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
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
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. ---bank accounts
taxation on realization Taxes
paid on an asset’s return only
when that asset is sold.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
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. –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.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
Capital Gains Taxation
Current Tax Treatment of Capital Gains
Capital Gains Tax Rates through the Years
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
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: to protect asset owners against
the effects of inflation; to improve the efficiency of capital markets; and to
promote entrepreneurship.
Protection against Inflation
Because 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.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
Capital Gains Taxation
What Are the Arguments for Tax Preferences for
Capital Gains?
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
Capital Gains Taxation
What Are the Arguments for Tax Preferences for
Capital Gains?
Evidence on Taxation and Capital Gains
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.2
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:
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
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.3
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. ---Only if >$3.5 million
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.3
Transfer Taxation
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.3
Transfer Taxation
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.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.3
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
It is morally inappropriate to tax individuals upon their death.
The Estate Tax Amounts to Double Taxation
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.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23.5
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
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
Corporate Taxation
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
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CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE
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CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
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
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.1
What Are Corporations and Why Do We Tax Them?
shareholders Individuals who
have purchased ownership stakes
in a company.
Ownership vs. 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
24.1
What Are Corporations and Why Do We Tax Them?

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.
Continued...
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.1
What Are Corporations and Why Do We Tax Them?

APPLICATION
Executive Compensation and the Agency Problem
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.

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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.1
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.1
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.1
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
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.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.2
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.2
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.2
The Structure of the Corporate Tax
Expenses
Economic Depreciation
economic depreciation The
true deterioration in the value of
capital in each period of time.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.2
The Structure of the Corporate Tax
Expenses
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.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.2
The Structure of the Corporate Tax

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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.2
The Structure of the Corporate Tax
Corporate Tax Rate
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.2
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.4
The Consequences of the Corporate Tax for Investment
Theoretical Analysis of Corporate Tax
and Investment Decisions
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.4
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.4
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.4
The Consequences of the Corporate Tax for Investment

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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.4
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.5
The Consequences of the Corporate Tax for Financing
The Impact of Taxes on Financing
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.5
The Consequences of the Corporate Tax for Financing
Why Not All Debt?
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.5
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):
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.
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
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
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.6
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.6
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. --used by US and most OECD countries
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.6
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. ---not
taxed again
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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.6
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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CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
24.7
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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