One of our perennial themes at The Agenda is the taxation of capital income. Recently, a number of tax reform proposals have called for taxing ordinary income and capital income at the same rate(s), e.g., the Bowles-Simpson proposal, the Bipartisan Policy Center’s Debt Reduction Task Force proposal, and the Progressive Policy Institute’s Modified Zero Plan, among many others.
A few immediate thoughts and concerns arise:
(1) The corporate income tax complicates the picture, as Josh Barro explains. As the Tax Policy Center observes:
Roughly half of all capital gains represent profits on the sale of corporate stock. However, about half of those profits are never taxed at the corporate level because of various tax breaks that benefit corporations. A lower rate of tax on capital gains appropriately offsets corporate taxes only in a minority of cases.
So while the double taxation argument is salient in some cases, it isn’t salient in all cases by any means.
(2) High capital gains taxes might create a lock-in effect. Yet TPC suggests that this might not be so pressing a concern:
A capital gains tax discourages sales of assets-the so-called lock-in effect-which may 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 hardly the final word on the matter, but it is worthy of note.
(3) One reason to equalize the tax treatment for ordinary income and capital income is that a tax preference for capital income creates an arbitrage opportunity, i.e., firms and individuals might structure investment vehicles so that ordinary income is treated as capital income.
Recently, Donald H. Taylor Jr. brought to light an alternative strategy:
The main reason that I think the many calls for corporate tax reform of ‘broadening the base while lower the rate’ are likely to fail, is that a reduction to a rate of say 20 or 25% while removing exemptions and deductions will represent a profound tax increase on corporations who now pay little or not corporate income tax. Presumably they obtained their very low effective tax rate through being effective advocates for themselves, so there is little reason to believe such a reform can withstand the political pressures inherent with such a proposal.
One item that I suggest in my book Balancing the Budget is a Progressive Priority (out in May 2012), is to go ahead and reduce the corporate income tax rate to 0%, make dividends and capital gains normal income, and to then raise the top personal marginal income tax rate. The burden would fall largely (but not wholly) on higher income persons who would accrue most such income. The share of total federal tax receipts produced by corporate taxes has been between 10 and 13% since 1980 (~2% GDP), a precipitous decline since the 1950s. The table below shows federal tax receipts by source. There is lots of evidence that it is very hard to collect a predictable amount of tax from corporations.
If we moved to a 0% rate on corporate income (or very low rate), this would have to be done in conjunction with an overhaul of the individual income tax code that prevented individuals from becoming corporations and paying themselves in ways other than salary, capital gains and dividends. However, we should be able to figure that out. And we could end the strange dance in which some decry the high corporate tax rate while many corporations pay none or a very low effective rate, and it raises a relatively small slice of federal tax receipts.
We could of course redouble efforts to collect more in the way of corporate taxes, but treating dividends and capital gains as normal income and raising the top personal income tax rate seems to me a better way on many fronts. [Emphasis added]
Assuming a shift to a progressive consumption tax — the first best strategy, in my view — is off the table, this might be a good way forward. The obvious political downside is that this kind of “tax swap” might induce sticker shock as the top personal marginal income tax rate is increased. This sticker shock could be mitigated somewhat if the elimination of tax expenditures allows for a significant lowering of rates, a strategy that poses political challenges of its own.
Viewed in the context of PPI’s Modified Zero Plan, this would imply higher rates than the 12, 22, and 28 percent personal income tax rates and the elimination of its 28 percent corporate income tax rate.