Transcript Slide 1

USC Gould School of Law
JANUARY, 2012
REIMAGINING CAPITAL
INCOME TAXATION
Edward D. Kleinbard
Professor of Law
[email protected]
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Overview - I
• The income tax on labor income is not dysfunctional
– Its theoretical failings (e.g. imputed income) are well-known
and basically unavoidable
– Its practical failings (e.g. personal itemized deductions) also are
well-known and easily remedied as a technical matter
• But our taxation of capital income is dysfunctional
– We cannot measure a consistent capital income tax base
– And we have no clue at what rate to tax that base
– The usual articulation of an ideal is inconsistent with economics
• The dominant academic response, driven both by
economics and by existential tax design despair, has
been to recommend the abandonment of capital income
taxation
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Overview - II
• Capital income taxation should not be abandoned
• The “Business Enterprise Income Tax” (BEIT) points
the way to a comprehensive capital income tax base
– But without more it is incomplete
• “Dual income tax” (DIT) principles show how to tease
apart labor from capital income
• And DIT principles further liberate our thinking about
capital income tax rates
• BEIT and DIT principles can be integrated into a
feasible and sensible comprehensive capital income tax
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Capital Income
• All returns to savings and investment
– Not just “capital gains”
– Includes interest, rents, dividends
– Also includes net business profits, because labor inputs are
deductible. This includes the corporate income tax.
• Accounts for roughly 1/3 (latest numbers as high as
40%) of all private sector income
– More concentrated at the top end than is labor income
– A separate issue is whether incidence of a tax on capital
income may shift in part to labor through market forces
• In private firms returns from labor and capital often are
undifferentiated
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Current Law Mismeasures Capital Income
• Realization principle leads to systematic undertaxation of
economic income not paid currently in cash.
– And to ‘lock-in’ of inefficient investments.
• Taxing income from real assets requires getting both
depreciation and capitalization right, which is impossible
• Coordination of firm and investor-level incomes
– But there is no effective coordination solution for public companies
– Leads to the “irreducible complexity” (D. Weisbach) of current law
• Arbitrary tax distinctions between debt and equity
Encourages both overleveraging and exotic hybrid securities
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Current Law Inefficiencies - I
• The oft-dishonored “ideal” of a single progressive rate structure
– Capital gains tax, corporate income tax, “bonus” depreciation, etc. etc
– Not a particularly attractive ideal from economic perspective
• CBO 2005 study found enormous variations in the tax burdens
on returns to different investments, taking into account:
– Form of business organization
– Nature of investment asset
– Choice in financing the investment
• CBO study found that effective tax rates on corporate
investments varied from +36% to -6%
– A 42 percentage point swing!
– Would be worse today, thanks to “bonus” depreciation
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Current Law Inefficiencies - II
• Some labor income easily recharacterized as low-taxed capital
income
– E.G. capital gains on selling pass-through entity
– Not a particularly attractive ideal from economic perspective
• Special importance of taxing international income correctly
– Corporate income tax is largely a tax on big public companies
– And they in turn earn high percentage of their income outside U.S.
– Poor tax system design not only encourages foreign investment, but leads to
domestic base erosion
– Stateless Income, 11 Fla. Tax Rev. 699 (2011)
• Consequences?
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–
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Underinvestment (over-consumption) where capital tax burden is high
Distorted financing and business organization decisions
Misdirected real investment, compared to a world of constant–burden taxation
Bizarre world of high-income labor taxed at lower rates than ordinary workers
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Why is capital income taxation so broken?
• One answer is in the premise!
– U.S. tax ideal has always been to tax “all income from whatever
source derived” under one progressive tax rate schedule
– But lawmakers intuitively understand that there are sound reasons in
many cases to tax capital income more lightly than the general rate
schedule needed to generate adequate revenue
• Distorts current vs. future consumption
• Can actually be seen as a form of double taxation on labor income
• Taxes inflation (nominal rather than real income)
– So lawmakers implement a broad and uncoordinated array of
exceptions, exemptions and subsidies to bring down the effective tax
rate on the returns to some capital investments while retaining
conformity in nominal statutory rates
– But at the same time ignore labor income masquerading as capital
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So why tax capital income at all?
• Economic consensus is that it’s a bad idea
– Familiar argument that capital is ultimately “stored labor,” and a
tax on capital income is more distortive than a single tax rate
schedule on all labor income, whenever actually reduced to
consumption
– “Savings neutrality” as a preferred benchmark
• And capital income taxation certainly is enormously
difficult as a practical matter
– A principal reason for David Bradford’s rejection of it
• Consumption taxes can have progressive rates
– E.G. Shaviro, Replacing the Income Tax with a Progressive
Consumption Tax, 103 Tax Notes 91 (2004).
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The case for taxing capital income - I
• Recent economic arguments to tax capital income
– As summarized in Tax By Design: The Mirrlees Review, 30717:
• Taxes those with greater patience or cognitive ability
• Compensates for market failures in human capital investment
• Taxes human instinct to overhedge against future unknowns
• Maybe future consumption is complementary to leisure
• But in light of increasing “tax wedge” over time, these
arguments also don’t support “ideal” income tax
– One solution is sophisticated age-specific rates
– More plausibly, imply moderation in the taxation of capital income
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The case for taxing capital income - II
• Consumption tax has well-known transition issues
• And often a counterintuitive system (e.g. debt)
• And very important political economy constraints:
– Removing a large fraction of existing tax base means high
nominal consumption tax rates
– Duplicating (or increasing) progressivity becomes harder
once capital income excluded, since it is so top-heavy
– Financing bump in government debt in shift to new system
(through backloading of tax payments) seems implausible
– The specter of tax holidays
• Think section 965
• Does anyone doubt that, had we a progressive consumption
tax in 2008, we would have seen a “one-time only” tax holiday
“to jumpstart our economy”?
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One Capital Income Rate or Many?
• Economic components of capital income :
– “Normal” returns (boring “returns to waiting”)
– Risky returns
– Supernormal returns (economic rents)
• Good arguments for taxing each differently
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–
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Normal returns should be taxed at zero, or a low(ish) rate
Risky returns require symmetry in profit/loss tax treatment
Supernormal returns (economic rents) can bear higher tax
But many practical issues in differentiating, e.g., in
distinguishing rents and risky returns
• No particular reason to believe that any logically should
be taxed at the same rates as labor income
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Suggested Capital Income Tax Roadmap
• Retain capital income taxation
• Abandon “ideal” income tax as simply not ideal
• Tax capital income consistently at one moderate rate
– Regardless of form of organization, nature of investment or
type of financing
– Requires a new approach to defining the tax base
– Tease apart labor and capital income when the two are
undifferentiated (private firms)
– Not optimal: overtaxes normal returns and undertaxes rents
– But don’t let the perfect be the enemy of the good
• Retain separate progressive labor income tax structure
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Past Capital Income Reform Strategies
• Realization principle leads to systematic undertaxation
– Generally are proposed for publicly-traded assets only
– Result would be an extremely distortive exercise in line-drawing
• Other strategies ignore the flawed real asset tax base
– Firm income from operations may be “integrated” or may “flow through,”
but it is still mismeasured.
– CBIT resolved debt/equity problem, but had no solution here
• Retrospective” solutions are unadministrable
– Assumptions about rate of income accrual lead to surprising results
– Government must assume large credit exposure to taxpayers
– And tax rates can appear confiscatory
to laymen
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Business Enterprise Income Tax
• The BEIT is best seen as an implementable definition of
a comprehensive capital income tax base
– The BEIT technology is agnostic about rates
– Has been promoted along with a flat rate, but need not be
• The BEIT aims to achieve its objective in part and
also to promote simplicity through a “featureless tax
topography” – a single set of rules for:
– Choosing the form of a business enterprise
– Capitalizing the enterprise
– Selling or acquiring business assets or entire business enterprises
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BEIT Overview – The Enterprise
• Step One: Subject all businesses (except the tiniest) to a
new entity level-tax (the BEIT)
• Step Two: Replace business interest deductions with a
Cost of Capital Allowance (COCA)
– COCA rate set each year by reference to 1-year Treasuries
– Rate x Adjusted basis in all assets = deduction. So effect is
a deduction for both equity and debt-financed assets.
– COCA + depreciation = same economics as cash flow tax
at entity level. Self-corrects
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BEIT Overview – Investors
• Step Three: Investors taxed only on “Minimum Inclusion”
amount
– Minimum Inclusion = same COCA rate x investor basis in
financial investments in business enterprises
– So price of system is current investor taxation on COCA
rate returns, regardless of cash flow
– Basis increases for prior income inclusions, etc.
– Investor level the cleanest base for taxing normal returns
• Step Four: International system is worldwide true
consolidation, with foreign tax credit
– Effect is an enterprise-level apparent subsidy (FTC for foreign tax
on normal returns that are exempt in the US) offset by inclusion of
those normal returns at investor level
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Cost of Capital Allowance
• COCA interacts with depreciation deductions
– Faster depreciation = lower basis = smaller COCA deduction
– Unrecovered basis x COCA = constant PV = Same PV as
expensing
– Equivalence dependent on setting the COCA rate correctly
• Examples
– $1000 investment in land. Deduction = COCA rate in perpetuity
– $1000 investment that is immediately expensed. Expensing is
equivalent to tax exemption of normal return – the COCA rate by
another name.
• Political economy reasons for COCA
– Minimal disruptions to asset prices and cash flows
– Stretched-out deductions mitigate against effects of changes in
tax rates
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Tax-Neutral Environment For Business
• Consumption tax base facilitates radical firm tax
simplification
• All acquisitions of business assets or entire firms are
treated as taxable asset sales/purchases
– Seller’s managers are now indifferent to tax burdens on sales of
assets or of entire enterprise, because there is none in PV terms
– That is what a consumption tax means!
– So no more “alphabet soup” of tax-free reorganizations, and 2,000
page consolidated tax return treatise can be thrown away
• Examples
 Firm sells Division to Buyer. Tax = PV of buyer’s COCA benefit
 Investor A sells 100% of stock of Enterprise to Investor B. Treated as
sale by Enterprise of its assets (to “New” Enterprise) followed by
liquidating distribution to Investor A.
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Why Tax Normal Returns at Investor Level?
• Investor level is superior for measuring normal returns
– Investor base is unaffected by depreciation/capitalization dilemmas
– Financial assets presumptively turn over more rapidly than do real
assets.
– Addresses international capital mobility problems. Firms are more
mobile than citizens. Normal returns collected on cross-border income
• Issuer-specific information reporting not required
– M.I. uses same rate, but is not tied to issuer’s COCA deduction
– Acquisition of firm triggers revaluation of investors’ basis (but no
immediate tax consequence)
– But investors must pay tax even in a loss year
• “Lock-in” problems mitigated (but not eliminated)
 No tax on sale of investment at a gain
 But “step-up” in basis in replacement asset means more Minimum
Inclusions in the future
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BEIT Results
• BEIT economics:
– Entity consumption tax (exemption of normal returns)
– Plus investor tax on normal returns
– Equals comprehensive and consistent tax on all capital
income from business – complete “integration”
– I.E. firm is taxed on risky returns + rents, investors taxed
only on normal returns.
• Other achievements of BEIT:
– Completely eliminates debt/equity distinctions
– Optically closer to current law than a cash flow tax, but
identical economics at enterprise level
– More robust than cash flow tax to changes in tax rates, and
easier transition (depreciation retained, COCA for interest)
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BEIT Results (con’t)
• Worldwide tax consolidation may seem countercompetitive
– But that overlooks fact that normal returns from foreign
operations are tax-free at entity level
– Tax on normal returns paid at investor level, where mobility
issues are much less salient
• Entity tax rate and investor tax rate on M.I. can:
– Be the same (DIT) and different in turn from labor tax rates
– Be the same as labor rates
– Be different from each other (e.g., lower rates on normal
returns to investors, higher on rents collected on entities)
• But price for all this is individuals accepting tax on
“phantom” returns
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Limits of BEIT’s Scope
• Doesn’t directly address appropriate tax rate on
capital income
– One rate?
– Different rate for normal returns (investors) and rents +
risky returns (enterprises)?
• Does not directly address problem of labor income
masquerading as capital income
– Epidemic in private firms
– Current law has no effective tools to tease the two apart
• Enter Dual Income Tax Principles!
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Dual Income Taxes
• What happens if we abandon the premise of one tax
rate for all types of income?
– As noted, many economists have advocated such an
approach in the form of consumption tax proposals (= zero
tax on normal returns)
– But consumption taxes raise both revenue and transition
issues as well as distributional issues
• Instead, tax capital income under a flat rate
schedule and labor income under a graduated one
• This is the essence of a simple “dual income tax”
– Theoretically imperfect (normal returns taxed too heavily,
and rents too lightly) but nonetheless attractive compared
to current hodgepodge approach
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DIT: Simple Example
Current Law
Dual Income Tax
Narrow
Very Broad
Corporate Income Tax:
35%
25%
Unincorporated
Business Income Tax:
35%
25%
Dividend Tax:
15%
0% (ideal)
Capital Gains Tax:
15%
0% stock (ideal)
25% other
Personal Interest
Income Tax:
35%
25%
Base:
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DIT: Making a Virtue of Necessity
• A bifurcated tax rate schedule for capital and labor
income may be inevitable in practice
– Corporate income tax is the most important tax on income from
capital – and it is a flat tax already
– Ditto capital gains tax
– Globally, corporate income tax rates appear to be trending down,
while personal income tax rates appear to be heading up
• So, the question is not, do we want a dual income
tax – but rather, do we want a thoughtful one?
– Inattention will lead to the return of the corporation as a tax shelter
– And existing devices to distinguish labor from capital income are
useless (carried interest debacle)
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Dual Income Taxes Supported by Theory
• Constant tax burden on capital income minimizes misallocation
of investment
• Relatively low rate minimizes under-investment generally
• Mitigates some distortions attributable to over-leveraging
(because value of “tax shield” to debt is reduced)
• Flat rate creates more hospitable environment for risk-taking,
because gains and losses are taxed symmetrically
• Addresses taxation of inflationary gains, in part
• Addresses corporate tax international competitiveness /
mobility issues
• Consistent with recent theoretical arguments for some positive
tax on capital income (See earlier)
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The Labor-Capital Income Centrifuge
• An ideal dual income tax requires a magic labor-capital income
centrifuge to distinguish between capital and labor income
– Not true of ideal income or consumption tax
– The classic problem is the case of the small business owner-manager
– How can we allocate business profits attributable to the owner-manager’s
labor from amounts earned by her invested capital?
• Current U.S. tax techniques for addressing this issue are based
on attempts to deduce “reasonable” compensation.
– This approach is unadministrable and plainly inadequate
• Preferred Nordic solution has been to isolate “capital income”
through a formula, with residual returns treated as “labor
income”
– Nordic states have used a formula that specifies capital income as invested
capital x a statutory rate of return – the COCA by another name!
– A more complex formula could be designed to tailor for different capital
income categories, if desired 28
Experience with Dual Income Taxes
• Dual income tax systems are not exercises in ideal taxation
• For over 15 years the four Nordic countries have experimented
with different implementations of dual income taxes.
– The results have not always been completely successful, but the Nordic
experiences can help in making implementation decisions elsewhere.
– What choice do we have but to at least consider these ideas, considering
trends in corporate and individual rates?
• Other European countries (e.g., Netherlands, Italy, Germany)
also have adopted “schedular” systems that include dual
income tax principles (e.g. for personal interest income)
– Some impose low tax on net business income only so long as profits are
retained in the business (Italy, Germany, new Norwegian system)
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Are DITs Workable?
• Dual income tax depends on administrable rules to distinguish
between labor and capital income of owner-managers.
– U.S. has the same issue, but basically ignores the problem
• Issues with the Norwegian dual income tax have been closely
studied.
– Many owner-managers over time avoided income splitting rules
by bringing in friends/relatives as investors, to dilute ownermanager below their statutory 2/3 ownership trigger.
– Norway did not experiment with refining the income splitting
trigger, but instead adopted an even more complex and unusual
system designed to avoid the issue entirely. New system taxes
“normal” returns at low rate, all other returns like labor
– U.S. anti-avoidance rules in roughly analogous circumstances are
more encompassing.
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Are DITs fair?
• Some observers applaud the ideal of the current income tax, that
those with the same incomes from any source pay the same tax
• But practice already belies the ideal, since current rules and
trends in tax rates create just this distinction:
– The crazy-quilt of current capital income tax rules produces widely divergent
effective tax burdens.
– The largest single capital income tax component (corporate income tax)
already in practice is a flat rate tax. That tax rate is trending down and
personal income tax rates up.
• As noted earlier, academic thinking argues that capital is just an
accumulated store of prior labor, so that any tax on capital
income effectively is a double tax on labor income.
– Following this analysis, a dual income tax’s reduced rate on capital income is
a useful step toward mitigating the double tax burden.
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Integrating DIT and BEIT- I
• BEIT and DIT rely on same fundamental COCA
mechanism
• Widely held firms (generally, public ones) can be
presumed to pay 100% of labor factors as wages
– BEIT by itself works fine here, using the same tax rate for
income of firm and M.I. of investors
• But other firms do not differentiate
– So COCA again determines firm-level deduction and owner
inclusion, taxed at capital income flat rate
– BUT, remainder of firm income taxed at labor rates, as
presumptively not capital income at all
– This implicitly denigrates economic rents story at private
firms (which strikes this author as correct)
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Integrating DIT and BEIT- II
• Higher apparent rate on “small business” not a very
artful solution
– Whining will be directly proportional to the extent to which
labor income today masquerades as capital income
– Defeats the promise of a “featureless tax landscape”
• One could offer an especially generous COCA
– Higher COCA on first $X million of capital, etc.
– Or even a maxi-tax on net business income somewhere
between capital income and labor income maximum rate
• And how to implement?
– Presumably flow-through taxation required to get rates right
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Integrating DIT and BEIT- III
• Taxing all firms at labor rate is the the other move
– Firm-level tax still does not burden normal returns; they
remain taxed to investors at capital income rates (BEIT)
– Rents can theoretically bear the tax, just like labor can
– But to the extent rates are not flat (private firms) we have
introduced some asymmetry in tax of risky returns
– And of course this appears to row against current trends: will
anyone understand that the base is different?
• Public firms just assumed at maximum rate
– Private firms again would rely on flow-through
– An unfortunate introduction of a feature in the tax topography,
but one with little ultimate consequence
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