USC Gould School of Law

November 2, 2009

An American Dual Income Tax: Making a Virtue of Necessity

Edward D. Kleinbard Professor of Law 1

Sources of Private Sector Income • The private sector generates income from two sources:

– Labor (roughly 2/3) – Capital (roughly 1/3)

• Capital income :

– All returns to savings & 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.

• A separate issue is whether ultimate burden − incidence − of a tax on capital income may shift in part to labor through market forces

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Current Law Inefficiencies

• Current law does an acceptable job of taxing labor income, but a terrible job of taxing capital income • 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!

• Consequences?

– Underinvestment where tax burden is high – Misdirected investment, compared to a world of constant–burden taxation 3

Why is capital income taxation broken?

• Perhaps the 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 – 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 4

Dual Income Tax as an Alternative

• What happens if we abandon the premise of one tax rate for all types of income?

– Many economists have advocated such an approach for years in the form of various consumption tax proposals – But consumption taxes raise both revenue and transition issues as well as distributional issues • Another approach might be to retain the general structure of the Internal Revenue Code, but tax capital income under one rate schedule and labor income under another.

• This is the essence of a “dual income tax.” 5

Basic Dual Income Tax Principles

• Broaden business / investment / savings tax base to track economic income more closely – A comprehensive base is key to economic efficiency gains and to raising adequate revenues • In return, tax all capital income at one low flat rate* – Corporate income – Personal capital income (e.g. interest income earned by individuals) • Retain current law treatment of labor income • Variations on the theme have been adopted, but this is the essence of the idea in its original, simplest, form * The U.S. has several very low tax rate brackets; in practice, a U.S. dual income tax probably would have graduated rates up to a lower maximum rate than would apply to labor income.

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Base: Corporate Income Tax: Unincorporated Business Income Tax: Dividend Tax: Capital Gains Tax: Personal Interest Income Tax:

Simple Example

Current Law

Narrow 35% 35% 15% 15% 35%

Dual Income Tax

Very Broad 25% 25% 0% (ideal) 0% stock (ideal) 25% other 25% 7

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 corporate tax international competitiveness / mobility issues • Responds to use of corporation as a tax shelter if corporate income tax < personal tax and law not amended 8

Is A Dual Income Tax Inevitable?

• A bifurcated tax rate schedule for capital and labor income may be a practical inevitability – Corporate income tax is the most important tax on income from capital – and it is basically a flat tax already – 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? • Problems in a poorly-implemented Dual Income Tax – Continuing misallocations and tax arbitrage opportunities – Corporation as a tax shelter • “Capital stuffing” • “Labor stuffing” 9

Experience with Dual Income Taxes

• Dual income tax systems are not just ivory tower fantasies.

• 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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Dual Income Tax Design Issues

• A dual income tax applies different tax schedules to capital income and to labor income. The system thus must distinguish between capital and labor income.

– 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 – A more complex formula could be designed to tailor for different capital income categories, if desired 11

Objection 1: It’s Unworkable

• Dual income tax depends on administrable rules to distinguish between labor and capital income of owner-managers.

• Issues with the Norwegian dual income tax have been closely studied.

– Analysis showed that many owner-managers over time avoided income splitting rules by bringing in friends / relatives as investors, to dilute owner-manager 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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Objection 2: It’s Unfair

• Many observers applaud the ideal of the current income tax, that those with the same incomes from any source pay the same tax.

– A dual income tax, by contrast, would explicitly apply different rate schedules to the two different sources of income.

• 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.

• Recent 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 positive step toward eliminating the double tax burden.

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