Posts by:
Chris Sanchirico
Chris Sanchirico, Samuel A. Blank Professor of Law, Business, and Public Policy at the University of Pennsylvania. Chris has a law degree and a Ph.D. in economics, both from Yale University. In graduate school, his fields of study were mathematical economics and public finance. At Penn Law School, he teaches Federal Income Tax, Taxation of Business Entities, International Taxation, and Tax Policy. Before moving to Penn, Chris taught in the economics department at Columbia University and the University of Virginia School of Law. Chris’s research focuses on a variety of issues in tax policy using a diverse array of methodologies.
“Common Sense” Aside, What Do We Really Know About Capital Income Taxes and Growth?
March 15th, 2013If you’re discussing tax policy with someone who asserts that his or her point is “just common sense,” this could indicate one of two things: Either no deep thought is required—as the person would have you believe. Or no deep thought has been applied.
The “common sense” notion that capital income taxes hinder growth seems to be more a case of the latter.
Long term capital gains are taxed only when the asset is sold and at roughly half the rate on wages and salaries. Dare to suggest that the rate on investment profits could be raised a bit—so that perhaps the rate on labor income could lowered—and you’re liable to be reprimanded for failing to understand something as plain as the nose on your face: To tax capital income is to tax the reward for saving and thus to discourage saving. Less saving means less investment and less investment means slower growth, fewer jobs, and lower wages.
Everyone knows that.
Everyone, that is, except the people who study the issue.
Economic theory teaches that the impact of capital income taxes on savings is robustly ambiguous. Empirical research has yielded mixed results, but overall the data seem to indicate that reducing capital income taxes decreases rather than increases savings. In addition, lowering capital income taxes is likely to go hand in hand with raising labor income taxes or government borrowing, both of which are arguably at least as harmful to growth as capital income taxation.
I step through these points in a recent Wharton policy brief. Here’s a brief of the brief:
Notwithstanding the common sense story that taxing the reward for saving reduces it, the effect of capital income taxes on savings is theoretically indeterminate. There are several sources of indeterminacy. Here is one:
Suppose that you’re putting money away for retirement and Congress increases taxes on what you earn from that savings. There are two countervailing effects on how much you save. First, every future dollar of retirement consumption now requires additional savings—to pay the additional future tax. Second, you’ll probably plan to spend fewer future dollars on retirement consumption—because it’s become in effect more expensive. Whether, in the end, you save more or less depends on whether the first effect is greater or less than the second.
What then do the data say? Econometricians have taken several different approaches, and findings vary. On balance, however, the empirical literature seems to lend greater support to the view that capital income taxes increase rather than decrease savings.
Some of the best empirical research, for example, focuses on estimating a key parameter of individual choice called the “intertemporal elasticity of substitution”. Applied to the retirement savings story told above, the bulk of estimates for this parameter support the conclusion that the first effect dominates, and retirement savings increase in response to greater capital income taxation.
But even if one could support the claim that capital income taxes—considered in isolation—hinder growth, that would not be enough. Capital income taxes aren’t set in a vacuum. Lower capital income taxes mean higher labor income taxes or additional government borrowing. (Yes, capital income tax reductions could be offset with spending cuts. But that just begs the question of why such cuts aren’t instead being used to reduce labor income taxes or borrowing .) Thus, to make the case against capital income taxes, one has to argue not just that such taxes hinder growth, but that they hinder growth more than labor income taxes and government borrowing.
That’s not an easy task.
Government borrowing is generally thought to crowd out private investment. CBO, for example, posits that each dollar of government borrowing reduces domestic investment by anywhere from 10 to 50 cents.
And although existing research is not definitive, there are valid reasons to believe that labor income taxes are at least as likely to reduce savings as capital income taxes. Consider, for example, that in the retirement savings story, labor income taxes have only the second, savings-reducing effect. Like capital income taxes, they reduce planned future consumption by making it more expensive (in this case, in terms of “leisure”). Unlike capital income taxes, however, they do not increase the number of current dollars that must be saved per dollar of future consumption.
In short, trying to spur growth by keeping capital income taxes low seems—at best—like trying to fix one side of the roof with shingles from the other.
Camp’s Investment Tax Plan: Implications for Lower Rates on Capital Gains?
January 30th, 2013House Ways and Means Committee Chairman Dave Camp (R-MI) has proposed requiring most derivatives investors to pay tax on their annual returns even if they don’t realize their gains by selling their securities. This proposal, which requires investors to mark-to-market the value of financial derivatives, has ramifications far beyond the heady world of high-tech finance. It implicitly challenges our most basic and firmly held beliefs about why we tax investment gains the way we do.
Camp’s plan raises two key questions: First, should mark-to-market be required for all investment assets, not just derivatives? Second, does his proposal fracture one of the main justifications for taxing long term capital gains at roughly half the rate on ordinary income?
Ask most tax experts why, in a nutshell, rates should be lower for capital gains, and you’re liable to get a mini-lesson on the “lock-in effect.” There’ll be other reasons too. But the lock-in effect is going to be pulling some serious weight.
What the lock-in effect is and how it relates to mark-to-market—and why Camp’s proposal calls it into serious question—is best explained by way of analogy.
Imagine you’re a law professor, and your student comes to you with a note from the Dean saying that he should be allowed to take as much time as he needs on your upcoming exam. You shake your head, but decide it’s not worth bothering the Dean. The next day the student returns to your office to argue that his exam should also be graded more leniently. After all, given that he has as long as he likes on the exam, he’ll be temped to work on it an inordinate amount of time to the detriment of his other classes—unless, that is, he knows that he’ll get a decent grade in any event.
You’re astounded by the student’s audacity. Think of it: arguing that one problematic advantage, dubiously secured, deserves another. Rather than agreeing to grade more leniently, you resolve to call the Dean to question why the student is getting extra time in the first place. (And you make a note to hire the student should you ever need legal help.)
The “lock-in” argument has the same basic structure as the student’s argument for lenient grading.
Start with the fact that investors “get as much time as they need” to pay tax on their accrued gains. Investment gains are taxed, not as they accrue, but only when they are “realized”—by, for example, selling the asset. This is a tax advantage because the unpaid tax stays on the taxpayer’s balance sheet and continues to earn income.
The lock-in argument then comes back for more: given that gains aren’t taxed until realized, it says, realized gains should be taxed at lower rates. Because investors can delay the tax until they sell the asset, they’ll be tempted to delay selling for an inordinate amount of time. That’s inefficient because better investments might crop up in the meantime. Keeping rates low reduces this tax-borne inertia.
Might it not be time to “call the Dean” about taxing only upon realization? Camp’s proposal—though it applies only to derivatives—is a strong prod to pick up the phone.
Proponents of the lock-in argument offer two main reasons to take the realization advantage as given. Camp’s proposal implicitly challenges both.
First, they say it’s just too hard to determine the market value of investments at year-end. That argument has always been suspect when it comes to publicly-traded securities for which prices are readily available with the click of a mouse.
But Camp now calls for marking to market derivatives whose underlying asset values are neither widely published nor even publicly traded. A derivative is merely a financial instrument, like an option or forward contract, whose value is tied to some underlying asset. One has to wonder: If it’s feasible to value the derivative, how can it not be feasible to value the underlying asset to which the derivative’s price is linked?
Second, proponents of the lock-in argument raise the specter of inconsistent treatment across assets. Sure, they say, some assets, like publicly traded stock, are easily valued and can be precisely marked-to-market. But others, like uniquely situated land, cannot be. Won’t that distort investment decisions and open up tax arbitrage opportunities?
In the context of a tax code full of partway measures, this too has always been a dubious argument. But it is even more suspect in light of Camp’s proposal.
He’d mark-to-market most derivatives but none of the assets from which they are derived. If disparate tax treatment distorts investment decisions between land and stock, would it not distort investment decisions between derivatives and their underlying assets? If tax arbitrage is a danger between stock and land, surely it is a danger between a derivative and its underlying assets. The arbitrage seems readymade.
Camp’s proposal is more than food for thought regarding derivatives. It’s a four-course meal for fundamentally rethinking how we tax investment gains.
New Ways to Think About a Tax on Public Companies
December 30th, 2012Suppose someone proposed a special tax on businesses that make their ownership shares publicly available in affordable, easy-to-sell units. Such an idea would probably generate a lot of push-back. Efficiency advocates might complain that it taxed the very attributes that make equity markets efficient. Progressivity advocates might object on the grounds that it taxed those who have no alternative to publicly available investment opportunities.
In fact we already have such a tax. We call it the corporate income tax.
In what sense is the corporate tax a special levy on being publicly traded? And what do we know about the policy implications of such a charge?
Corporate earnings are taxed twice: First at the corporate level, then again as dividends when they are distributed to shareholders or as capital gains when those investors sell their shares.
But not all businesses are double taxed in this manner. The earnings of certain businesses—commonly referred to as “pass-through entities”—are taxed only once, at the individual level.
At one time, businesses that wished to be taxed as pass-throughs had to give up certain legal benefits of the corporate form, including the concept of “limited liability” that bars creditors from going after the owner’s personal assets. Alternatively, they had to qualify as special “Subchapter S corporations,” which strictly limited their ownership structure.
Now, businesses have available to them alternative forms that replicate many of the legal benefits of the corporation, impose none of the requirements of Subchapter S, and yet avoid corporate tax. Limited liability companies and limited liability partnerships are two prominent examples. According to the Congressional Budget Office, the share of business receipts generated by these pass-through entities has more than doubled since 1980.
But there is still one circumstance in which a business cannot avoid the double tax. No matter its legal form, a firm is taxed as if it is a corporation if its ownership interests are publicly traded. (Entities whose earnings consist almost entirely of “passive type income” are exempt from this rule.) A firm meets Treasury’s definition of “publicly traded” if it is listed on an established exchange or otherwise makes its ownership rights publicly available in affordably small, readily salable units.
CBO reports that more than three-fifths of all business receipts are still earned by corporations. It is likely that many have not converted to pass-throughs because, wishing to remain publicly traded, there is no benefit to doing so.
Thus, the corporate tax is a tax on being publicly traded in the following sense: there is no real reason for a business to pay it unless that business is publicly traded.
Understood in this way, the corporate income tax would appear to have important implications for the progressivity and efficiency of the tax code. But those consequences are largely unstudied.
Consider, for instance, progressivity. One hypothesis worth considering is that the existing corporate tax is more regressive than a general tax on business investment because the corporate tax is borne more heavily by those who have no alternative to publicly available investment opportunities.
Unfortunately, existing research on who pays the corporate tax has little to say about hypotheses of this kind. That literature, which has been nicely summarized by my Tax Policy Center colleague Jim Nunns, has been primarily concerned with how the market shifts the corporate tax burden away from its original legal placement—for example, onto workers as lower wages.
But the literature makes counterfactual assumptions regarding the place from which the burden is shifted. The central economic model assumes that certain goods must be produced in corporate form, and that—for at least some consumers—such corporate-specific goods have no close substitutes. This is what gives the corporate tax its bite in the model.
But what really gives the corporate tax its bite is that it is effectively a fee on being publicly traded, and that—for at least some businesses and investors—publicly traded ownership has no close substitute.
While the original legal placement of a tax burden is not the whole story, it is part of what determines who bears the ultimate economic burden. In recent years, we have learned a great deal about how statutory burdens translate into economic burdens. The next big challenge for students of corporate tax incidence will be to apply those lessons to the actual statutory burden that is the modern corporate income tax.