Donald H. Taylor Jr. taxation of capital income

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One of our eternal themes at Agenda is the taxation of capital income. Recently, a number of tax reform proposals have called for ordinary income and capital income to be taxed at the same rate(s), e.g. the Bowles-Simpson proposal, the Tax Reduction Task Force proposal the Bipartisan Policy Center’s Debt and the Progressive Policy Institute’s Modified Zero Proposition. Plan, among many others.

A few immediate thoughts and concerns arise:

(1) Corporate tax complicates the picture, as Josh Barro explains. As the Tax Policy Center observes:

About half of all capital gains represent profits on the sale of company shares. However, about half of these profits are never taxed at the corporate level due to various tax breaks enjoyed by corporations. A lower capital gains tax rate only adequately offsets corporate tax in a minority of cases.

Thus, although the argument of double taxation is salient in some cases, it is by no means so in all cases.

(2) High capital gains taxes could create a lock-in effect. Still, TPC suggests it may not be such a pressing concern:

A capital gains tax discourages asset sales – the so-called lock-in effect – which can be inefficient. However, a 1994 study found that this effect was very small for permanent changes in capital gains tax rates (but not for temporary changes).

This is not the last word on the matter, but it should be noted.

(3) One of the reasons for equalizing the tax treatment of ordinary income and capital income is that a tax preference for capital income creates an arbitrage opportunity, i.e. companies and individuals could structure investment vehicles so that ordinary income is treated as capital income.

Recently, Donald H. Taylor Jr. highlighted an alternative strategy:

The main reason I think the many calls for corporate tax reform to “broaden the base while lowering the rate” are likely to fail is that a reduction to a rate of 20 or 25%, while removing exemptions and deductions, will represent a profound tax increase on corporations which now pay little or no corporation tax. Presumably, they got their very low effective tax rate by being effective advocates for themselves, so there is little reason to believe that such reform could withstand the political pressures inherent in such a proposal.

An article that I suggest in my book Balancing the budget is a progressive priority (released May 2012), is to go ahead and reduce the corporate tax rate to 0%, make dividends and capital gains normal income, and then increase the rate of highest marginal personal income tax. The burden would fall largely (but not entirely) on high earners who would accrue most of that income. The share of total federal tax revenue generated by corporate taxes has been between 10 and 13% since 1980 (~2% of GDP), a steep decline since the 1950s. The table below presents federal tax revenue by source. There is plenty of evidence to show that it is very difficult to collect a predictable amount of tax from corporations.

Moving to a 0% rate on corporate income (or very low rate) would have to be done in conjunction with an overhaul of the personal income tax code that prevented individuals from becoming companies and to be remunerated other than by salary, capital gains and dividends. However, we should be able to figure this out. And we could end the strange dance in which some are decrying the high corporate tax rate while many corporations pay none or a very low effective rate, and that only generates a relatively small share of the federal tax revenue.

We could of course work harder to collect more corporate taxes, but treating dividends and capital gains as normal income and raising the top personal income tax rate seems to me a better solution in many ways. [Emphasis added]

Assuming that a move to a progressive consumption tax — the first best strategy, in my opinion — is not an option, this could be a good way to go. The obvious political downside is that this type of “tax swap” could induce sticker shock as the top marginal personal income tax rate is increased. This sticker shock could be somewhat mitigated if the removal of tax expenditures allowed for a significant drop in rates, a strategy which itself poses political challenges.

In the context of PPI’s modified zero plan, this would involve rates higher than the personal income tax rates of 12, 22 and 28% and the elimination of its corporate income tax rate from 28%.

Reihan Salam is president of the Manhattan Institute and a contributing editor to National exam.

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