The Right Tax at the Right Time.

AuthorKleinbard, Edward D.
  1. Introduction 211 A. From Theory to Practice 211 B. Capital Income Is the Issue 215 1. Capital Income Taxation in Theory 215 2. Capital and Labor Income Taxation in Practice 220 C. Structural Obstacles to a Functioning Capital Income Tax 227 D. Criteria for Measuring the Success of a Capital Income Tax 232 1. An Annual Flat Rate Tax 232 2. Applied Consistently and Comprehensively 233 3. A Feasible Labor-Capital Income Centrifuge 234 4. A Featureless Tax Topography 234 5. Resistant to Base Meddling 236 6. Extensible to All Financial Instruments 237 7. Minimal Recordkeeping and Coordination Requirements 237 8. Clear Constitutional and Treaty Compliance 238 II. Key Features of the Dual BEIT 239 A. High Level Overview 239 1. Introduction to the Dual BEIT 239 2. The "Dual" in Dual BEIT 243 3. Operationalizing the Dual BEIT 245 4. More on Firm-Level Computations 253 5. More on Investor Income Inclusions 254 B. Tax Rates and Revenues 259 C. Transition from Current Law to the Dual BEIT 263 III. What Is a Normal Return, Anyway? 267 A. Role of COCA Rate 267 B. Normal Returns Are Not Necessarily Riskless Returns 273 C. Application to the COCA Rate 277 IV. The Labor-Capital Income Centrifuge 283 A. Version 1.0 283 B. Version 2.0 287 C. Special Rules to Reward (or Tax) Entrepreneurs 298 V. Superconsolidation and Its Implications 299 A. Consolidated Tax Returns vs. Superconsolidation 300 B. The Dual BEIT in International Application: A Residence-Based Tax 308 VI. Drilling Down on the Dual BEIT's Mechanics 323 A. Firm-Level Computations 323 1. Coordination between COCA and Asset Depreciation Rules 323 2. Business Enterprise Portfolio Investments in Another Business Enterprise 325 3. Mutual Funds and Personal Holding Companies 325 4. Rents and Royalties 327 5. Business Losses 328 B. Investor Taxation of Normal Returns 328 1. The Special Problem of Investor Losses 328 2. Tax-Exempt Investors 330 3. Inflation 332 C. Special Industries and Circumstances 332 1. Financial Institutions and Products 332 2. Non-Business Capital Income 335 VII. Evaluating the Dual BEIT 337 A. In General 337 B. Efficiency Considerations 339 C. Incidence 342 VIII. Competing Solutions 344 A. Wealth and Bequest Taxes 345 B. Alternative Income Tax Proposals 349 1. Pass-Through Models 349 2. Entity-Driven Tax Models 350 3. Mark-to-Market Models 354 C. A Novel Alternative: The Destination-Based Cash Flow Tax 360 1. In General 360 2. Border Adjustments 366 3. Destination-Based Tax or Superconsolidated Residence Tax? 372 IX. Conclusion 374 X. Appendix 377 I. Introduction

    1. From Theory to Practice

      A companion paper (Capital Taxation in an Age of Inequality (1)) argues that a relatively low flat rate tax on business capital income, measured and collected annually, is a desirable instrument for U.S. federal fiscal policy, and in practical application dominates progressive consumption tax proposals. Economic theory does not proscribe taxing capital income, once real-world considerations like the importance of gratuitous transfers of capital are considered. Further, political economy considerations strongly support using a well-designed capital income tax as an important constituent fiscal policy instrument, both to raise substantial revenues and as a targeted inequality remediation device.

      Capital Taxation in an Age of Inequality explains the desirability of imposing a flat rate tax on all instances of business capital income, measured and collected annually. As a proportional tax, a flat rate capital income tax applies at the same marginal and effective rates to both ex post income and ex post losses, thereby preserving the symmetry on which rests the theoretical analysis of returns to risk. This is an essential feature if the resulting tax is not to distort ex ante investment decisions. In particular, the theory of why a cash flow tax operates to exempt normal returns from tax is that the expensing of investment makes the government an undivided proportional co-investor in that investment: a progressive tax structure destroys that neutral co-investment ex post and therefore burdens investment decisions ex ante.

      As a political economy matter, a flat rate capital income tax measured and collected annually operates as a progressive tax in application: because only high-ability taxpayers or those who are the beneficiaries of gratuitous transfers can afford indefinite deferral of consumption, the increasing "tax wedge" on savings over time introduces a measure of top bracket progressivity along the margin of time. In other words, what many economists view as the fatal flaw of capital income taxation (the increasing tax wedge over time) in fact is a feature, not a bug. A low flat capital income rate actually imposed annually may thus offer some efficiency gains when compared with an "ideal" progressive consumption tax strawman, while still being progressive in fact.

      An annual capital income tax fits with American Constitutional constraints that would bedevil an annual wealth tax. Further, it is more robust to legislative panic (or pandering) in the face of recessions or other developments than is any system (including the estate tax) that relies on collecting tax decades in arrears. The 2004 tax holiday for "repatriating" offshore, low-taxed earnings held by foreign subsidiaries of U.S. multinational firms demonstrates the fragility of any taxing scheme that allows inchoate tax liabilities to accrue over an extended time period; (2) like a reservoir behind a dam, all those contingent tax revenues can be flooded away in a single breach of the system.

      While the case for a higher tax rate on economic rents is easy to make in theory, Capital Taxation in an Age of Inequality demonstrates that it is difficult to implement in practice, particularly when one remembers that firms and investors in those firms make investment decisions at different points in time. For example, a firm might capture economic rents through the extension of its market-dominant core intangibles, but to a late-arriving investor in the firm's stock, those firm-level rents would be priced as normal returns. (3)

      The corporate income tax today is a flat rate tax in practice. (4) A flat rate tax on business capital income therefore operates as an incremental extension of current tax policies and, thus, minimizes transition issues and dislocations to asset prices. By taxing all business capital income in whatever form derived (that is, regardless of entity type, form of financing, or nature of industry) in a consistent manner, such a tax also minimizes allocative distortions resulting from current law's uneven application of capital taxation.

      Finally, there is no reason, beyond pure coincidence, why an ideal income tax should burden labor income and capital income under an identical rate schedule. (5) The elasticities of labor and capital taxable income, and the elasticities of real labor and capital supply in the face of taxation, are not identical to one another, and the role played by each in the economy and in social structures also differ. As suggested above, a flat (proportional) tax on capital income will operate as progressive along the relevant margin of time, but that reasoning does not extend to labor income. From the other direction, and particularly in light of the relatively inelastic real labor responses to tax rates in the range with which we have recent experience, an explicit progressive tax rate structure on labor income whose top rates are greater than those applied to capital income both raises necessary revenues and does so in a way that satisfies political economy income inequality concerns.

      This Article takes the reasoning and the conclusions of Capital Taxation in an Age of Inequality as prologue, and extends that paper by specifying in reasonable detail the design of the flat rate, uniformly applied capital income tax that I have in mind. The proposed tax--called the Dual Business Enterprise Income Tax, or Dual BEIT (where "BEIT" is pronounced "bite," as in a tax bite)--builds on earlier work of mine but is substantially amended and restated from its earliest iterations. A third article, Business Taxes Reinvented, comprises a comprehensive term sheet summarizing the mechanical rules of the Dual BEIT. (6) That article serves as a complement to this longer narrative explanation; its term sheet appears here as the Appendix to this Article.

      The BEIT half of the Dual BEIT is a robust technology for measuring explicit returns to capital, but it is agnostic about tax rates and does not by itself address the issue of labor income masquerading as capital income. The dual income tax structure adds a conscious commitment to different tax rates on capital and labor income--for example, 25% on the former and 40% on the latter (ignoring lower tax rate brackets on lower incomes). Marrying the two themes yields the Dual BEIT.

      U.S. academic and policy circles are awash in proposals that generally might fall under the rubric of business tax reform. The Dual BEIT differs from some competing ideas in its breadth, as it covers all forms of business organization and all forms of financing a business; in its depth, in that it encompasses and coordinates firm and investor taxation; and in its practicality, as it requires very little by way of new information exchange or collection.

      More generally, it is incumbent on proponents of new tax structures intended for actual implementation to specify their proposals in sufficient detail that their operation and administrability can be assessed. This is surprisingly difficult work, and while that work might be described by some as tax engineering rather than physics (or as mere lawyers' work, to put things more directly), it is what separates tax policy chatter from feasible legislation. Business Taxes Reinvented and this Article are my efforts to summarize succinctly the operation of the Dual BEIT, at a level of specificity that would enable...

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