Chapter 23 Taxes on Risk Taking and Wealth © 2007 Worth Publishers Public Finance and Public...

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© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Taxes on Risk Taking and Wealth

23.4 Property Taxation

23.3 Transfer Taxation

23.2 Capital Gains Taxation

23.1 Taxation and RiskTaking

Chapter 23

23.5 Conclusion

In June 2006, Warren Buffett, the world’s second-richest man, made the shocking announcement that he is giving 85% of his fortune to the Bill and Melinda Gates Foundation rather than bequeathing it to his own children.

Buffett has argued that allowing children to inherit all of their parents’ riches causes them to be spoiled and sapped of all motivation, and keeping the estate tax in force helps to preserve America’s meritocracy.

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Taxation and Risk Taking23 . 1

Basic Financial Investment Model

expected return The return to a successful investment times the odds of success, plus the return to an unsuccessful investment times the odds of failure.

E(Ret) = P1( R1) + 1-P(R2 )

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Basic Financial Investment Model

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Real-World Complications

tax loss offset The extent to which taxpayers can deduct net losses on investments from their taxable income.

Less-Than-Full Tax Offset

Redistributive Taxation

The idealized model of risk taking also assumes a constant rate of tax on investment income.

In reality, tax systems are typically progressive, with higher marginal tax rates as income rises.

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Evidence on Taxation and Risk Taking

There is no clear prediction about how taxation will affect risk taking in the real world.

Ultimately, what the effect of taxes is on risk taking is an empirical question.

There is very little evidence about the effect of capital income taxation on risk taking.

Labor Investment Applications

Financial investments are not the only risky investments individuals make—they can also invest in human capital through education or other job training.

Investing in human capital is risky because individuals are making an up-front sacrifice in return for some expectation of higher earnings in the future.

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Capital Gains Taxation23 . 2

Current Tax Treatment of Capital Gains

taxation on accrual Taxes paid each period on the return earned by an asset in that period.

taxation on realization Taxes paid on an asset’s return only when that asset is sold.

capital gain The difference between an asset’s purchase price and its sale price.

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basis The purchase price of an asset, for purposes of determining capital gains.

“Step-up” of Basis at Death

Exclusion for Capital Gains on Housing

The tax code in the United States has traditionally featured an exclusion for capital gains on houses.

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Capital Gains Tax Rates Through the Years

1. From 1978 through 1986, individuals were taxed on only 40% of their capital gains on assets held for more than six months.

2. The Tax Reform Act of 1986 ended this difference and treated capital gains like other forms of income for tax purposes, with a top tax rate of 28%.

3. The Tax Reform Act of 1993 raised top tax rates on other forms of income to 39% but kept the tax rate on capital gains at 28%.

4. The Taxpayer Relief Act of 1997 reduced the top rate on long-term capital gains to 20% (though certain items, like collectibles such as art and coins, are still taxed at 28%).

5. The 2003 Jobs and Growth Act reduced the top rate further, to 15%, for gains realized after May 5, 2003 (collectibles are still taxed at 28%).

Even with this long list of tax preferences for capital gains, this form of income has traditionally borne lower tax rates than other forms of income:

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Capital Gains Tax Rates Through the Years

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What Are the Arguments for Tax Preferences for Capital Gains?

Protection Against Inflation

Although it may not seem fair to tax capital gains at a rate that is much lower than rates on other forms of income, three major arguments are commonly made for these lower tax rates:

Improved Efficiency of Capital Transactionslock-in effect In order to minimize the present discounted value of capital gains tax payments, individuals delay selling their capital assets, locking in their assets.

Encouraging Entrepreneurial Activity

prospective capital gains tax reduction Capital gains tax cuts that apply only to investments made from this day forward.

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What Are the Arguments for Tax Preferences for Capital Gains?

Evidence on Taxation and Capital Gains

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What Are the Arguments Against Tax Preferences for Capital Gains?

There are two arguments against the existing favoritism shown to capital gains income in most nations:

First, capital gains taxes are very progressive. Capital gains income accrues primarily to the richest taxpayers in the United States.

Second, lower tax rates on capital gains violate the Haig-Simons principle for tax systems. The goal of taxation should be to provide a level playing field across economic choices, not to favor one choice over another, unless there is some equity or efficiency argument for doing so (such as a positive externality that justifies a tax preference).

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Transfer Taxation23 . 3

transfer tax A tax levied on the transfer of assets from one individual to another.

gift tax A tax levied on assets that one individual gives to another in the form of a gift.

estate tax A tax levied on the assets of the deceased that are bequeathed to others.

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Why Tax Wealth? Arguments for the Estate Tax

There are at least three arguments for taxing wealth.

The first is that this is an extremely progressive means of raising revenue.

The second argument is that wealth taxes are necessary to avoid the excessive concentration of wealth and power in society in the hands of a few wealthy dynasties.

A third issue that has often been raised by supporters of the estate tax is the claim that allowing children of wealthy families to inherit all their parents’ wealth saps them of all motivation to work hard and achieve their own success.

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Arguments Against the Estate Tax

There are four major arguments made against the estate tax as it is levied in the United States.

A “Death Tax” Is Cruel

The Estate Tax Amounts to Double Taxation

Administrative Difficulties

Compliance and Fairness

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Conclusion23 . 5

The impact of the tax code on decisions about how much to save, and in what form to save it, will always be central to debates over tax reform.

Taxation doesn’t necessarily reduce, and under certain assumptions definitely increases, risk taking.

The strongest arguments for the preferential tax treatment of capital gains are that:

(a) lower capital gains tax rates will “unlock” productive assets, and

(b) lower capital gains taxes will encourage entrepreneurship.

The existing evidence on the former suggests that such unlocking is not large in the long run.

The theoretical discussion suggests that the predictions for entrepreneurship are unclear.

Even if lower capital gains taxation promotes risk taking and entrepreneurship, it does so at the very high cost of providing large subsidies to previous investments.

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Corporate Taxation

24.4 The Consequences of the Corporate Tax for Investment

24.3 The Incidence of the Corporate Tax

24.2 The Structure of the Corporate Tax

24.1 What Are Corporations and Why Do We Tax Them?

Chapter 24

24.5 The Consequences of the Corporate Tax for Financing

To its detractors, the corporate tax is a major drag on the productivity of the corporate sector, and the reduction in the tax burden on corporations has been a boon to the economy that has led firms to increase their investment in productive assets.

To its supporters, the corporate tax is a major safeguard of the overall progressivity of our tax system. By allowing the corporate tax system to erode over time, supporters of corporate taxation argue, we have enriched capitalists at the expense of other taxpayers.

24.6 Treatment of International Corporate Income

24.7 Conclusion

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Corporate Taxation

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What Are Corporations and Why Do We Tax Them?

Corporations are distinct entities

Corporations have special priviliges

Corporate tax protects the integrity of the income tax system

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What Are Corporations and Why Do We Tax Them?24 . 1

shareholders Individuals who have purchased ownership stakes in a company.

Ownership Versus Control

agency problem A misalignment of the interests of the owners and the managers of a firm.

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Executive Compensation and the Agency Problem

A P P L I C A T I O N

A number of corporate executives have made the news in recent years for receiving compensation packages that seem wildly out of proportion to the executives’ actual value.

How can executives receive such high compensation? There are two possible reasons:

First, they may be worth it: after all, these individuals are running some of the most important companies in the world. Nonetheless, this high compensation doesn’t seem to be related to superior performance in many cases.

The second possible reason is that owners of firms have a hard time keeping track of the actual compensation of the firm’s managers, and the managers exploit this limitation to compensate themselves well. Owners of corporations try to keep control of executive mismanagement through the use of a board of directors.

board of directors A set of individuals who meet periodically to review decisions made by a firm’s management and report back to the broader set of owners on management’s performance.

Continued

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Executive Compensation and the Agency Problem


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debt finance The raising of funds by borrowing from lenders such as banks, or by selling bonds.

bonds Promises by a corporation to make periodic interest payments, as well as ultimate repayment of principal, to the bondholders (the lenders).

Firm Financing

equity finance The raising of funds by sale of ownership shares in a firm.

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dividend The periodic payment that investors receive from the company, per share owned.

capital gain The increase in the price of a share since its purchase.

Firm Financing

retained earnings Any net profits that are kept by the company rather than paid out to debt or equity holders.

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economic profits The difference between a firm’s revenues and its economic opportunity costs of production.

accounting profits The difference between a firm’s revenues and its reported costs of production.

Why Do We Have a Corporate Tax?

Pure Profits Taxation

Retained Earnings

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The Structure of the Corporate Tax24 . 2

Revenues

The taxes of any corporation are:

Taxes = ([Revenues – Expenses] × τ ) – Investment tax credit

These are the revenues the firm earns by selling goods and services to the market.

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Expenses

depreciation The rate at which capital investments lose their value over time.

depreciation allowances The amount of money that firms can deduct from their taxes to account for capital investment depreciation.

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Expenses

depreciation schedules The timetable by which an asset may be depreciated.

Depreciation in Practice

expensing investmentsDeducting the entire cost of the investment from taxes in the year in which the purchase was made.

economic depreciation The true deterioration in the value of capital in each period of time.

Economic Depreciation

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What Is Economic Depreciation? The Case of Personal Computers


Personal computers are an excellent example of the difficulties in defining economic depreciation.

Doms et al. (2003) gathered data on the market value of personal computers and modeled it as a function of the age of the PC.

They found that the depreciation period for a PC is very rapid, on the order of only five years.

Moreover, the depreciation during this period is exponential, not linear.

The researchers also reached another important conclusion: most of the depreciation of PC value is not due to actual wear and tear on the machine but to the revaluation of the product as microprocessors improve.

Economic depreciation is a subtle concept that goes far beyond physical depreciation of the actual machine. Tax policy makers face a daunting task in setting depreciation schedules appropriately across the wide variety of physical assets employed by firms in the United States.

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Corporate Tax Rate

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Investment Tax Credit

investment tax credit (ITC) A credit that allows firms to deduct a percentage of their annual qualified investment expenditures from the taxes they owe.

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The Incidence of the Corporate Tax24 . 3

The burden of the corporate tax is shared by consumers, workers, corporate investors, and noncorporate investors in some proportion.

Unfortunately, we have little convincing empirical evidence on the incidence of corporate taxation.

The true incidence of the corporate tax remains one of the primary mysteries of public finance.

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The Consequences of the Corporate Tax for Investment24 . 4

Theoretical Analysis of Corporate Tax and Investment Decisions

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The Effects of a Corporate Tax on Corporate Investment

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The Effects of Depreciation Allowances and the Investment Tax Credit on Corporate Investment

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Effective Corporate Tax Rate

effective corporate tax rate The percentage increase in the rate of pre-tax return to capital that is necessitated by taxation.

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Effective Corporate Tax Rate

More generally, the effective corporate tax rate (ETR) is measured as:

With depreciation and the ITC, the effective tax rate is:

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Negative Effective Tax Rates

With a large enough z and ITC , the effective corporate tax rate could be negative.

Policy Implications of the Impact of the Corporate Tax on Investment

For any given corporate tax rate, the tax system can be designed to offer very different incentives for investment.

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The Impact of the 1981 and 1986 Tax Reforms on Investment Incentives


Two of the most important pieces of government legislation of the 1980s were the major tax reform acts of 1981 and 1986.

The 1981 tax act introduced a series of new incentives to spur investment by corporate America. Depreciation schedules were made much more rapid and an investment tax credit was introduced.

Contributing to the low effective tax rates in the early 1980s were active tax avoidance and/or evasion strategies by corporations.

The Tax Reform Act of 1986 made three significant changes to the corporate tax code:

First, it lowered the top tax rate on corporate income from 46% to 34%.

Second, it significantly slowed depreciation schedules and ended the ITC.

Finally, the 1986 act significantly strengthened the corporate version of the Alternative Minimum Tax (AMT).

Corporate use of legal loopholes in the tax codes seems to have rebounded in the late 1990s and continues to the present day.

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Evidence on Taxes and Investment

There is a large literature investigating the impact of corporate taxes on corporate investment decisions.

The conclusion of recent studies is that the investment decision is fairly sensitive to tax incentives, with an elasticity of investment with respect to the effective tax rate on the order of –0.5: as taxes lower the cost of investment by 10%, there is 5% more investment.

This sizeable elasticity suggests that corporate tax policy can be a powerful tool in determining investment and that the corporate tax is very far from a pure profits tax.

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The Consequences of the Corporate Tax for Financing24 . 5

The Impact of Taxes on Financing

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Why Not All Debt?

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The Dividend Paradox

Empirical evidence supports two different views about why firms pay dividends, as reviewed by Gordeon and Dietz (2006).

The first is an agency theory: investors are willing to live with the tax inefficiency of dividends to get the money out of the hands of managers who suffer from the agency problem.

The second is a signaling theory: investors have imperfect information about how well a company is doing, so the managers of the firm pay dividends to signal to investors that the company is doing well.

How Should Dividends Be Taxed?

An important ongoing debate in tax policy concerns the appropriate tax treatment of dividend income.

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The 2003 Dividend Tax Cut


One of the measures President Bush signed into law on May 28, 2003, under the Jobs and Growth Tax Relief Reconciliation Act, was a reduction in the rate at which dividends are taxed.

The 2003 law reduced both the dividend and capital gains rates to 15%, making dividends significantly more attractive for investors.

Proponents of the dividend tax cut believed it would both stimulate the economy and end what they perceived as the unfair practice of taxing corporate income and then taxing it again when that income was paid out in the form of dividends.

Opponents of the dividend tax cut argued, however, that dividends are primarily received by higher income households and that such a tax cut would both worsen the country’s fiscal balance and make the tax burden less progressive.

Several recent papers have studied the impacts of the 2003 tax reduction and there has been a clear rise in dividend payouts. The key question of whether this tax cut actually raised investment, however, remains unanswered.

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Corporate Tax Integration

corporate tax integration The removal of the corporate tax in order to tax corporate income at the individual (shareholder) level.

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Treatment of International Corporate Income24 . 6

multinational firms Firms that operate in multiple countries.

subsidiaries The production arms of a corporation that are located in other nations.

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territorial tax system A tax system in which corporations earning income abroad pay tax only to the government of the country in which the income is earned.

global tax system A tax system in which corporations are taxed by their home countries on their income regardless of where it is earned.

How to Tax International Income

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foreign tax credit U.S.-based multinational corporations may claim a credit against their U.S. taxes for any tax payments made to foreign governments when funds are repatriated to the parent.


Foreign Dividend Repatriation

repatriation The return of income from a foreign country to a corporation’s home country.

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A Tax Holiday for Foreign Profits


The proper taxation of foreign profits was the focus of the debate around the passage of the American Jobs Creation Act of 2004.

The bill was intended to rejuvenate the economy and create jobs.

One of its most important provisions was a one-year reduction of the tax rate on repatriated profits from 35% to 5.25%.

Critics of the bill voiced a number of concerns.

One of these was the difficulty in controlling how companies would spend the repatriated money.

Others were skeptical of the bill’s ostensible intention of stimulating the economy.

By October 2005, U.S. companies had announced the repatriation of roughly $206 billion—an amount representing nearly $37 billion in lost revenues due to the lower tax rate. However, it was clear that the expected surge in hiring and job creation was not materializing. As of this writing, a final evaluation of the bill’s effects has not yet been compiled because many companies operate according to the fiscal calendar and thus have been able to extend the deadline for repatriation well into 2006.

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transfer prices The amount that one subsidiary of a corporation reimburses another subsidiary of the same corporation for goods transferred between the two.


Transfer Pricing

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Conclusion24 . 7

Despite the declining importance of the corporate tax as a source of revenue in the United States, it remains an important determinant of the behavior of corporations in the United States.

The complicated incentives and disincentives that the corporate tax creates for investment appear to be significant determinants of a firm’s investment decisions.

And both corporate and personal capital taxation substantially, although not completely, drive a firm’s decisions about how to finance its investments.

The United States faces a difficult set of decisions about how to reform its corporate tax system.

Despite repeated calls for ending “abusive corporate tax shelters,” there has been little movement to end the types of corporate tax loopholes that cause such activity.

This lack of interest should not be surprising: corporate tax breaks have highly concentrated and powerful supporters, with only the diffuse taxpaying public to oppose them.

Chapter 23 Taxes on Risk Taking and Wealth © 2007 Worth Publishers Public Finance and Public...

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Transcript of Chapter 23 Taxes on Risk Taking and Wealth © 2007 Worth Publishers Public Finance and Public...