1

USC Gould School of Law

REIMAGINING CAPITAL INCOME TAXATION

Edward D. KleinbardProfessor of Law

ekleinbard@law.usc.edu

JANUARY, 2012

2

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

3

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

4

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

5

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

6

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

7

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?– 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

8

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

9

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).

10

The case for taxing capital income - I

• Recent economic arguments to tax capital income– As summarized in Tax By Design: The Mirrlees Review, 307-

17:

• 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

11

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”?

12

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– 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

13

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

14

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

15

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

16

• 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

BEIT Overview – The Enterprise

17

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

18

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

19

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.

20

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

21

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)

22

BEIT Results (con’t)

• Worldwide tax consolidation may seem counter-competitive

– 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

23

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!

24

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

25

DIT: Simple Example

Current Law Dual Income Tax

Base: 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%

26

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)

27

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)

28

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

29

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)

30

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 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.

31

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.

32

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)

33

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

34

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