Shrinking the wealth gap calls for a two-pronged attack: offer more opportunity to those at the bottom and trim the undue advantages of those at the top. In this editorial, we address the latter issue by discussing how best to tax the rich. The smartest approach is the one endorsed in 2018 by economists at the Organization for Economic Cooperation and Development (OECD): significant, broad-based taxes on capital gains, coupled with similarly efficient levies on transfers of wealth through gifts and inheritance. As the OECD report concluded, this promises the greatest increase in equity with the fewest costly side effects.

Sharing the Wealth

This would not be the direct tax on wealth favored by many progressives. Sen. Elizabeth Warren (D-Mass.) recently renewed her call for such a tax — “to make the ultra-rich finally pay their fair share” — after ProPublica reported, based on leaked tax-return data, that the 25 wealthiest individuals in the United States, “pay income taxes that are only a tiny fraction of the hundreds of millions, if not billions, of dollars by which their fortunes grow each year.”

ProPublica muddied a basic distinction, which, properly understood, actually fortifies the case against a wealth tax. The story likened on-paper asset price appreciation with actual cash income, then lamented that the two aren’t taxed at the same rate. However, the income tax system never required people to pay taxes on the appreciation of their assets, until they sold them and “realized” capital gains. For good reason: ProPublica’s logic implies that, when the stock market goes down, Elon Musk, whose billions are tied up in shares of Tesla, should get a tax cut.

In Ms. Warren’s version of the wealth tax, which calls for 2 percent annual levies on net wealth above $50 million, and 3 percent above $1 billion, very rich people would face large tax bills even when they had little or negative net income, forcing them to sell assets to pay their taxes. That could set off a downward spiral in the markets, affecting people of more modest means. Though prices of marketable securities are easy to track, the huge chunks of private wealth tied up in real estate, rare art and closely held businesses are more difficult — sometimes impossible — to assess consistently.

Such problems help explain why national wealth taxes yielded only modest revenue in the 11 European countries that levied them as of 1995, and why most of those countries subsequently repealed them. Americans should be familiar with the issues from our existing equivalent to a wealth tax: state and local property taxes, which raised $547 billion in 2018, a surprising 10 percent of all federal, state and local revenue. The fairness and accuracy of property-value assessments is a perennial bone of contention. Reforming local property taxes — though a difficult battle that would have to be waged across thousands of counties and cities — could go a long way toward reducing national wealth inequality, without adding a new layer of political controversy and policy complexity by trying to replicate them at the federal level.

Fortunately, legitimate goals of a wealth tax can be achieved through other means, as the OECD report indicates. This would require undoing not only some of the 2017 GOP tax cuts, but much previous tax policy as well, which has produced a top federal marginal tax rate on capital gains of 23.8 percent — far below the top rate on ordinary income, which is 37 percent. The Treasury Department has aptly summarized the effect of this differential: “Preferential tax rates on long-term capital gains and qualified dividends disproportionately benefit high-income taxpayers and provide many high-income taxpayers with a lower tax rate than many low- and middle-income taxpayers.” The disparity “also encourages economically wasteful efforts to convert labor income into capital income as a tax avoidance strategy.” A notorious example of the latter is the “carried interest” loophole that enables hedge fund managers to characterize their multimillion-dollar annual compensation as lightly taxed capital gains.

The higher capital gains rate should be applied to a broader base of investment income, of which carried interest, egregious as it is, represents a relatively small slice. The big money is in changing rules that let wealthy people pass on securities that have increased in value to their heirs, without the latter having to pay taxes on the appreciation. President Biden’s American Families Plan calls for reform of this so-called “stepped-up basis” loophole that would yield an estimated $322.5 billion over 10 years.

After years of erosion, due largely to Republican-sponsored tax cuts, the U.S. estate tax barely exists. Only the amount of an estate exceeding $11.7 million (twice that for couples) is currently subject to the 40 percent rate; 4,100 estate tax returns were filed in 2020, down from more than 100,000 in 2001, according to the Tax Policy Center, as the charts below show:

Mr. Biden has proposed no changes, a disappointing exception to his otherwise progressive approach to taxation. (Current law, passed by a GOP Congress and signed by then-President Donald Trump in 2018, expires after 2025, at which point the individual estate tax exemption would revert to between $5 million and $6 million.) Sen. Bernie Sanders (I-Vt.) proposes slashing the exemption to $3.5 million and subjecting larger inheritances to progressively higher rates, up to a maximum of 65 percent on those larger than $1 billion. Yet there is plenty of revenue to be raised without going that far.

A Brookings Institution analysis of several alternative approaches showed that simply reverting to estate tax rules in place as recently as 2004 could yield $98 billion per year, far more than the $16 billion the government raised in 2020.

If the inheritance tax were more substantial people could still aspire to bestow a legacy on their children, but without unduly perpetuating unearned privilege. The former is part of what the United States has always been about; the latter, more consistent with the aristocratic empire patriots ousted in 1776. The public sector could use new revenue from stiffer capital gains and estate taxes to expand opportunity for those who were not born into wealth. How best to do that is the subject of our next editorial.