∗ The Equity Tax and Shelter Leonid A. Levin (Lnd at bu.edu) Boston University; Institut Des Hautes Etudes Scientifiques Abstract Due to its limited scope, this article ignores many important issues of taxation. Such are Taxes have major costs beyond the collected matters, often discussed in the context of tax revenue: deadweight from distorted incentives, reform, that concern the tax spending process compliance and enforcement costs, etc. A sim- morethanthetaxlevies–forinstancethebenefit 8 0 ple market mechanism, the Equity Tax, avoids principle, or the incentive of democratic govern- 0 these problems for the trickiest cases: corporate, ments to use taxation for transfers from groups 2 dividend, and capital gains taxes. It exploits the withgreaterabilitytopaytogroupswithgreater n ability of the share prices to reflect the expected ability to vote. I ignore special externalities a J true annual return (as perceived by investors, (harm or benefit to others, specific to particular 8 not as defined by law) and works only for pub- economic activities) which might call for special licly held corporations. Since going or staying taxes, tax breaks, or other remedies. I do not ] E public cannot be forced, and for some constitu- discuss the (seemingly small) incidence effects of C tional reasons too, the conversion to equity tax thereformandpay limitedattention tothetran- . must be a voluntary contract. Repeated recon- sition problems. s c versions would be costly (all capital gains are My main goal is alleviation of distortive ef- [ realized) and thus rare. The converts and their fects of general taxes on corporations and in- 7 shareholders pay no income, dividend, or capital vestors. It is prominent in economic literature v gain taxes. Instead, they give the IRS, say, 2% and lately in political media, though the propos- 3 1 of stock per year to auction promptly. Debts are als typically introduce greater distortions than 0 the lender’s assets: its status, not the debtor’s, those they claim to remove. 2 determines their equity-tax or income-tax treat- 1 0 ment. The system looks too simple to be right. 1.1 Corporate Income Tax Problems 0 However, it does have no loopholes (thus low- / s ering the revenue-neutral tax rate), no compli- Corporate income is spent in various ways: one c ance costs, requires little regulation, and leaves part(Expenses)isconsumedbytheneedsofpro- : v all businessdecisions tax neutral. Thetotal cap- ducing the current taxed income; another (Divi- i X ital the equity taxed sector absorbs is the only dends) is divested to the shareholders; the third r thing the tax could possibly distort. The rates (Reinvestment) is invested in growth, renova- a should match so as to minimize this distortion. tion, debt or stock repurchase, etc.; the Masked The equity tax enlarges the pre-tax profit since part is a hidden reinvestment, treated as ex- this is what the taxpayers maximize, not a dif- penses due to the subtleties of the tax law and ferent after-tax net. The wealth shelter is paid depreciation rules. Most tax systems tax Divi- for by efficiency, not by lost tax. dendstotheshareholderandsparetheExpenses. TheU.S. law also taxes Dividends and Reinvest- ment to the corporation. The Reinvestment and 1 Introduction Masked parts accumulate in the stock value; the current system, as well as some new proposals, Casual readers may skip this section which does may tax them eventually when they are realized not discuss the mechanism at hand, but only as capital gains. puts it in a context of problems faced by other The income tax is distortive. The laws, approaches. however complicated, cannot adequately expose ∗Tax Notes 93(9):1203-1208, 11/26/2001. Maskedincome; itremains,whetherlarge,small, 1 2 Leonid A. Levin or negative. Theincentive to maximize it stands 1.3 Radical Recipes behind many otherwise detrimental business de- The oldest proposed remedy to the tax-caused cisions and probably behind double taxation of distortions is to reject taxation altogether along capital gains, gifts, and estates. It may also mo- with all other forms of coercion. This extreme tivate the double taxation of dividends without libertarian idea is far from even the libertarian which the doubletaxation of capital gains would mainstream. I will mention its much discussed promote divestment through higher dividends to faults since similar elements are present in more avoid stock price appreciation. This distortions popular proposals. The freedom from coercion, reduce net profits and tax revenue, and convo- far from being a natural right (and quite un- lute accounting and decision making. known in nature), is not free. Thus, private ser- vices must replace public goods such as defense fromextralegal andforeignwould-be“tax collec- 1.2 Capital Gains and Dividends tors”. The decentralization of power would raise manyobviousissues,unimportanthere. Another aspect, however, is fundamental. The awkward double taxation can be avoided in many ways, e.g., by adding the taxed corporate Unprotected economic power, like unrefriger- income to the inflation-adjusted share cost ba- ated food, creates major externalities in and sis, deducting the dividends from the latter and of itself. Not only it is hard to deny defense- taxing only their excess. Various proposals are less neighbors the free ride on one’s defense actively studied (see, e.g., [Graetz, Warren]). arrangements, it is also hard to prevent them fromincreasingthepay-offtotheconquerorand, This would not remove the disincentive to re- consequently, the cost of an effective deterrent. alize gains or any problems of corporate income The sudden and unprotected affluence of “new tax. If the corporate tax is dropped instead, the Russian businessmen” breeds racket structures dividends/gains disincentive becomes the main which also endanger their neighbors and pub- deadweight and fairness problem. The dividend lic order. Kuwaiti oil tempts foreign aggression, and capital gain taxes may differ drastically for endangering nonowners of oil and world peace. firms of similar size and operation (and, thus, of General taxes remedy such externalities through similarshareinconsumptionofpublicgoods)de- coercive funding of common defense, public or- pendingon their dividendpolicy andstock trade der, and other public goods. This coercion both frequency. This frequency determines how often isjustifiedasadefenseagainstnegligently harm- the nominal tax rate is compounded, which has ful neighbors and violates no natural freedoms, a major effect on the effective tax rate. since the freedom from coercion does not come Suppose a stock portfolio gains 10% per year free. Theargumentcan even bestretched to jus- and is taxed annually at 30% of gain, i.e., 3% of tify public provision of other public goods when value. It will grow at a 7% rate, ending up ten demanded by efficiency: the conquest pay-off times smaller than if taxed 30% after 95 years of and the cost of deterrent depend on the value 10% growth. The strong disincentive for moving of the best possible use of the resources, includ- capital among investors and corporations harms ing the optimal level of publicly provided goods. them with no public purpose. Many popular ideas about nondistortive tax- Dividend and capital gains taxes are also al- ation are mythical. Lump-sum taxes are an ex- mostvoluntary. Nothingforcescompaniestopay ample. Onecannotassignlumpsumsarbitrarily, dividends and many do not. They can spend all e.g., above taxpayer’s worth or even close to it, income (say, by buying their own stock) and let lest he runs away or shoots the collector. So, the investors choose when to realize it by selling the lump sums must be based on some rational shares. Much of the stock may avoid trade for method. Clever taxpayers will guess it before- generations. hand and distort their behavior for tax advan- The Equity Tax and Shelter 3 tage. There are myths of inelastically supplied 1.4.1 Progressivity resources, such as land area, or head count. As Some forms, such as value-added or sales taxes, a tax base, they are supposedly immune to dis- haveanadditionalproblemwithvaluation of the tortions: nobodywouldcommitsuicideorshrink labortax base. Laborisapeculiarresource. Hu- the Earth’s surface to escape a tax. Such ideas man mind admits only very inefficient external are misleading: one cannot collect taxes from control. Besides, organized humanity claims col- unused land, unemployed people, or postponed lective ownershipof basichumanrights andfree- children; meanwhile,overtaxingcanrenderthese doms and outlaws their transfer. Due to this resources quite elastic. In fact, in a long run, public element in the otherwise private human adapting technology seems to confer great elas- capital, it can be measured and taxed only indi- ticity on all resources. Such tax systems avoid rectlythroughtheincomeitgenerates. Eventhis distortion in allocation of untaxed resources at income is hard to determine. Haig-Simons con- the expense of an extreme distortion in the allo- cept of income includes personal consumption, cation between taxed and untaxed types. only part of which is investment in growth of human capital through better education, bigger families, etc. The other part is the cost of sustaining it 1.4 Consumption Taxes against hunger, physical and psychological fa- tigue, illness, aging (by raising two kids), etc. Progressive taxation of earnings attempts to ex- A less radical idea of similar nature is presently clude this part assuming some uniformity in the popular. Itwouldscraptheincometaxsystemin structure of basic human needs. Proportional favor of one of the several forms of consumption taxes are most adequate for unearned income. taxes, suchasvalue-added,sales, flat, etc. These For earned income, however, their base includes taxes exempt all nonhuman resources from their whatisreallyanoperatingcost,creatingasortof base which consists entirely of the cost of labor a head tax element. In the long run, when head (besides pre-existing capital). Their distinct as- count becomes elastic, such taxes are too dis- pect is the elimination of tax on reinvested in- tortive to be used for general budget purposes. come. (Investing labor income also defers its (A benefit argument may justify their special- taxation until the proceeds are withdrawn for ized use, e.g., financing social safety nets with consumption.) Thus, companies reinvesting all FICA.)Thisproblemisaddressedtosomeextent income grow tax-free, subsidized by other tax- in [Hall, Rabushka] through its 0-tax bracket. payers through free public services. Consumption taxes, too, remove the distor- 1.5 Property Taxes tions in allocation of untaxed resources (invest- ment in nonhuman capital) at the price of ex- Another, rarely advocated, type of partial taxes treme distortion of the choice between invest- is based on wealth. They do just the opposite: ment (in nonhuman capital) and consumption spare labor and target nonhuman capital. Since (i.e., investment in human capital). It is hard the idea of pressing for larger but poorer popu- to guess why this distortion is seen as accept- lation seems unattractive, apossiblemotive may able. Perhapsthepressuretowardasmaller(and betofurthershifttheburdenawayfromtheelec- less educated) but richer population seems at- toral majority. tractive. Or perhaps human capital is perceived Unlike labor, wealth can betaxed based on ei- as a more evenly distributed base of taxation, ther its market value or the generated income. lessdeviantfromtaxpayers’representationinthe The difference is not significant: investors, seek- budget process. Widespread confusion may also ing the best return, price commercial property play a role. according to its annual income potential includ- 4 Leonid A. Levin ing value appreciation. Taxing the price or in- [Fraenkel, Lichtenstein] proved, must take com- come,thewholeicebergorjustitstipatatenfold putation time that is exponential in the size of rate, is the same. thechess boardtheytreat as variable. Exponent Some assets such as a family home or a pri- isquiteadramaticbound: theentireknownUni- vate business produce fruits that are hard to verse contains far fewer atoms than ten to the separate from those of the owner’s labor, ren- number of letters in this sentence. Note that dering separate taxation of labor and wealth dif- this problem is unrelated to the sufficiently rec- ficult. Combined, labor and wealth taxes form ognized and studied issue of the stochastic veil. an income tax, based on all income whatever Life is morecomplex than chess andtaxpayers the source. Then, neither human uniformity nor cannotusevaluation methodsthatpowerful. So, market value of wealth can help to assess their they must be inconsistent in their valuations as economic power for a graceful taxation. isamplyevidentfromthestockmarketbehavior. How then can the Law valuate assets in a way consistent withthemotives of rational taxpayers 2 A Different Mechanism (if such can be defined at all)? In fact, it can- not, which may explain why a nondistortionary 2.1 Consistent Valuation is Impossible. taxsystem hasnotbeenachieved yet. Whatthis The long term elasticity of resources has a no- article suggests is that for some assets such val- table exception: the resource the taxpayer max- uation is not necessary. imizes. Based on it, a tax with a less than 100% marginal rate would be nondistortionary. Let us 2.2 In-Kind Taxation call this maximized resource the value of a tax- payer’s assets.1 We can treat it as the market Iftaxliabilityisexpressedin-kind,ratherthanin value for alienable assets (which taxpayers can national currency units, it could avoid the need sell if somebody else values them more) and ig- for any distortive valuation methods. The use nore the difficulties of valuating human assets of a non-market mechanism for translation of discussed in section 1.4.1. in-kind assets into the currency is the needless Since tax needs to be collected periodically, source of distortion. it would help if taxpayers’ goals were consistent, An exampleof an in-kindtax ismilitary draft, say,foroneandtwoyearsperiods. However,here if we ignore that it singles out healthy human lies a fundamental difficulty, full understand- males from all other assets. Draft, however, in- ing of which has not yet spread in the economic volves slavery and thus creates a far greater in- literature. Let me illustrate it with an example. efficiency than tax-caused distortions. This inef- Inplayingchessthefirstideathatcomestomind ficiency prevents in-kind taxation of human cap- is to understand how to compute the value of ital, which is not too bad since income taxes each position, and to choose each move to max- can handle salaries reasonably well. Besides la- imize this value. The value must be consistent bor, the earned income tax covers indirectly the across a move, i.e., agree with the best value of earners’ personal property which supports their the next position one move can achieve. Such ability to work. Only commercial property re- consistent valuation algorithms do exist, but as mains a candidate for in-kind taxation. How- ever, its diversity, indivisibility, and difficulty of 1 Consumption is often added as a separate term of distinguishingfrompersonalpropertycreatema- utility. This should not be done here since human assets jor problems. are included. Most consumption serves to maintain, re- store,andgrowhumancapitalandso,addingitexplicitly On some backgrounds, addition of a commer- wouldamounttocountingittwice. Consumptionalsoin- cial property tax would smooth, rather than cludes economically useless waste, a negative income on create, the distortive distinction between com- human weaknesses. Whether it can be deducted against mercial property and other assets. An example taxed positive income, I do not discuss: the equity tax ignores human assets anyway. would be a consumption tax background, e.g., The Equity Tax and Shelter 5 [Hall, Rabushka]type, which defines commercial winners; theIRS receives only the proceeds. property and exempts investment in it from tax- The auction timing and procedure may be ation. To be eligible, the property must yield no made more or less automatic to minimize significant personal benefit besides taxable in- the IRS’s influence on the market. come. The diversity and indivisibility of prop- • The tax applies to equity, which fluctuates erty can be handled as follows. in value along with its issuer. Other long- The owner posts the property price and is term securities, such as bonds,issued by eq- taxed at, say, 2% of it per year. He also faces uity taxed firms for income-taxed holders a 2.5% chance per year that the IRS takes and must have value readily computable from auctions the option to buy the property for this contract terms and global economic param- price. (The extra .5% of this rate encourages eters and be so depreciated or appreci- accurate pricing, offsets auction costs, and can ated. Ifdefaultbecomesadanger,securities be used to reward the second highest Vickrey cheapen below whattheIRSallows, encour- bidder who loses the bid but sets the payment.) aging the holding of such low-grade secu- Taxpayers would face the auction of their com- rities through equity taxed intermediaries, mercial property typically once in a lifetime and such as mutual funds. couldminimizetheriskbyaccuratepricing. This stochastic tax may be too volatile for the US. • Equity-taxed corporations may own each- It is interesting as a thought experiment and other’s shares, directly or through shares may provide a convenient complement to con- of income-taxed intermediaries. To avoid sumption taxes for countries where administra- double taxation, the IRS waives the tax on tive structures are too rough to allow a smooth cross-ownedshares,creditingittotheshare- function of income taxes. It has similarities holder. The income tax code may provide with the Swiss land tax system. However, Swiss a similar credit in the case when the owned authorities have the discretion to choose which company is income-taxed; then it must use properties to take and how to dispose of them; averyconservativemethodofallocating the this is not a matter of chance and auction and income to the period of ownership. so is open to distortive variations or even abuse. • Since equity-taxed companies cannot accu- mulate untaxed gains, the gift and estate 2.3 Equity Tax taxes, too, shouldsparedividendsandgains One major part of the economy, the corporate of their shares and apply only to the cost sector, yields itself to in-kind taxation, the eq- basis. (Ideally, these taxes might exempt uity tax, quite gracefully. The conversion to the all wealth that had been fully taxed while systemisavoluntarycontract. Theconvertsand accumulated.) their shareholders pay no income, dividend, or • Equity tax needsless accounting regulation, capital gain taxes. Instead, they give the IRS, but some is still needed to prevent fraud, say, 2% of stock per year to auction. The effect such as disproportional benefits to major is roughly similar to lifting the corporate income shareholders, unrecorded compensation for taxinexchangeforsomehowassuringtheannual employees andother income taxed partners, realization of capital gains on all stock. A few such as creditors, etc. particularities need to be mentioned. • Attracting multinationals would require a • The IRS accumulates the shares at a con- protection from multiple taxation by differ- tinuous rate. It receives distributions on ent jurisdictions. but cannot vote its shares: the taxpayer acquires its own shares or prints new ones • The 2% rate is just an example. The actual for the auction and transfers them to the taxratesmayvarywitheconomicconditions 6 Leonid A. Levin to accommodate general constrains, e.g., to Variations. Thetwogivenexamplesofin-kind keep public debt below public assets. Eq- taxes consist of several largely independent ele- uity taxed firms are not affected by the rate mentsthatcanbeusedindifferentcombinations. fluctuation, except for timing investments, The investments in in-kind taxed sector can be divestments, or conversions. So, what the or be not tax-deferred, i.e. deducted from in- income and equity taxes must avoid is sig- vestor’s income tax in exchange of taxing future nificant predictable rate mismatch. withdrawals,suchasdividends. Thetaxcanbea fraction of interest in the business or a chance to take it in a lottery. It can apply to the business 2.4 Conversion Tax itself or to an option to get it at a price set by the owner. This price would be subject to a sep- arate tax. It can be an asset tax, based on the Stocks have equal expected return, but varying untaxed appreciation may be foreseen. To pre- value or, in case investments are tax-deferred, an income tax, based on its change. All these vent tax savings via reconversions, it must be variations work automatically, sparing the tax- recaptured, i.e., the convert’s capital gains real- ing authority any valuation responsibilities. ized. The formula may vary with specifics of income tax; assume 20% income tax rate. A company reconverting to income tax gives the 3 Effects IRS put options for 20% of its shares at a price which sets the new cost basis. 3.1 The Advantage Acompanyconvertingtoequitytaxissuesnew Let us define the corporate net return as the shares, comprising20% of all shares and the IRS stock price growth plus the dividends minus the auctions a part of them. The other part is re- resulting stockholders’ tax liability. I assume turned to the old shareholders as a credit to off- the companies and investors act rationally max- set, at the auction price, the second taxation of imizing this return. Its near future expectation the cost basis. This basis includes, in constant drives the investors and determines the share dollars, the share’s purchase price and all after- prices. Under the equity tax, the net and pre- tax per-share corporate income reinvested after tax (net plus all general taxes) returns are pro- the share’s acquisition. portional: maximizing one, maximizes both. I The auction bids contain the upper limit for assume special externalities are offset by special the share price and the total dollar amount of liabilities or otherwise do not affect my conclu- the purchase. When the bids are unsealed, the sions. Then maximization of each company’s shares are distributed for the price at which the pre-tax return maximizes the one of the sector. demand and supply meet. The cost-basis credit Under most other tax systems maximizations is treated as an auction bid with infinite share of net and pre-tax returns are in conflict. Taxes price limit. cannot be based directly on the taxpayer’s re- Assume I have 2,000 shares bought for $75 turn to avoid games with the share prices. Yet, each (prices in constant dollars) and going now the sector’s total return can be easily monitored at $100. Since my purchase, the company rein- andkeptina monotonecorrespondencewith the vested $20 of after-tax income per share. My total tax revenue. I assume this correspondence cost basis is $(75+20) x 2,000 = $190,000 with is set independently of the tax system and tax- 20% tax credit of $38,000. The company prints payers’ actions. Since the total tax would not be me 500 new shares which is 20% of the new total lowered without lowering the net return, compa- of 2,500. They would sell for $100 x (100%-20%) nies are thrown into a competition to shift the = $80 per share. I shall keep $38,000/$80 = tax onto each other at the expense of lower pre- 475 new shares; the new owners will pay the IRS tax return. This loss of efficiency makes the sec- $2,000 for the remaining 25. tor worse off than under the equity tax. The Equity Tax and Shelter 7 3.2 Transition 3.4 Dangers of Evolution. An issue with any new tax is its possible evo- The equity-taxed sector has a uniform tax bur- lution. Can the equity tax start as a voluntary den, i.e., the ratio of tax to either return or the replacement for a wealth-based part of income stock price reflecting the expected return. The tax and end up its mandatory addition, stripped burden of some income-taxed companies, how- oftheincometaxshelterfeature? Thisseemsun- ever, is significantly lower than average. Such likely. A smaller obstacle is the lack of motives. favored companies (e.g., start-ups) would stay The equity tax leaves no reason for corporate, under the income tax despite the efficiency loss. dividend, or capital gains taxes. The amount of The others would flock to the equity tax, escap- revenue collected is just a matter of rates, not of ing both the loss and the higher burden. Thein- eclectic additions. Aseriousrateimbalance (cre- come tax laws wouldbeeasier tofine-tunetothe ating, in effect, a separate wealth tax) would be diminished sector, making its tax burden flatter a more real danger if the equity tax was manda- andfurtherdiminishingthefavoredlayer. Above tory. Such a mandate, though, might require a this layer, the income tax will retain primarily constitutional amendment, as income tax did. businesses that cannot go public. A greater safeguard is that corporations can- This approach sets the equity and income not be forced to become or stay public and meet tax rates to equalize the sectors’ burdens. A variousrequirementsneededfortheequitytaxto smoother transition would be achieved if these work. So, a mandatory version of the equity tax rates are introduced gradually, starting from the would be a tax simply on the status of publicly pre-reform income tax rate and the equity tax traded corporations. This status could not bear ratethatwouldberevenue-neutraloncethebulk much tax since corporations would just change of initial conversions is completed. Even these it. The damage to the economy would be great rateswouldlowertheburdenimbalance: theeffi- and the revenue small. In some town the tax ciencybonuswouldraisetheconverts’price,low- classification of a building depended greatly on ering their burdenat the same tax revenue level. its plumbing facilities. So, people just used the Whilenotasequitableorstimulating,theserates woods, avoiding the larger tax! leave no losers: the willing converts must think themselves better off; the others pay the same tax and the IRS still collects the same revenue. Conclusion Fundamental reasons preclude objective valua- 3.3 Volatility tion of assets or income they generate. Result- ing distortions can be avoided if tax liability is A small difference between the equity and in- expressed in-kind, leaving valuation to the mar- come taxes lies in the effects of volatility. Shares ket. Human and, closely related, personal assets with the same expected return but lower volatil- are hard to tax in-kind. Thus, only commercial ity may be higher priced, though proliferation of sectors of the economy are eligible for the tax diversified mutual funds diminishes this effect. options discussed here. These instruments are Thus, some low volatility companies may have interesting at least as a thought experiment and an incentive to stay out of the equity tax, pos- may have practical applications as well. sibly counterbalanced by their lower ability to The in-kind taxes leave out labor markets, maskreinvestedincomeasdeductibleproduction thoughtheirmorelimiteddiversitymitigates the expenses. Another effect is that the share price difficulties of taxation. This tax also, of course, reflects the expected, not actual return. So, the leaves alone the exempt sectors. Less fortu- equity tax leaves its subjects fully exposed to nately, unlike its rougher stochastic variation, their fortune, while the income tax makes them it cannot add grace to the taxation of private share part of the volatility with the public. business. However, it frees the publicly traded 8 Leonid A. Levin sector from the tax games. This body of “demo- cratic capitalism” thus should grow more attrac- tive andabsorban even greater partof economic life. This “attractive distortion” is purely posi- tive, without cost to other sectors. Acknowledgments This article benefited from criticism of many. I am especially grateful to Zvi Bodie, Michael Manove, Oliver Oldman, Jayendu Patel , James Poterba, Daniel Shaviro, David Weil, and Eric Zolt. This gratitude does not imply their en- dorsement of my opinions. This research was partially conducted by the author for the Clay Mathematics Institute and supported by NSF grant CCR9820934. References [1] A.S. Fraenkel, D. Lichtenstein. Computing a perfect strategy for n×n chess requires time exponential inn.J. Combin. Theory (Ser.A) 31:199-214, 1981. [2] M.J. Graetz, A.C. Warren, Jr. Integration of the Individual and Corporate Income Taxes: The TreasuryDepartment andAmericanLaw Institute Reports. Tax Analysts, Arlington VI, 1998. [3] R.M. Haig. The Concept of Income. In R.M. Haig (ed). The Federal Income Tax, 1921. [4] R.E.Hall, A.Rabushka.The Flat Tax.Hoover Inst. Press, Stanford, 1983, 1995. [5] L.A. Levin. The Century of Bread and Cir- cus. Tax Notes, 77(7):858-860, 11/17/1997. Sections “A Gentler Taxman,” “A Straighter Taxpayer.” http://www.cs.bu.edu/fac/lnd/civic/bread.htm [6] W.S. Vickrey. Counterspeculation, Auctions, andCompetitive Sealed Tenders.J. Finance, 16, 1961. The Equity Tax and Shelter 9 Appendix: a brief summary. A Tax Simplification Debate: Asimpleway outisto expresstheliability not Income Tax vs. in dollars but in corporate shares the IRS would Consumption Taxes. collect and promptly auction. If t,i are the in- come tax and interest rates, a fraction t·i of all For decades, we have witnessed periodic surges shares held outside the publicly traded sector is of debate about the need to simplify our mon- regularly paid as tax interest. A further neutral strous tax code. Indeed, some its parts, espe- simplification is to drop thetax deduction at the cially those dealing with corporations and in- investment time along with shareholders taxes vestors, have evolved into a bizarre game with on dividends, shares sales (and even estates). the IRS. This game devours resources, distorts With no risks or chances to hide or delay liability, incentives, andthrowsafairamountofsandinto the rates should be low: t·i close to the taxes/price the wheels of economy. (The 2005 Report of the ratio, total for all large business. Firms averse to di- President’s Advisory Panel on Federal Tax Re- luting shares or paying interest can buy back shares form mentions a trillion dollar annual loss.) or debt. Going public – eligible for the above tax treatment – or reconverting to income-taxed sector A switch to some form of consumption taxes, triggers a conversion tax of call (or put, respec- such as value-added, sales, flat tax, etc., is often tively)optionsforafractiontofallshares. Callstrike proposed. Their simplicity attracts wide sup- price, returned to the shareholders, is roughly their port, but soon major gaps in the tax base be- cost basis; put price – the new cost basis chosen by come apparent and freeze the movement. (In the convert. (Sect. 2.4 above covers more details.) fact, there are fundamental reasons forcing any Bonds,iftradableinfractions,canbetreatedsimi- traditional tax mechanism to cause distortions.) larly. Yet,asbondscarrynovotingpowers,asimpler Sometimes the debate degenerates into a par- equivalent is taxing their proceeds with interest t·i, tisan warfare over the 3% of tax revenues the compounded from the bond’s issue. Other corporate poorest majority of voters contributes: should it obligationstoindividuals(e.g.,consumerwarranties) be higher or lower. The reform debate subsides, can stipulate a termination price cap, its growth, if only to reappear a few years later. any, treated as income to the holder. (The inability Let us see if the appealing aspects of income totax unrealizedappreciationofsecuritiesseems the and consumption taxes are compatible. Suppose main reason for messy secondary layers of taxation, a form of consumption taxes is adopted: quali- such as corporate or inheritance taxes.) fied publicly traded corporations pay no income This approach avoids complicated decisions or tax, and investment in them is deducted from regulations, is as gap-free as ideal income tax- investors’ taxed income. The tax is deferred un- ation, but preserves the grace of consumption til divestment and applies to dividends and pro- taxes: undistorted incentives, minimal compli- ceeds from sold shares. Then the entire stock ance and enforcement costs, etc. No corporate market value would be untaxed income and the actions can alter the fraction of shares owed the deferred tax on it an enormous interest-free loan IRS, and economy of scale would keep auction from the IRS: a major hole from the income tax costs low. A regular trickle of auctioned shares viewpoint. may even have a little stabilizing effect on parts Plugging it, however, does not require paying of the stock market. Yet, this approach has the missing tax, only the interest on it. This a limited scope and cannot help simplify tax- removes the need to monitor business to decide ation of personal labor. This problem seems which part of firms’ value is untaxed income: all fundamentally trickier, yet less acute: corporate of it is. Still, these values cannot be gauged andinvestment taxes aretypically morecumber- by share prices: the incentive to manipulate the some. Besides, simpler taxation may lure some stock market would challenge its integrity. personal business into the corporate sector. 10 Leonid A. Levin B Why usual taxes cannot avoid distorting incentives. And real life, far messier than this toy example, is Moderneconomistsdidnoticetheneed,besidesgrain, even harder to tax. A way out is to defer tax till the land, and coal, to consider another commodity: in- game ends. Consumption taxes do this. With them, formation. I doubt they all fully realize how subtle a companies reinvesting all gains grow tax-free, subsi- conceptisinformation,butevensimplisticaccounting dized by other taxpayers;the entire business capital- for it broughtprogress. Yet, economists may need to izationconsiststhenofuntaxedincome. Thedeferred acknowledgeonemorefactor-intelligence. Evenwith taxonit becomes a hugeinterest-freeloandistorting full and perfect information the Government cannot greatly the incentive to invest in non-human capital. matchallitssubjectsinintelligence,andthusinabil- My positive part consists of two observations. ity to evaluate their assets. Lacking such ability, the First, a minor one, is that fixing this gap does not IRSactslikeanelephantinachinashop,vandalizing require collecting the missing tax, only the interest our economic life. onit. Thisremovestheneedtodeterminewhichpart Here is a toy illustration. Suppose I play a game ofthecompany’svalueisuntaxedincome: allofitis. andyouwanttotaxmygains. Myopponentisexter- Thesecond(andcrucial)observationisthattheprob- nal to your tax system: it may be a foreign entity or lemsmentioneddo notcomefromthe taxationitself, just Nature. (For very technical reasons that I can- only from evaluation it involves. Collecting taxes in not explain in such a short note, the opponent may natural units, not in dollars, would void the above need no skill or intelligence, only my intelligence is objections. relevant.) Barring evaluation, the IRS still needs to collect I make many unrealistic simplifications: the game periodicallyafractionofnation’sworth. (Nottocon- hasnootherplayers,isfully deterministic,likechess; fuse with wealth taxes, since I count human assets youknow all its rules andobserve the entire configu- too.) One couldthink ofmany waysto do this. Mili- ration at all times. Chess have 3 outcomes: victory, tarydraftenslavesafractionofhumancapital. Since defeat, and a draw. A more diverse (e.g., integer) ownershipofintelligentbeingsistough,consumption outcome may seem more realistic but can be simu- taxes surely work better here. A lottery taking non- lated by playingmultiple gameswith different stakes human assets with, say, 2 percent/year chance (soft- simultaneously. So binary outcomes suffice. While enedbyinsurancearrangements),isacomplementary simplistic, my example preserves all my concerns. radical method. Unlike chess,ourgamelastsdecades,ormore;you I discuss a less drastic tool: companies paying cannot wait until it ends and want to tax the im- taxes with their own securities,leaving the dollar as- provements in my position (what, I believe, is called sessmenttomarkets. Thissparesthecorporatesector ”economic income”). This seems straightforward: In any distortive effects of all usual (evaluation-based) chess, any position has a clear value with either a tax tools. winning strategy for one side (assuring a victory, no The income tax would still distort non-corporate matter what the opponent does) or a draw strategy economy;yetitssmallerscopemayallowbettermon- for each side. Suboptimal moves change the value: itoring and finding/removing some holes even there. you tax the gain or recognize a loss. It is for the income taxed sector to decide if com- You probably see the problem now: an ability to panies choosing this traditional tax form are allowed do this would make you an unbeatable world cham- to be publicly traded. If full flexibility is allowed, pion of chess :-). In fact, such policy REQUIRES the tax savings via conversions between systems are exponential computation, about as slow as searching prevented by special rules forcing, in effect, full real- through all possible future game configurations. (A ization of the convert’s capital gains. boardtwice the standardchesssize,has farmorepo- The mechanism may look like taxing business sitions than atoms in the known Universe :-). NO wealth. This concern is misleading. As an asset tax, faster evaluation can be consistent across one move, thetoolwouldhaveanegativeratesinceitcarriesan i.e. yield values equal to the highest values it gives income-taxshelterofgreatervalue. (Andinisolation to the positions attainable in one move. Obviously, its rate would be zero, being tied to the rate of its taxing wrong values will conflict with my incentives, complementary consumption tax.) One may observe impairing my winning chances. My interest in win- that a balanced combination of a consumption tax ning is distorted by an added interest in appearing a with a business asset tax (unlike either component loser to you during much of the game. alone) does simulate a sort an of income tax.