September 25, 2005
Taxing Capital Income
Posted by Victor Fleischer

The Brookings/Urban Institute conference on Taxing Capital Income was interesting on several levels.  For one thing, it reminded me that I'm not in LA anymore.  In LA, even at the tax powerhouse of UCLA, I might expect a conference like this to attract a dozen people, excluding panelists.  So I show up at Brookings at 9 am Friday, expecting a front-row seat.  Instead, the room is packed with 100 policy wonks.  DC is an Industry town, but it's certainly not the same industry as la-la land.

The biggest surprise for me was discovering that perhaps 70-80% of the room, or more, favored an income tax over a consumption tax.  This surprised me, as I would guess that a solid majority of economics-minded tax academics favor a consumption tax (perhaps coupled with an estate tax or wealth tax on the uber-rich).  When it comes to folks from the IRS, Treasury, and practice, though, most favor trying the fix the devil we know rather than try something new. 

More below the fold for those who are interested.  Go on.  Try it. 

Let me back up.  David Weisbach called the case for the consumption tax "overwhelming."  I wouldn't go that far, but it's pretty strong.  The income tax system, as it turns out, doesn't do a very good job of taxing capital income.  Because the tax system usually allows you to take losses to offset gains, it doesn't really tax the return to risk.  (The government shares in your gains, but it also shares in your losses.) 

When it comes to investments, then, the income tax mainly taxes the risk-free rate of return, which is quite low, perhaps trivial.  (Reed Shuldiner pointed out that it's actually not as trivial as we thought, but is probably more like 2-3%.  The income tax also catches extraordinary returns like those from entrepreneurial activity and monopoly rents.  This may or may not be a good thing to catch.)  The status quo is arguably the worst of all worlds.  Our income tax is mostly a de facto wage tax; to the extent that we tax capital income we do so in a terribly ineffective and wasteful manner.  If we can manage to crack the problem of transition relief, a progressive consumption tax seems like the better option.  The big surprise of the day, then, was hearing numerous questions and comments in opposition to this notion.  (My favorite was from an older gentleman who pointed out that older American would like a shift to a consumption tax about as much as they would like to lose their social security benefits, "and WE vote," he said pointedly.  And we all know how that social security reform thing is going.  The guy had a point.)

James Poterba asked what I hope was a telling question.  One problem with the consumption tax is transition relief.  For example, if we wipe out everyone's basis, people who have bought assets recently will be unhappy.  (After all, they will be disadvantaged vis-a-vis people who buy assets under a consumption tax system, who would get an immediate deduction.)  Another problem with a consumption tax is distributional.  People with extremely high incomes (think Bill Gates) will not be taxed at a very high rate, since they consume about the same amount as the merely very rich.  Poterba asked the brilliant question -- do these two problems cancel each other out?  In other words, (and I am paraphrasing, obviously) if a lack of transition relief mainly screws the super-rich, do we care? 

Poterba is on the tax reform commission, and it would be a glorious day for tax academics if they propose a move to a consumption tax.  I am already outlining in my head a paper on the impact of a consumption tax on the venture capital industry. 

Whether a shift to a consumption tax would be good for America is a different question.  Unfortunately, a shift to a consumption tax could also prove to be a field day for tax planners, not just academics.  Michael Schler (Cravath) talked about a few simple ways to abuse the new system, and he pointed out that the really scary holes are the ones we haven't thought of yet.  I have a hard time imagining that the consumption tax would be administratively worse, in the long run, than the income tax.  After all, consumption is easier to measure than income.  But Schler is certainly right that the first couple of years would need more design and enforcement resources than we currently have, and would demand a political will to keep the consumption tax "clean" --- a political will we were unable to maintain following the 86 Act.  And, as Schler point out, certain difficult distinctions not only remain under the consumption tax, they get worse, such as the distinction between consumption and investment.  Perhaps there's a Conservation of Tax Planning principle here ... the amount of wasteful tax planning remains constant under all tax systems?  I don't believe that to be true, but I am starting to wonder if some of the social welfare gains we expect from a shift to a consumption tax may be illusory. 

I find it hard to walk out of a good conference without two or three new paper ideas.  This conference was no exception.  They won't all get written up as Tax Law Review articles, of course, but they may get blogged about.  Stay tuned.

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