Liquid Net Worth may be a Better Basis than Income for Income Tax Rates

America does not have an income inequality problem so much as it has a wealth inequality problem. The top 1% make about the same total income as the bottom 40% combined, which is significant, but it is nothing compared to the wealth gap.

The top 1% have 139x as much wealth as the bottom 40%.

So, why are income and capital gains tax rates based on income, not wealth? This is an outdated and oversimplistic way to ballpark wealth, and modern technology makes it much easier for track wealth now than in the past. 

If we want to devise a more sensible tax system, we should strongly consider basing income and capital tax rates on a metric I will call Liquid Net Worth, instead of the traditional “taxable income”. This ensures that tax rates are assessed on a more full picture of someone’s financial situation, not just their year-to-year income.

This idea is a work in progress and would surely create some unintended consequences, so I look forward to your thoughts and comments. I would add that it is important to remember that our existing tax laws have plenty of unintended consequences of their own.

Liquid Net Worth would be defined as the sum of:

  1.       Taxable income for that tax year
  2.       Cash & cash equivalents
  3.       Publicly traded stocks and bonds
  4.       Any positive net real estate assets (e.g. if you have $300k in equity, $200k in debt, this counts for $100k. If you have $200k in equity and $300k in debt, this counts for $0.)

Your Liquid Net Worth would be calculated (and easily verified by the government because your social security number is attached to all these assets), and from this calculation, you would figure out your marginal income tax and capital gains tax rates.

Tax rates would be stretched out of a much wider range, moving from the current structure for a single person filing:

Income Tax Rate Taxable Income Bracket Capital Gains Tax Rate
10% $0 to $9,325 0%
15% $9,325 to $37,950 0%
25% $37,950 to $91,900 15%
28% $91,900 to $191,650 15%
33% $191,650 to $416,700 15%
35% $416,700 to $418,400 15%
39.60% $418,400+ 20%

To an income tax structure like this (these are sample numbers), where rates are based on Liquid Net Worth (with the caveat that these numbers would need to add up in a way that funds the government):

Income Tax Rate Liquid Net Worth Bracket Capital Gains Tax Rate
10% $0 to $30,000 0%
20% $30,000 to $100,000 0%
30% $100,000 to $500,000 0%
40% $500,000 to $5,000,000 10%
50% $5,000,000 to $20,000,000 25%
60% $20,000,000+ 35%

For example, a 30 year-old who makes $80,000, but still has $40,000 in student debts and virtually no savings would only pay a marginal income tax rate of 20%.

A different 30 year-old who makes $80,000, but has $1m of illiquid equity in the small business he started or invested in, would also only pay a marginal income tax rate of 20%. It would not be until the potential of this business was realized (either through dividends or liquidity) that he would pay the higher marginal rate.

A different 30 year-old who makes $80,000, but has no student debt and was given a stock portfolio from his parents worth $250,000, would pay a marginal income tax rate of 30%.

A different 30 year-old who makes $80,000, but has no student debt and was given a stock portfolio from his parents worth $2,000,000, would pay a marginal income tax rate of 40%.

By basing marginal income and capital gains tax rates on Liquid Net Worth, we will be able to accomplish a few things:

  1.  Create a more economically mobile and anti-fragile system – tax people less when they are trying to pay down debt and build up their net worth. Make it easier for those at the bottom to improve their lot and make saving and investing cheaper when you are poor.
  2. Tax people more they have reached a point where they can bear the burden – which has much more to do with Liquid Net Worth than taxable income.
  3. Encourage investment (especially by the wealthy) in “illiquid assets” – like small businesses and startups, which are job-creating investments, as opposed to investment in “liquid assets” like stocks, bonds, and income-producing real-estate, which are lower-risk and generally not job-creating.
  4. Encourage immediate consumption by the wealthy by making the marginal growth of huge wealth more expensive.

I imagine there would be plenty of downsides/adjustments to this. Debt based real-estate speculation would increase, while stock prices would decrease. Liquid net worth would be calculated at the end of the year, which could encourage all sorts of weird behavior. Altogether though, I think this is a more logical system than the one we presently have.

Would love to hear people’s thoughts.

 

7 thoughts on “Liquid Net Worth may be a Better Basis than Income for Income Tax Rates

  1. This is a brilliant idea, although I can’t grasp everything from your examples.
    Probably the rich will find it a easier way to take advantage from this system, but this could be a great way to distribute wealth more equally for the bottom 40%.
    Did you already made a research to see if this type of calculation has been developed before?

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  2. I do really like the idea, it would be a good help for indebted people, helping them to get out of the debt trap.
    Starting the tax for 5’000’000 Net Worth make it targeted to a small part of population, it would clearly be a “rich-tax”, which is maybe more a political problem.
    The calculation of the total assets seems a big struggle for me, tax evasion would be strong with this kind of system. Total calculation would be tricky.

    I expect a future with these kind of tax structures, avoiding a world with richier people controlling more of the global wealth.

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  3. France (and other European countries I think) have a hybrid system of income tax and wealth taxt. So you pay a fairly normal type income tax plus say 0.5% of your net wealth if you are valued at over €1M. This has some aspects of your scheme but maybe wouldn’t generate the huge fluctuations in asset prices I suspect your approach may bring.

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  4. This scheme would be amazing for the rich. If I make 200k in income and owe 400K on my 600K house, I pay zero in taxes! When my net worth creeps up to positive numbers, I take equity out of my house with a refi, buy a small business or mortgage a new rental property, and BAM, zero taxes.

    You also create a negative incentive for saving and planning for retirement. Each savings/investment milestone you hit makes your income DECREASE as your tax burdeon rises drastically. (This is why we currently have marginal tax brackets; you are never punished for making more money.) I can easily imagine situations where middle class families could not afford to save money, lest their income be docked by hundreds or thousands of dollars a month.

    If you want to tax wealth, do it directly with a wealth tax or an inheritance tax, or via a consumption tax (with a corresponding stipend for the poor, to keep it progressive).

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    • You either didn’t read the entire post or you missed rule 4 of Liquid Net Worth.
      Your hypothetical person would pay at least 60K in taxes (the 30% bracket).
      The OP is making the point that our tax system’s ideas of wealth are screwed up and using taxable income as the baseline, we can adjust (only upwards in the given formulation) to accommodate folks like your hypothetical.
      The idea is not without it’s issues; as you point out with your recognition of the savings disincentive.

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  5. How about we just pay for government services we use.(we all pay some , like defense, social security, universal health) Pay for roads when you buy or operate a car. Pay for education while your kid is in public schools. Pay for wars if you vote to go to war.

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