Capital income taxes.

• Author: Gordon, Roger H.
• Position: Research Summaries

In public economics the conventional wisdom has been that taxes on capital income generate high efficiency costs with few offsetting benefits. (1) Average tax rates on the return to capital are measured to be very high, (2) as are marginal tax rates on savings and investment. (3) There is a large body of research indicating that these high capital taxes have important effects on the rate of corporate investment, on the allocation of capital across uses, on whether profits are reported in the United States or offshore, and on corporate and personal financial decisions. (4)

Consistent with these forecasts of very high efficiency costs, Slemrod and I find that tax revenue would have been virtually unchanged if the United States had shifted in 1983 to an R-base under the personal and corporate income tax, thereby exempting capital income from tax. (5) Thus, adjustments that taxpayers made to reduce their tax liabilities were extensive enough to wipe out all tax revenue from taxes on capital income.

Are there any obvious distributional benefits that compensate for these high efficiency costs? At least in a small open economy, the answer is no. (6) Capital can easily escape taxation by going abroad, so that domestic workers, rather than capital, end up bearing taxes imposed on capital. Even if the economy is closed, Atkinson and Stiglitz argued, there are no distributional gains from taxing the return to savings as long as utility functions are weakly separable between leisure and consumption."

Using data from 1983, Slemrod and I examined the distribution of gains and losses to individuals that would result from shifting to an R-base. We found that the existing U. S. tax system, relative to an R-base, imposed higher taxes on lower-income investors, who largely invest in taxable bonds, while imposing lower taxes on higher-income investors, who borrow heavily to buy more lightly taxed assets. These results suggest that the existing tax treatment of capital income has perverse distributional effects.

Thus, capital income taxes have large efficiency costs, collect little revenue, and have no obvious distributional gains. So, the case for using them appears to be very weak. Yet actual tax rates on capital income remain high, implying a sharp contrast between theory and practice. A major focus of my research during the last few years has been to look more closely at these above arguments, to see if there are important omissions from the theory that could call into question its implications for capital income taxes.

Capital Immobility

One questionable assumption of the standard model is that the United States is a small open economy. As documented by French and Poterba (8), individual portfolios show strong "home bias:" investors invest far more in financial securities from their own countries than can be explained easily, given the standard forecast of worldwide portfolio diversification. However, the implications of capital immobility for tax policy depend on why capital is immobile.

One possible reason for home bias in portfolios is real exchange rate risk. Gaspar and I examine the implications of random fluctuations in the relative values of goods produced in different countries for both portfolio choice and tax policy. (9) If random relative values of goods are reflected in random fluctuations of the domestic price level but stable exchange rates, then the model forecasts substantial home bias in equity portfolios, as a hedge against random consumer prices. But since domestic investors buy equity as a hedge, they end up bearing too much production risk from domestic firms. Capital taxes exacerbate this misallocation of risk-bearing. The fact that capital is immobile does not make taxation of capital income a plausible policy per se.

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