Bill Gates Gets This One Entirely Wrong

On New Year’s Eve, multi-billionaire Bill Gates called for raising taxes even higher on rich people like himself in order to reduce inequality. Here’s how he thinks it should be done:

“Although I’m not an expert on the tax code, I think America should shift more of the tax burden onto capital, including by raising the capital gains tax, probably to the same level as taxes on labour.”

There are three big problems with his idea.

Firstly, it's a bad idea because taxing capital disincentivises capital accumulation, and therefore negatively affects investment, production and labour. But it’s worse than that, because in the current tax systems money is taxed multiple times, which produces even greater inefficiencies and retardations of economic development. Taxing your earnings and then your capital amounts to double taxation, because capital gains are the fruits from the income that has already been taxed once. Taxing both income and capital is like fining a pedestrian for being drunk and then fining him again half an hour later for having too much alcohol in his bloodstream. Moreover, what Gates seems to have missed is that taxing capital is also a deferred tax on labour, because capital is earned by past labour that has already been taxed at the point of earnings, and is therefore the deferred benefits of past labour. Tax the capital that is the present reward for past labour and you’re double taxing the original labour.

Secondly, Bill Gates' proposal misunderstands something fundamental about who really pays for the capital taxes. Here's why poorer people are hurt most by taxing rich people's capital. If a rich man has £1 million pounds and puts it in a suitcase in his loft, the rest of the world is richer by £1 million pounds because that's £1 million pounds' worth of resources that aren't being consumed. In economics, people are negatively affected not by other people's hoarding of money, but by other people's spending or use of resources. This is because people aren’t rich by having money - they are rich because of what that money buys (goods, free time, holidays, etc). When Jack earns a bank note and doesn't spend it, the rest of the world is one bank note richer, because Jack produced one bank note's worth of goods and didn't consume them. By not using fuel, there is more for everyone else; by not having a big mansion there is more bricks and mortar for everyone else; by not buying a yacht there are more raw materials for those who might wish to build a shed or a new porch.

I said that in hoarding his bank notes and not spending them on resources, Jack leaves more for everyone else. How are those extra resources shared around? Well it depends on how the savings are made. If Jack puts £1 million pounds worth of banknotes in his loft and never touches them, then everyone else is better off by £1 million pounds, which they'll find by having the prices of goods driven down. If Jack takes his £1 million pounds out of the loft and puts it in his bank he will bid down interest rates to the tune that others will be able to afford £1 million pounds worth of goods or services. Conversely if he buys £1 million pounds worth of timber he will bid up the price of timber for everyone else, and reduce the supply too. 

The moral of this story is that when money is spent by Jack we all become poorer not richer. Every banana or laptop or car Jack buys there will be one less banana, laptop or car, and the prices of those goods will rise. When Jack buys a banana, the rest of the world will be able to buy one less banana.

If we translate that to billionaire Jack, and raid his savings for tax gains, here's what you'll find. Jack's money is just paper and ink - it doesn't produce a new council HS2 office. What produces a new council HS2 office is bricks, concrete, steel, wood and glass. If you tax him £1 million pounds, you don't get the HS2 council office, because Jack doesn't have any bricks, concrete, steel, wood and glass. So those resources will come from somewhere else, which means there'll be fewer restaurants, cinemas, car parks and roads. When the government taxes Jack £1 million pounds for the HS2 office, the price of bricks, concrete, steel, wood and glass gets bid up, and the gymnasium or bowling alley never gets built because the cost is slightly too expensive.

Let me spell that out again, because so few people seem to realise this. If you tax Jack £1 million pounds but Jack's consumption remains unaffected, then the consumption costs will land on those it does affect, and that will probably be on Jill who can no longer acquire a mortgage or Dick who can no longer afford to fund his idea for a small business. This does not mean that there are never good ways for governments to spend money - just that the popular idea of taxing rich people at no cost to poorer people is an idea built on a fundamental misunderstanding about who pays the costs of taxation.

Now let's take it further, and consider how all money is spent (by both poor and rich people). What people forget most is that the state doesn't provide anything - only people provide things, through their work, their skills and their ideas (doctors, nurses, teachers, HR consultants, etc). The state can only claim to provide at an abstracted, filtering level what people actually provide at the ground level in hospitals, schools, and so forth. If workers cannot provide something, the state cannot provide it either. The only thing the state can do that workers cannot do on their own is take money from people and spend it on their behalf. Because of the free-rider problem, sometimes this works (as in defence and rule of law), but often it just causes inefficiencies.

Consider a country with no central government providing any services at all apart from defence, rule of law, welfare, roads and some light regulations. In this country pretty much every pound you spend goes exactly where you’d choose to spend it, and ditto everyone else. Let’s call it model 1. Now consider our current UK model (let’s call it model 2), and ask yourself how closely the current state spends its money roughly similar to how its citizens would spend it if left to their own desires. In a Gini coefficient type of measurement, where 1 equals the state spends our money 100% exactly as we’d spend it ourselves, and 0 equals the state spends our money 0% exactly as we’d spend it ourselves, what would the true figure be? Would it be 0.75, where the state spends our money about three quarters as well as we’d spend it ourselves? Or would it be 0.50 perhaps, where they spend it half as well? Or perhaps even 0.25?

What we do know is that it’s impossible in model 2 for the state to spend our money exactly as well as we’d spend it, but we also know that there will be some things on which the state spends our money roughly as we’d spend it. To get a rough idea of what you think the true figure might be, imagine you are a self-employed person who refuses to pay any tax in the next financial year. Instead of paying the tax, you spend the money however you want: on some education for your daughter, you contribute a little towards defence and to the police force, you help support the local youth club, you do a grocery shop and donate it to a food bank, you buy a few more things you otherwise couldn’t afford, and you save a little in a private pension fund and a health care fund. Because of this, you get hounded by the government for not paying your taxes, and eventually arrested, sent to court, fined, re-arrested, sent to court again, and eventually to prison. Your crime was spending the money you earned on whatever you wanted to spend it on for the good of you, your family, your city and your country.

Now consider what you spent the rest of your money on – the money the government was going to let you keep anyway. You were going to buy a Laptop, but you decided on a tablet; you were going to buy a summer house but instead you bought a family holiday to the Lake District; you were going to buy a cheeseboard but instead you bought a DVD; you were going to give a donation to Cancer Research but instead you gave it to WaterAid. At no point would you get any threatening letters, have to appear in court, or get sent to prison - your consumption habits were freely chosen and with a multitude of choices at your disposal, with suppliers competing for your custom. I hope you can see from that illustration how markedly different model 1 is from model 2.

Thirdly, not only is Bill Gates’ desire to target wealth that has already been taxed at the point of labour a regressive one, it directly contradicts the environmentalist work he champions elsewhere. Here’s why. There are only three things the present earthly inhabitants can do to make the world a better place for our descendants. We can consume less, leaving more resources for them to consume; we can work harder to create future value in the form of goods and services that they will inherit and build upon; and we can innovate by advancing our technological capabilities and standard of living that they will inherit and build upon. Increasing capital taxes reduces the incentive to save, increases the incentive to consume, and diminishes the incentive to work and innovate, which has a triple whammy negative effect on the three things that will do most good for future generations.