This nation soon must address the large gap between its spending and tax collections. Deficits are at an all-time high amid low unemployment. Because programs like Social Security and many health programs grow faster than the economy, that unsustainable rate of growth must be reined in.
However, it is highly doubtful that the public would accept reform that focuses only on spending. Many analysts believe reform will include not only higher taxes, but higher taxes on owners of capital. Why? Capital income comprises a large share of the income of the rich, and their share of market income and of wealth has increased considerably over recent decades. The math of budget reform makes it difficult to rely solely on middle-income households, whether through spending cuts or tax increases. And because low-income households command such a small share of the nation’s resources, asking more of them would do little to close the gap.
My concern here is over what is the most efficient way to tax capital income?
Uniform taxation of capital income can improve economic efficiency
A basic lesson of public finance is that taxation is generally most efficient when effective tax rates on capital income are uniform across organizational forms and income sources. “Effective tax rate” refers to the total tax imposed at both the business and owner levels. Uniformity suggests, for example, that the tax rate on income allocated to a wealthy partner should roughly equal the combined corporate and shareholder tax rate on comparable corporate income.
Uniformity has benefits. When an owner expects different tax rates depending on how they earn capital income, they’ll have reason to seek tax shelters, delay realizing capital gains, borrow excessively because debt and equity are taxed differently, shift profits to tax havens, or choose one business form over another. More equal taxation of all sources of capital income limits these costly tax-sheltering games.
Effective tax rate differences also distort investment, drawing funds to a firm even when its marginal investments are less productive than those of less favored businesses. Beneficial tax treatment for interest debt encourages investment in unproductive assets. Resulting capital misallocations can be severe, especially during inflation, and contribute to a stagnating economy.
Reducing these behaviors can enhance investment and improve the economy’s productivity and growth. More uniform taxation of capital income also advances horizontal equity (or equal justice) by treating similarly situated taxpayers more alike. While policymakers may choose to encourage activities such as charitable giving or discourage activities such as pollution, those interventions should be aimed at the specific public purpose involved and designed to minimize unnecessary differences in the taxation of capital income.
Budget reform requires more than taxing the rich
In their recent Tax Vox post, TPC affiliated scholar Zachary Liscow and Edward G. Fox note that the primary legal tax-avoidance strategy available to the rich is recognizing only small shares of their capital income. Borrowing, rather than selling assets, to finance their consumption can add to that avoidance, but the rich consume such small portions of their income that many don’t need to borrow to finance consumption.
Will McBride of the Tax Foundation has separately argued that even substantial tax increases will not solve our debt problems. Among other reasons, tax avoidance opportunities, particularly for capital income, will reduce what Treasury would otherwise collect.
Other coauthors and I have reached similar conclusions. One study comparing estate and income tax returns found that the rich report only a small share of their income.
Taxing accrued gains at death provides one key to achieving more uniform taxation
It would be a mistake, however, to conclude that nothing can be done about taxing the rich or their capital income. Applying efficiency and equal justice principles and equalizing tax rates across sources of capital income could give Congress a way to tax the rich more efficiently as part of budget reform.
Both the Fox-Liscow and McBride articles identify tax law’s forgiveness at death of previously accrued capital gains as central. Much of the wealth accumulated by the rich consists of these untaxed gains.
If Congress taxed accrued but unrealized gains at death, the tax preference would shift from an exclusion to a deferral. Borrowing to finance consumption, rather than selling assets, would become less attractive.
McBride notes that tax sheltering will expand as tax rates rise, limiting the effectiveness of tax increases. But if the primary shelter is holding assets with accrued value until death, taxing those gains at death would greatly reduce the opportunity to avoid tax on capital income during life.
The efficiency and equal-justice benefits apply regardless of the ultimate tax rate. Investors would be more willing to recognize gains during life, diversify, and reduce portfolio risk. Less money would go to the tax shelter industry. Owners of houses and land with significant accrued gains would be more willing to sell during life, opening up real estate markets.
As the original organizer and economic coordinator of the Treasury’s last major tax reform study more than 40 years ago, I saw how applying the efficiency principle across dozens of capital-income provisions helped secure bipartisan support for the Tax Reform Act of 1986.
Major budget reform requires that level of sustained effort. Raising rates without reducing disparities and shelters would collect less revenue, impose greater economic costs, make it more difficult to achieve sustainability, and generate greater opposition by those concerned with issues of equal justice.
