Capital Income Taxation, Corporate Taxation, Wealth Transfer Taxes and Consumption Tax Reforms

Capital Income Taxation, Corporate Taxation, Wealth Transfer Taxes and Consumption Tax Reforms Alan Auerbach Becker Friedman Institute September 27, 2013

Outline • The Choice between Income and Consumption Taxes • Corporate Taxation • Wealth Transfer Taxes

Income vs. Consumption Taxes • Tax Wedges, Timing, and the Components of Capital Income • Equity, Efficiency and the New Dynamic Public Finance • Tax Salience, Inertia, Self-Control and Targeted Saving

Tax Wedges, Timing, and the Components of Capital Income • Atkinson-Stiglitz (1976) and Chamley (1986)/ Judd (1985): two different rationales for avoiding capital income taxes • Not helpful vs. very distortionary • But many additional, subtle points to consider, regarding timing and what capital income is

Timing • Dynamic inconsistency • How much of an issue, in practice (TRA86 example) • Labor income taxes vs. consumption taxes • Differ “only” in transition but can represent the difference between efficiency gains and efficiency losses (Auerbach, Kotlikoff, Skinner 1983) • Intertemporal elasticity of substitution less crucial a parameter than in simple models

Components of Capital Income • Safe return to capital vs. other components • Quasi-rents to old capital • Rents • Disguised labor income • Compensation for risk • Consumption tax (EET) hits these, labor income tax (TEE) does not • Third alternative emphasized in Mirrlees Review: TtE; makes clear role of safe return

Components of Capital Income • How much of a difference does a tax on the safe return to capital make? • May be other reasons for taxing it, for example to substitute for age-based variations in tax schedules • For other components, different factors matter • Flexibility of converting labor to capital income • Efficiency of risk-pooling in private markets • Mobility of rents

New Dynamic Public Finance • Another reason to tax capital income: to relax self-selection constraints in dynamic optimal income tax setting • Implications for capital income tax rates not clear, since results relate to tax wedge • Can be consistent with zero average tax rates • Relates to “the” return to capital, not other components of reported capital income

Tax Salience, Inertia, Self-Control and Targeted Saving • Saving is an area of focus in behavioral economics • Requires long-term planning and delayed gratification • Trade-offs may be difficult to understand • Limited opportunity for learning

Issues and Implications • With self-control problems, may want to subsidize saving; but may not • Offsetting aversion to saving vs. facilitating meltdowns • With excessive discounting, timing of tax payments may matter – another distinction between TEE and EET

Issues and Implications • Employers and organized activity may be critical • Saving could actually be discouraged by more general favorable tax treatment • Are targeted saving schemes a good idea? • Tax arbitrage vs. mental accounts; conflicting evidence

Summary, So Far • Capital income is different from labor income • Tax rate on the normal return to capital is a small part of the issue of how to tax capital income • Conclusions depend critically on how saving decisions are made

Corporate Taxation • A lot since Harberger! • Developments in theory and evidence • Also, a changing economic environment

Theory and Evidence • As before, components of capital income matter • Sources of finance • Debt vs. equity finance • Retained earnings vs. new shares • Dividend tax capitalization and the vanishing Harberger triangle • A marginal tax on new equity rather than on all corporate capital?

Theory and Evidence • As before, components of capital income matter • New vs. old capital • With investment incentives, the same distinction as TEE vs. EET

Theory and Evidence • Consistent evidence of responsiveness to taxation, but implications for tax policy not always clear • Strong cross-section responsiveness to investment incentives • Less evidence on aggregate responsiveness • Relevance of liquidity constraints not clear • Timing of policy interventions very predictable

Theory and Evidence • Consistent evidence of responsiveness to taxation, but implications for tax policy not always clear • Dividend policy responds to taxation • Could be a timing response • Evidence of agency effects

Theory and Evidence • Consistent evidence of responsiveness to taxation, but implications for tax policy not always clear • Borrowing responds to tax advantage • But, again, may be limited by agency considerations

Tax Policy and Agency Problems • Dividend tax may exacerbate agency problem • Encouraging managers to overinvest • But, if so, why not raise the corporate tax? • Managers may borrow to little for shareholder wealth maximization • But this may help offset the underlying tax distortion between debt and equity

Changing Economic Environment • The fall of the corporation • Only half of business income now in traditional corporate form • The rise of the multinational corporation • Most corporate assets now in multinationals • Implications for corporate tax incidence, distortions and design • Additional margins of response to consider

Taxing Multinational Corporations • With cross-border capital mobility, another argument against capital income taxation • Some evidence of shifts to labor, but econometric challenges in using cross-country data • Capital is not all that moves • Financial and accounting adjustments to take advantage of tax differentials • Another cause for thinking about different components of capital income

Taxing Multinational Corporations • Hard to know what optimal tax system is, with so many margins of responsiveness • Another complication: tax competition • How will other countries react (or cooperate)?

Taxing Multinational Corporations • Typically, think about combinations of tax on three components of income • Domestic earnings of domestic corporations • Domestic earnings of foreign corporations • Foreign earnings of domestic corporations • Existing systems choose 2 of 3, based on source or residence, but obvious problems with both • Relative immobility of consumers represents an added argument for consumption-based taxation

Wealth Transfer Taxes • In some respects, equivalent to capital income taxation; but important differences: • Difficulties in administering taxes on wealth transfers • Uncertain lifetimes – annuity effect • Different individuals involved • Role in intergenerational persistence of inequality

Administering Wealth Transfer Taxes • Infrequent taxation facilitates tax planning • Should integrate with inter vivos transfers, which may be hard to observe • Clear evidence of responsiveness to estate tax rates, but also that tax planning falls short of rational optimization

Optimal Wealth Transfer Taxes • Is the optimal tax a subsidy? • How to take account of different generations in measuring social welfare • Can be progressive without being positive (Farhi-Werning, 2010) • May want to tax, for the same logic as in NDPF (Kopcuzk, 2013)

Optimal Wealth Transfer Taxes • Bequest motive matters • Accidental bequests vs. warm-glow vs. altruistic • Correlation of ability matters • Can generate large optimal top tax rates (Piketty-Saez, 2013) • Also an argument for taxing inheritances vs. bequests

Optimal Wealth Transfer Taxes • As yet, a lack of integration of theory, evidence on responsiveness and issues of administration

Conclusions • Capital income is different than labor income, so no obvious reason to think of income taxation as a logical objective • Capital income has different components, and should think about how to tax these components differently • The intertemporal consumption decision is one of many that are relevant to optimal tax rate

Conclusions • Administration and enforcement need to be integrated in tax design, particularly in considering taxes on multinational corporations and wealth transfers • Decision-making and agency considerations relevant, in some cases central • Notions of optimality are also more difficult once other generations and the responses of other countries come into play

Capital Income Taxation, Corporate Taxation, Wealth Transfer Taxes and Consumption Tax Reforms