Capital Income Taxation, Corporate
Taxation, Wealth Transfer Taxes
and Consumption Tax Reforms
Discussion
Many decisions affected by
taxation of capital income
Savings
 Portfolio choice (tax arbitrage)
 Income shifting between tax bases
 International issues
 Consequences of a shift to consumption
taxes

Taxes and savings

Efficiency implications seem small
 Risk-free
interest rate close to zero, so little
effects of behavioral responses on tax
revenue:
 Size of behavioral response modest
Lifecycle model forecasts large responses to
taxes,
 But precautionary-savings model and behavioral
anomalies forecast much smaller effects.

Taxes and portfolio choice

Huge variation in personal tax treatment of
different forms of savings:
 Nominal
income fully taxable: interest income
 Real income fully taxable: non-corporate real
capital
 Reduced tax rate: dividends, capital gains
 Tax exempt: muni’s, implicit rent from O-O
housing, human capital, assets held in TEE
pension plans
 Subsidized: Assets held in EET pension plans
Resulting tax arbitrage

Common form for this arbitrage
 Those
in high brackets borrow to buy more
lightly taxed assets
 Tax exempt funds and low-bracket investors
buy these bond issues

Potential efficiency costs very large, as
emphasized in Stiglitz (1985)
Resulting role for the corporate
tax
Tax used to lessen distortion favoring
corporate over non-corporate investments
under the personal tax
*
t
 t  (1  t )e  m ,
 To avoid distortions, need
where t is the corporate tax rate, e
captures any personal taxes on corporate
income, while m is the statutory personal
tax rate on non-corporate earnings

Remaining distortions still large

Huge variation in t across firms, and in m
across investors, leaving many distortions
 Choice
of organizational form
 Choice of debt vs. equity finance
 Transactions between corporate and noncorporate firms, e.g. equipment leasing or oildrilling tax shelters
Efficiency and equity
implications of tax arbitrage

Gordon and Slemrod (1998,2004) find on net that little
or no revenue is collected from existing taxes on
capital income, implying large efficiency costs of these
taxes




Drop interest, dividends, and capital gains from tax base
Replaces depreciation with expensing for new investments
Existing taxes on capital income appear to benefit
those in very high tax brackets
As a result, existing taxes on capital income seem
unappealing on both efficiency and equity grounds
Income shifting between tax
bases



Income shifting between personal and corporate tax
bases affects tax treatment of labor income as well as
capital income
By retaining entrepreneurial profits within a
corporation, these earnings are taxed at t* rather than
at rate m. Similar tax benefits for equity compensation
of workers in closely-held corporations
Corporate tax is then a backstop as well for the
personal tax on labor income, leaving a tax rate equal
to min(t*,m), as argued in Feldstein and Slemrod
(1980)
Evidence for such income
shifting

Observed responses to the Tax Reform
Act of 1986
 Major
shift from C corporate to S corporate
status
 Aggregate partnership income shifted from a
large tax loss to a large tax profit

Broader evidence in Gordon and Slemrod
(2002)
Implications of income shifting
for tax policy
Pressure to set t* close to the top m
 Suggests large potential efficiency costs
from a reduction in t to 28%, given a top
rate for m of 39.6%

International issues
Investments abroad favored over
investments at home under domestic tax
code: No domestic corporate taxes on
FPI, and deferral of corporate tax for FDI
 Neutral taxation would require domestic
corporate taxes at accrual on all shares
owned by domestic investors. Of course,
many barriers to doing this.

International issues



With income shifting in addition, large
opportunities for tax avoidance by
multinationals on domestic as well as foreignsource income
Tax distortions yet larger due to expectation
of future tax holidays at repatriation
Would have even larger distortions favoring
multinationals under a territorial tax system
International issues
Deferral per se, though, of no benefit when
savings not taxable, assuming stable tax
rates at repatriation. Simply equivalent to
tax treatment of pension vs. wage income.
 Current tax rules then yield neutrality of
tax on labor income if there are no net
taxes on savings

Advantages of consumption
rather than income taxes


With a consumption tax, no threat of
avoidance of taxes on labor income through
shifting income abroad, or shifting income
between personal and corporate tax bases.
No opportunities for tax arbitrage.
Various forms of a consumption tax:
 VAT
 EET
base under the personal tax for all forms of
savings where income shifting possible
Other implications of a shift to a
consumption tax



The corporate tax serves as a backstop for
personal taxes on income.
No need for such a backstop under a
consumption tax (EET) base for the personal
tax
Tax on repatriation of foreign-source income
also no longer needed to protect a
consumption tax (EET) base.
Conclusions
Existing tax treatment of savings seems
both inefficient and inequitable,
encouraging tax arbitrage by those in high
brackets and facilitating avoidance of tax
on labor income
 A shift to a consumption tax base can
alleviate these problems, and allow for a
variety of other attractive tax reforms
