Chapter 23 Taxes on Risk Taking and Wealth
Taxes on Risk Taking and Wealth
Chapter 23
23.1 Taxation and Risk
Taking
23.2 Capital Gains Taxation
23.3 Transfer Taxation
23.4 Property Taxation
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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Chapter 23 Taxes on Risk Taking and Wealth
Taxation and Risk Taking
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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Chapter 23 Taxes on Risk Taking and Wealth
Taxation and Risk Taking
Basic Financial Investment Model
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23 . 1
Chapter 23 Taxes on Risk Taking and Wealth
Taxation and Risk Taking
Real-World Complications
Less-Than-Full Tax Offset
tax loss offset The extent to which
taxpayers can deduct net losses on
investments from their taxable
income.
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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Chapter 23 Taxes on Risk Taking and Wealth
Taxation and Risk Taking
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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23 . 2
Chapter 23 Taxes on Risk Taking and Wealth
Capital Gains Taxation
Current Tax Treatment of Capital Gains
capital gain The difference between an asset’s
purchase price and its sale price.
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.
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23 . 2
Chapter 23 Taxes on Risk Taking and Wealth
Capital Gains Taxation
Current Tax Treatment of Capital Gains
“Step-up” of Basis at Death
basis The purchase price of an
asset, for purposes of determining
capital gains.
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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23 . 2
Chapter 23 Taxes on Risk Taking and Wealth
Capital Gains Taxation
Current Tax Treatment of Capital Gains
Capital Gains Tax Rates Through the Years
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:
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%).
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23 . 2
Chapter 23 Taxes on Risk Taking and Wealth
Capital Gains Taxation
Current Tax Treatment of Capital Gains
Capital Gains Tax Rates Through the Years
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23 . 2
Chapter 23 Taxes on Risk Taking and Wealth
Capital Gains Taxation
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:
Protection Against Inflation
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.
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23 . 2
Chapter 23 Taxes on Risk Taking and Wealth
Capital Gains Taxation
What Are the Arguments for Tax Preferences for Capital
Gains?
Evidence on Taxation and Capital Gains
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23 . 2
Chapter 23 Taxes on Risk Taking and Wealth
Capital Gains Taxation
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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23 . 3
Chapter 23 Taxes on Risk Taking and Wealth
Transfer 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.
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23 . 3
Chapter 23 Taxes on Risk Taking and Wealth
Transfer Taxation
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23 . 3
Chapter 23 Taxes on Risk Taking and Wealth
Transfer Taxation
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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23 . 3
Chapter 23 Taxes on Risk Taking and Wealth
Transfer Taxation
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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23 . 5
Chapter 23 Taxes on Risk Taking and Wealth
Conclusion
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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Chapter 23 Taxes on Risk Taking and Wealth
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Chapter 23 Taxes on Risk Taking and Wealth
Corporate Taxation
Chapter 24
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
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.
24.7 Conclusion
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Chapter 23 Taxes on Risk Taking and Wealth
Corporate Taxation
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Chapter 23 Taxes on Risk Taking and Wealth
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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24 . 1
Chapter 23 Taxes on Risk Taking and Wealth
What Are Corporations and Why Do We Tax Them?
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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Chapter 23 Taxes on Risk Taking and Wealth
 APPLICATION
Executive 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.
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.
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Chapter 23 Taxes on Risk Taking and Wealth
 APPLICATION
Executive Compensation and the Agency Problem
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24 . 1
Chapter 23 Taxes on Risk Taking and Wealth
What Are Corporations and Why Do We Tax Them?
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.
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24 . 1
Chapter 23 Taxes on Risk Taking and Wealth
What Are Corporations and Why Do We Tax Them?
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.
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24 . 1
Chapter 23 Taxes on Risk Taking and Wealth
What Are Corporations and Why Do We Tax Them?
Why Do We Have a Corporate Tax?
Pure Profits Taxation
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.
Retained Earnings
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24 . 2
Chapter 23 Taxes on Risk Taking and Wealth
The Structure of the Corporate Tax
The taxes of any corporation are:
Taxes = ([Revenues – Expenses] × τ ) – Investment tax credit
Revenues
These are the revenues the firm earns by selling goods and
services to the market.
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24 . 2
Chapter 23 Taxes on Risk Taking and Wealth
The Structure of the Corporate Tax
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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24 . 2
Chapter 23 Taxes on Risk Taking and Wealth
The Structure of the Corporate Tax
Expenses
Economic Depreciation
economic depreciation The true deterioration in the value of capital in
each period of time.
Depreciation in Practice
depreciation schedules The timetable by which an asset may be
depreciated.
expensing investments
Deducting the entire cost of the investment from taxes in the year in
which the purchase was made.
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
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Chapter 23 Taxes on Risk Taking and Wealth
 APPLICATION
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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24 . 2
Chapter 23 Taxes on Risk Taking and Wealth
The Structure of the Corporate Tax
Corporate Tax Rate
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24 . 2
Chapter 23 Taxes on Risk Taking and Wealth
The Structure of the Corporate Tax
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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24 . 3
Chapter 23 Taxes on Risk Taking and Wealth
The Incidence of the Corporate Tax
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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24 . 4
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Investment
Theoretical Analysis of Corporate Tax and Investment
Decisions
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24 . 4
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Investment
Theoretical Analysis of Corporate Tax and Investment
Decisions
The Effects of a Corporate Tax on Corporate Investment
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24 . 4
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Investment
Theoretical Analysis of Corporate Tax and Investment
Decisions
The Effects of Depreciation Allowances and the Investment
Tax Credit on Corporate Investment
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24 . 4
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Investment
Theoretical Analysis of Corporate Tax and Investment
Decisions
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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24 . 4
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Investment
Theoretical Analysis of Corporate Tax and Investment
Decisions
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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24 . 4
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Investment
Negative Effective Tax Rates
With a large enough z and ITC a, 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.
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
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Chapter 23 Taxes on Risk Taking and Wealth
 APPLICATION
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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24 . 4
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Investment
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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24 . 5
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Financing
The Impact of Taxes on Financing
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24 . 5
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Financing
Why Not All Debt?
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24 . 5
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Financing
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.
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
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Chapter 23 Taxes on Risk Taking and Wealth
 APPLICATION
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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24 . 5
Chapter 23 Taxes on Risk Taking and Wealth
The Consequences of the Corporate Tax for Financing
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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24 . 6
Chapter 23 Taxes on Risk Taking and Wealth
Treatment 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.
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24 . 6
Chapter 23 Taxes on Risk Taking and Wealth
Treatment of International Corporate Income
How 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.
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24 . 6
Chapter 23 Taxes on Risk Taking and Wealth
Treatment of International Corporate Income
How to Tax International Income
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.
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
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Chapter 23 Taxes on Risk Taking and Wealth
 APPLICATION
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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24 . 6
Chapter 23 Taxes on Risk Taking and Wealth
Treatment of International Corporate Income
How to Tax International Income
Transfer Pricing
transfer prices The amount that
one subsidiary of a corporation
reimburses another subsidiary of the
same corporation for goods
transferred between the two.
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24 . 7
Chapter 23 Taxes on Risk Taking and Wealth
Conclusion
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.
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