When I was a much younger economist, prior to going off for my Ph.D., I had the privilege of attending a speaking engagement by Franco Modigliani, a Nobel prize winner who did much of the pioneering work in modern finance. I was teaching at the Air Force Academy in the mid 1990s, and Colorado College was having Mr. Modigliani there, and as a professional courtesy Colorado College invited the USAFA economists to attend. I was especially excited, because I had always been puzzled by the nature of market capitalization, and I hoped to ask Mr. Modigliani about it.

Earlier this past week, headlines in the WSJ talked about the new difficulty of so-called unicorns (startups with private valuations >$1B) seeing their value plummet:

Once Silicon Valley’s highest-flying darlings, companies from WeWork to Uber Technologies Inc. UBER +0.34% have collectively lost about $100 billion in value this year, prompting some startup executives to talk up profitability over growth as venture-capital investors grow more cautious about spending.

This headline relates to my question for Mr. Modigliani, “what happens to this lost wealth? Where does it go? If you did not sell, how is it that you have a loss?” The answer may be obvious to you, but to me at the time, it was not. I had also discussed with some of the Ph.D.’s on USAFA staff and none could give me a satisfactory answer (although none were financial/money specialists). Hence my desire to discuss with the Master of Finance. I waited patiently in line at the end of the talk to ask my question, and it was finally my turn. Professor Modigliani, “what happens to the wealth in the stock market when we have a crash? Where does it all go?” Prof Modigliani looked at me, and in his very Italian accent he replied, “Young man, you have a fundamental misunderstanding about the nature of capital.” He proceeded to tell me how capital market valuations are based on future expectations, and that it is not the capital itself that has been lost, but that the future valuations of the yield that could accrue to capital are now lowered. Now many people might have been humiliated by learning that they have a fundamental misunderstanding about finance–but for me to have the scales dropped from my eyes by the guru of finance was fantastic!

If Prof Modigliani were still alive today, I think he would similarly say to Ms. Warren, “you have a fundamental misunderstanding of the nature of wealth.” Now there are huge technical problems in implementing a wealth tax (beyond the dubious constitutionality of it, but hey, who cares about constitutionality when you have a living constitution?). How do you properly tax the wealth of a Picasso, or any other infrequently traded asset? What is the proper valuation? What size IRS army will it take? And there are millions of unique non-publicly traded assets like this. Unlike land (and a property tax is a kind of wealth tax), many assets are not readily seen. There are many reasons why it didn’t work well in Europe when tried there:

In 1990, there were 12 countries in Europe that had a wealth tax. Today there are only three. Perret says they didn’t work for a lot of reasons. Among other things, it costs a lot to enforce. It pushed rich people out of the country, and the wealth taxes didn’t raise a lot of revenue.

Warren argues her proposal learns from the failures in Europe. She told us in an email, quote, “I specifically designed this proposal to account for lessons learned from wealth taxes in other countries,” unquote. Unlike in the European Union, it’s hard for Americans to freely move to another country or state and escape national taxes. On top of that, the Warren plan imposes an exit tax, which would confiscate 40 percent of a person’s wealth over $50 million if they renounce their citizenship. 

Now if Ms. Warren’s glib plan to confiscate 40 per cent of someone’s wealth if they try to leave doesn’t strike you as likely to cause some unintended consequences, there are more fundamental reasons to think it won’t work. Let’s just take Mr. Bezos. The lion’s share of his wealth is ownership of Amazon and other companies. Ms. Warren almost treats the wealth tax as targeting money that is in the bank–that its just idly sitting there waiting to fill the Treasury’s coffers. In her mind, billionaires must be like Scrooge McDuck, who won’t miss a beat if 2% is taken every year. Since, like Piketty, she must think that capital automatically yields 4%, wealth would just grow more slowly for the extremely wealthy.

“You made it big? Good for you!” she said. “You had a great idea, you worked hard . . . or you inherited well. But either way, great fortunes in this country were built using workers all of us helped pay to educate . . . You make it really big? Put a little back in so everybody else has a chance to make it.”
In their new paper, economists Emmanuel Saez and Gabriel Zucman of the University of California at Berkeley argue that under Warren’s plan the great fortunes would not be taken away, but would simply grow more slowly.

The reality is capital (and therefore wealth) is not primarily physical–it’s primarly subjective valuations of the future. Ms. Warren assumes that her policies will not change the future valuations. Yet at the end of the day, 2% is taken from the private sector and feeding the public sector. At a minimum, the nation’s private sector GDP will be lower in the future because of her approach–there will be less savings put back into the business when it has to go to Uncle Sam. Amazon has never really made much profit–it has poured almost all of its earnings back into its business to become the powerhouse that it is. And its value today is still extremely rich (~80 price to earnings) compared to most firms–a P/E ratio that can only be justified by continued rapid growth that comes from continued massive reinvestment. Should Mr. Bezos and other shareholders have to pay a wealth tax, they will be forced to reinvest less. When that happens, expect the future to look less bright, and the stock price will come back down to a more normal PE. Since wealth is ultimately subjective, Ms. Warren’s “fundamental misunderstanding” will lead to less wealth to be taxed at all.