Does being rich make you better at allocating capital?

Thanks to this interesting debate last week between Saez, Summers and Mankiw on the wealth tax, there has been considerable discussion of the possible effects of a wealth tax. As is usual with these things, the main discussion has been what a wealth tax will do to the behaviour of those taxed at the margin. Summers, for instance, is concerned that the wealthy will change the mix of their wealth by spending more on consumption, less on investment and more on philanthropy (which includes, importantly, political influence).  In the process of making this argument, Summer’s lays bare (without debate) what I would regard is perhaps the core presumption in this debate. He argues that a wealth tax will be inefficient because it demotivates the rich from:

“Investing the money in the way they think is most productive based on the fact that they were smart enough to accumulate it in the first place.”

There are two parts to this statement. The first is whether a tax on wealth will cause the rich to actually invest less of their money. To be sure, holding money in risk-free assets would be penalised but we need to marry that with the second part of the statement — that the rich will allocate capital more productively. Let’s be clear, holding money in risk-free assets is something anybody can do. It is, literally, the thing that requires no skill and some rationality. (If you have no skill and some irrationality, you may actually take stupid risks so not everyone can be trusted with their money but it is unclear how that is related to whether you happened to accumulate wealth or not).

Given this, while we can all agree that the wealth tax likely deters risk-free saving, where the money actually goes otherwise is quite open. It could go to consumption which will cause actual resource use in ways that are certainly not in the direction people concerned with redistribution would like although just how much of that there can be given that the wealthy haven’t managed to do that spending previously is arguable. It could go to philanthropy which is a form of consumption (at least from the point of view of the donator) and is something that could be beneficial (but we have to consider whether the wealthy are the most productive to make those decisions — more on that another time). Or it could go to political influence which is a mixture of consumption (the naked expression of power) or investment to help them get wealthier (the well-dressed expression of power) but in actuality depends on how much other rich people are spending on these activities in terms of the potential return (a complicated game).

Finally, where the money could go is to riskier investment because at the margin this is now more attractive than risk-free investment. This is not a given as the wealth tax could deter or spur this type of investment based on other margins (something Summers notes) but given the presumption above, if it does cause the wealthy to get out and find places for their money with a higher potential return, it is causing the wealthy to live their intended social purpose.

So we are left with two empirically resolvable statements:

  1. Will the wealth tax increase or decrease riskier investment by the wealthy?
  2. Are the wealthy the most productive people to be making investment decisions?

I’m going to concentrate here on (2) as I am not aware of any solid theoretical nor empirical treatments of that. (I am not really up to date on (1) but I presume there are studies out there on that).

The baseline argument as to why the wealthy are presumptively the most productive people to make decisions regarding investments is that they have skills associated with how they became rich in the first place that makes them so. The counter is obvious: people who are rich because of pure luck, inherited wealth, or graft and corruption. I don’t know of any theory that would link these types of wealthy people to better decisions regarding capital allocation except maybe they have experience handling money and so presumably want to find ways to have more of it. However, this argument is easily dismissed with a bit of microeconomics and a recognition that being productive in allocating wealth requires some attention which is likely better spread amongst many than amongst the few.

Those people are not whom Summers has in mind (although these policies either take or leave money in their hands so ….). What he has in mind is the entrepreneur, someone like Bill Gates, Steve Jobs, Vinod Khosla or Jeff Bezos, who built companies and brought them to scale and, in the process, became wealthy. These people became rich while running their companies and would have expected to remain that way afterwards. But it is important to note that while they were running their companies, it is difficult to imagine that their attention was focussed on fulfilling their social role of allocating capital effectively. It is only once they have exited from the work that made them wealthy that this argument kicks in.

Therefore, we are left with either the early exit entrepreneurs (like Khosla) or the retired entrepreneurs (like Gates). But what skills did they have that they earned as a result of building a successful business that makes them likely to be presumptively socially optimal allocators of capital? I think there are things that likely do transfer so if I had to allocate capital between someone with their experience and someone with no experience, then the presumption makes sense. But note that, in terms of the impact of a wealth tax, wouldn’t it be presumptively sensible to suggest that the wealthy who have the skills are precisely those who are likely to end up investing more in riskier options than less when the risk-free capital is taxed so effectively?

But what is the counterfactual to having these people allocate wealth? With a wealth tax, it is the government who takes charge of that money. We can have a long argument about whether that is better or worse which is, of course, what we should have but I want to note that the government is taking the money of a whole lot of wealthy people who have no claim, based on history, to being presumptively efficient allocators of capital and only a few who do.

But stepping back from that, one can imagine that there are better people than the wealthy to allocate capital. For starters, all of those entrepreneurs, when they started had no capital and giving it to them really worked out. In other words, when young, those entrepreneurs were, at least ex post, the right set of people to be given capital. Presumptively, that means people like them are likely the right set of people to be given capital today — not those who have ended their entrepreneurial careers but those who are starting them.

At the same time, when they were young, the now wealthy weren’t given capital in some unconstrained manner. Instead, they were given all of the capital but only a fraction of the actual returns on that capital. Yet they allocated it well. Go figure. In other words, does the money really matter here as an instrument to get efficient capital allocation? This is a complex matter but it is one that macroeconomists in the debate have not really examined closely and I suspect we will need some good microeconomic work to get to the bottom of this.

 

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