A California Wealth Tax Wouldn't Work. But This One Would

Earlier this month, economists Robert E. Hall and Michael Woodford won the 2026 Nobel Prize in Economics for their work on “microeconomic foundations of macroeconomic stabilisation.” The two built the models that modern central banks use to stabilize the economy, shifting macro policymakers’ focus from big economic variables like inflation and unemployment to the actual decisions of individuals.

Hall’s win offers an opportunity to recall another of his major contributions: the idea of a single flat tax. Throughout their careers, Hall and his colleague Alvin Rabushka have proposed a flat tax that would simplify tax collection and increase investment in physical and human capital, without abandoning the idea of progressive taxes.

The idea is particularly relevant today, as states like California consider more aggressive ways to address inequality by taxing wealth directly. Such taxes would discourage the innovation that drives American economic dynamism. Hall’s proposal, by contrast, offers something close to an optimal tax system.

Hall and Rabushka’s proposal is remarkably simple. Under it, every business and household would pay a flat 19 percent rate. Their goal is to tax income just once, as close to its source as possible, and to tax families on what they take out of the economy rather than what they put into it.

Under their plan, businesses pay 19 percent on profits, excluding wages, pension contributions, and investments in capital and inputs. That matters because investment is the most important driver of future economic growth.

Households also pay 19 percent on wages above an adjustable exemption threshold, below which they pay nothing. As household income increases, a larger share becomes taxable, pushing the family’s average tax rate toward 19 percent. The result is a flat tax system that is also progressive. In the 1985 version of the proposal, for example, a family earning $25,000 paid an average rate less than half that of the highest earners.

The approach offers several advantages. First, it does not discourage savings and investment: interest, dividends, and capital gains are not taxed again since they were already taxed at the business level, where businesses pay 19 percent on their profits. All income is taxed at the same rate, and only once, thus acting as a consumption tax rather than an income tax.

Second, the flat tax collects revenue only on income above a household’s exemption threshold, without imposing higher rates on higher earners. It also discourages tax avoidance by eliminating loopholes, leaving just one exemption and one rate for everyone.

One objection to income taxes is that they discourage work, reducing the labor supply. The flat tax minimizes this problem by taxing each additional dollar of earnings at the same rate. Taking a better-paying job does not jeopardize the exemption, since income below the threshold remains untaxed.

The flat tax thus functions in important respects like a consumption tax. Families can spend all their income below the exemption threshold and 81 percent of their income above it. By exempting savings and investment from additional taxation, the system effectively taxes what households consume rather than what they save. Economists generally favor consumption taxes because they discourage productive activity as little as possible while still raising revenue.

All this compares favorably with the current vogue in “tax reform,” exemplified by California’s wealth tax. In November, Golden State voters will decide whether to impose a one-time, 5 percent tax on assets in excess of $1 billion. Recent Manhattan Institute polling suggests that the proposal is likely to lose at the polls.

That’s a good sign for California. While economists tend to like consumption taxes, they dislike wealth taxes, which discourage investment and reduce liquidity. To pay a tax on unrealized gains, owners must sell part of their companies, losing control of the wealth they created. This reduces the incentive to build wealth, thereby discouraging economic growth.

Under the Hall and Rabushka design, investment is deducted when it is made, so a firm reinvesting every dollar of revenue has no taxable profit. That encourages investment and growth. A wealth tax does the opposite, taxing the unrealized value of the company, determined by its expected value in the future, not today. A wealth tax can be levied on a company before any income even exists to tax. This makes it impossible for a startup to commit deeply to an idea and grow before becoming profitable.

Only about 35 percent of new businesses survive their first decade, so a wealth tax on growing enterprises effectively taxes this surviving cohort. These are the rare firms creating significant economic value. A wealth tax punishes them just as they need to grow, reducing innovation: one study found that a 10 percent increase in the effective tax rate on VC partners corresponds to a 4.5 percent to 7.5 percent decline in startup patenting, for example.

Hall’s flat tax points to a better way. Investment is deducted when it is made, and income is taxed just once, when it is taken out of the economy. Firms would be free to reinvest and grow, while the state would collect revenue from the wages and profits that growth generates. Wages are taxed at the household level, and profits at the company level, after deducting investments that drive economic growth.

The Nobel Committee honored Hall for showing that the economy is a complex system of millions of families and firms responding rationally to public policy. The flat tax applies the same principle to public finance. The economy is not a collective unit whose resources can be moved at will. Government must consider the incentives and decisions of individual economic actors before diverting resources from productive activity.