a larger and larger fraction of society’s total resources. In fact, depending on what the government does with the revenue from the tax, the system can even make skilled investors better off than before, at the expense of the unskilled ones. If wealth taxes are used to offset reductions in the corporate income tax, the entire economy becomes more efficient.

In other words, wealth taxation would have taken resources out of the hands of Donald Trump in the 1990s, and put it into the hands of Jeff Bezos, Bill Gates or the other truly successful titans of industry. The result is that more of the accumulated capital of the U.S. economy would go toward building the companies of the future, instead of flowing into failed casinos.

It isn’t yet clear what the ideal form of wealth tax would be. Inheritance taxes are obviously important, since they seem more equitable, and since they put limits on how much incompetent heirs get to squander their parents’ fortunes on bad investments. But inheritance taxes alone wouldn’t have helped shift resources away from Trump in the 1990s. For that, some other, ongoing kind of wealth tax would be needed.

In any case, it’s clear that U.S. policy makers should be thinking about ways to partially substitute wealth taxes for traditional corporate income taxes. With that system in place, we might not find ourselves struggling to understand how people can get so rich from doing so badly at business.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net