Who owns human capital?

• Author: Kahng, Lily

Abstract

This Article analyzes the tax law's capital income preference through the lens of intellectual capital, an increasingly important driver of economic productivity whose value derives primarily from workers' knowledge, experience and skills. The Article discusses how business owners increasingly are able to "propertize" labor into intellectual capital--to capture the returns on their workers' labor by embedding it in intellectual property and to restrict workers' ability to employ their skills and knowledge elsewhere. The Article then shows how the tax law provides significant subsidies to the process of propertization and thereby contributes to the inequitable distribution of returns between business owners and workers. The Article's analysis further reveals the tax law's fundamental capital-labor distinction to be questionable, perhaps even illusory, an insight which has profound implications for the tax law.

Introduction

The U.S. income tax makes a fundamental distinction between income from labor and income from capital, upon which substantially different tax treatment depends. Originally, the income tax targeted wealthy capital owners, and most wage earners were exempt from it. (1) However, the advent of World War II shifted its impact to labor income, transforming it from a tax on the rich to a tax on working people, from "class tax to mass tax." (2) Today, we tax capital income preferentially in a variety of ways, most prominently through a reduced rate of tax on capital gains and dividends. (3)

The preference for capital income has been the subject of intense study and debate for many years. (4) For the past couple of decades, efficiency-based arguments in favor of a capital income preference have dominated the debate. (5) In recent years, however, concerns about rapidly growing economic inequality have refocused attention on equity considerations and raised serious questions about the validity of efficiency-based arguments in favor of the capital income preference. Thomas Piketty's book, Capital in the Twenty-First Century, (6) is perhaps the most well-known work to analyze the widening economic gulf between capital owners and workers, and it has galvanized other scholars to address this urgent problem. (7) Piketty's central thesis is that the return on capital tends to exceed significantly the growth rate of the economy, which leads to increasing concentrations of wealth in the hands of the few and extreme inequality. (8)

This Article undertakes an equity-based analysis of the tax law's capital-labor distinction from a new perspective. It looks beyond explicit tax preferences for income from capital such as the capital gains rate and examines less transparent but equally significant ways in which the law undertaxes capital owners and overtaxes workers, thereby contributing to the growing inequality between capital owners and workers. (9)

The Article begins with an exploration of intellectual capital, a growing form of capital that includes not only legally protected intangible assets, such as patents and copyrights, but also other sources of value such as goodwill and organizational processes and know-how. The creation of intellectual capital enables capital owners to "propertize" labor: through the use of intellectual property laws, contract and employment laws, and other legal and organizational mechanisms, capital owners are able to capture the returns from their workers' economic productivity. The Article discusses how the legal landscape is rapidly evolving to facilitate and expand the propertization of labor.

The Article then turns to the ways in which the tax law subsidizes the process of propertization. Specifically, the tax law allows capital owners to immediately deduct most costs of creating intellectual capital, which has the effect of exempting from tax their income from intellectual capital. Furthermore, the tax law is overly generous to capital owners with respect to their investments in human capital, while, at the same time, it denies workers recognition of similar investments.IH In these ways, the tax exacerbates the widening wealth and income gap between capital owners and workers.

The Article concludes with reflections about the porous and changeable boundary between labor and capital. It questions whether the tax law distinction between labor income and capital income is useful or even meaningful. The Article posits that the tax law should not treat labor income and capital income as distinct categories, but rather, should recognize that workers and capital owners contribute to and share in the returns from their collaborative efforts. The Article concludes with an overview of specific reform proposals that would implement this reconceptualization of workers and capital owners.

1. Intellectual Capital and the Propertization of Labor

   1. The Rise of Intellectual Capital

      Capital encompasses forms of wealth including "land, buildings, machinery, firms, stocks, bonds, patents, livestock, gold, natural resources, etc." (11) The definition includes physical capital, such as land, buildings, and other material goods. (12) It also includes intangible assets such as patents or copyrights and financial assets such as bank accounts, corporate stock, and pension funds. (13)

      The composition of capital has changed significantly over the last several centuries. Agricultural land, which three centuries ago, accounted for more than one-half of total capital, comprises only a minimal fraction of total capital today, and has been supplanted by industrial and financial capital. (14)

      Of these new types of capital, financial capital, and in particular corporate stock, is comprised of the underlying assets owned by corporations. As Piketty observes, much of the value of corporate stock is attributable to what he calls immaterial capital:

      [M]any forms of immaterial capital are taken into account by way of the stock market capitalization of corporations. For instance, the stock market value of a company often depends on its reputation and trademarks, its information systems and modes of organization, its investments, whether material or immaterial, for the purpose of making its products and services more visible and attractive.... (15) This Article uses the term "intellectual capital" to refer to these forms of immaterial capital. Intellectual capital has been likened to dark matter-the essential substance that binds together the universe but is not directly observable. (16) It is broadly defined to be "nonphysical sources of value (claims to future benefits) generated by innovation (discovery), unique organizational designs, or human resource practices." (17) Intellectual capital includes not only separable, identifiable, and legally protected assets such as patents, trademarks, and copyrights, but also less distinct assets such as information systems, administrative structures and processes, market and technical knowledge, brands, trade secrets, organizational know-how, culture, strategic capabilities, and customer satisfaction. (18) Examples of this broader definition of intellectual capital include Wal-Mart's computerized supply chain, Amazon's customer service reputation, and Google's unique business model. (19)

      The growing importance of intellectual capital is indisputable. (20) Companies such as Google, Amazon, and Apple exemplify the new business model. Their most valuable assets are not property, plant, and equipment, but rather operating systems, product designs, organizational structures, and their reputation among customers. (21) Intellectual capital is also dominant in more traditional companies. For example, the physical assets of Nestle, the world's largest food company, comprise only thirteen percent of its total value. (22)

      The value of intellectual capital relative to total capital is difficult to estimate, in part because its value can be inferred only indirectly from the value of the corporations who own much of it, combined with the fact that financial and national accounting systems have historically undervalued or excluded intellectual capital from measures of economic productivity and wealth. (23) Economists estimate that official measures of gross domestic product in recent years omitted as much as one trillion dollars per year of investments in intellectual capital. (24) As Calvin Johnson points out, Google and Microsoft's self-created intangible assets are worth hundreds of billions of dollars, as evidenced by their market capitalization, but their balance sheets show none of these assets. (25) Other scholars have observed a similar anomaly with respect to pharmaceutical companies: their investments in research and development are not recorded as assets on their balance sheets, but their market capitalizations clearly demonstrate the value of these assets. (26)

      To remedy the failure of most accounting systems to measure adequately intellectual capital, Carol Corrado, Charles Hulten, and Daniel Sichel developed a framework for quantifying intellectual capital and its impact on the national economy. (27) Their model is the most theoretically advanced and comprehensive to date, and according to the Organisation for Economic Co-operation and Development (OECD), is widely accepted. (28) Based on this model, Corrado, Hulten, and Sichel found that, in recent years, intellectual capital accounted for 27 percent of economic growth, putting it on par with tangible capital in importance as a source of growth. (29)

      In response to the work of economists such as Corrado, Hulten and Sichel, government agencies and non-governmental organizations are beginning to recognize more fully the role of intellectual capital in economic activity. For example, in 2013, the U.S. Bureau of Economic Analysis (BEA) for the first time included research and development (R&D), as well as artistic creations such as films, music, and books, in its measures of national economic productivity...