Taxes on Risk Taking and Wealth

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 24

Taxes on Risk Taking and Wealth

23.1 Taxation and Risk Taking

23.2 Capital Gains Taxation

23.3 Transfer Taxation

23.4 Property Taxation

23.5 Conclusion


C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H

Current Tax Treatment of Capital Gains

23.2Capital Gains Taxation

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

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.





“Step-Up” of Basis at Death

basis The purchase price of an asset, for purposes of determining capital gains. –reset if inherited

Exclusion for Capital Gains on Housing

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





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:





Capital Gains Tax Rates through the Years



What Are the Arguments for Tax Preferences for Capital Gains?


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: to protect asset owners against the effects of inflation; to improve the efficiency of capital markets; and to promote entrepreneurship.

Protection against InflationBecause of inflation, current tax policy overstates the value of capital gains. For both capital gains and other forms of capital, the appropriate reaction to the inflation problem is not to lower the capital gains tax rate but to index the tax system.

Improved Efficiency of Capital Transactions

lock-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.



Evidence on Taxation and Capital Gains





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:

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

2. 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). ---affecting farm land investment



23.3Transfer Taxation

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. ---Only if >$3.5 million



Why Tax Wealth? Arguments for the Estate Tax


There are at least three arguments for taxing wealth:

It is an extremely progressive means of raising revenue.

It is necessary to avoid the excessive concentration of wealth and power in society in the hands of a few wealthy dynasties.

Allowing children of wealthy families to inherit all their parents’ wealth saps them of all motivation to work hard and achieve their own success.



A “Death Tax” Is Cruel

The Estate Tax Amounts to Double Taxation

Arguments against the Estate Tax


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

It is morally inappropriate to tax individuals upon their death.

You are taxed on income when you earn it and then your children are taxed on it again when you die.

Administrative Difficulties

To afford the tax, you may be forced to sell the asset.

Compliance and Fairness

Only those too unsophisticated to avoid the tax end up paying it.



23.5Conclusion

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.



Corporate Taxation

24.1 What Are Corporations and Why Do We Tax Them?

24.2 The Structure of the Corporate Tax

24.3 The Incidence of the Corporate Tax

24.4 The Consequences of the Corporate Tax for Investment

24.5 The Consequences of the Corporate Tax for Financing

24.6 Treatment of International Corporate Income

24.7 Conclusion


C H A P T E R 1 9 ■ T H E E Q U I T Y I M P L I C A T I O N S O F T A X A T I O N : T A X I N C I D E N C E


C H A P T E R 1 9 ■ T H E E Q U I T Y I M P L I C A T I O N S O F T A X A T I O N : T A X I N C I D E N C E

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.



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What Are Corporations and Why Do We Tax Them?

Corporations are distinct entities

Corporations have special privileges-limited liability

Corporate tax protects the integrity of the income tax system-avoids being a tax shelter-keeps progressivity



24.1What Are Corporations and Why Do We Tax Them?

Ownership vs. Control

shareholders Individuals who have purchased ownership stakes in a company.

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




APPLICATIONExecutive Compensation and the Agency Problem 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.

Continued...



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.


The issue of executive compensation came to a head in 2008–2009 as thousands of traders and bankers on Wall Street were awarded huge bonuses and pay even as their employers were battered by the financial crisis.

Congress and the public expressed outrage at these packages and voted to limit the compensation that could be paid by firms accepting bailout funds, but compensation remains uncapped at the vast majority of financial and other firms in the United States.

APPLICATIONExecutive Compensation and the Agency Problem



Firm Financing


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).

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



Firm Financing


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.

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



Why Do We Have a Corporate Tax?

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.


Pure Profits Taxation

Retained Earnings

If corporations were not taxed on their earnings, then individuals who owned shares in corporations could simply avoid taxes by having the corporations never pay out their earnings. If corporations paid out those earnings many years later, the present discounted value of the tax burden would be quite low.



Revenues

24.2The Structure of the Corporate Tax

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.



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.



Economic Depreciation

Expenses


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



Depreciation in Practice

Expenses


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

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




APPLICATIONWhat 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.



Corporate Tax Rate




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.



24.4The Consequences of the Corporate Tax for InvestmentTheoretical Analysis of Corporate Tax and Investment Decisions




The Effects of a Corporate Tax on Corporate Investment




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



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

24.4The Consequences of the Corporate Tax for Investment

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.



24.4The Consequences of the Corporate Tax for InvestmentEvidence 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.



24.5The Consequences of the Corporate Tax for FinancingThe Impact of Taxes on Financing



24.5The Consequences of the Corporate Tax for FinancingWhy Not All Debt?



24.5The Consequences of the Corporate Tax for FinancingThe Dividend Paradox

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

1. 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.

2. 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.



The real tax avoidance scandal centers on dividends and capital gains By Robert J. Samuelson, Sunday, April 3, 7:53 PM

GE :$14.2 billion in WW profits, no US taxes$5.1 billion pre-tax profits US –previous losses carried forward

-Tax avoidance –files taxes in 250 jurisdictions, steers profits to low tax countries

Solution: lower corporate taxes, raise capita gains tax and tax dividends at ordinary income rate

http://www.washingtonpost.com/linksets/2010/07/06/ABk6q7D_linkset.html



24.6Treatment of International Corporate Income

multinational firms Firms that operate in multiple countries.

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



24.6Treatment of International Corporate IncomeHow to Tax International Income

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. --- used by US and most OECD countries




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. ---not taxed again




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



24.7Conclusion

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.

Taxes on Risk Taking and Wealth

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