The Future of Capital Income Taxation

From Alan Auerbach:

The case against capital income taxation is stronger now than when Pechman wrote [in 1900], given the difficulty of collecting capital income taxes in a world of financial innovation and capital mobility.

[…] The rising importance of financial activities has two important implications for the future of capital income taxation. First, to the extent that financial companies have greater flexibility in responding to tax incentives, particularly with respect to the location of their activities (it is, after all, easier to move electrons than cement), the difficulty of chasing capital income in order to tax it can only get harder. Second, tax systems designed for nonfinancial companies may not work especially well when applied to the financial sector. As I discuss below, this shift has particular consequences regarding the alternatives to our current system of capital income taxation.

[…] Capital income is difficult to measure and capital income taxes are difficult to collect. Moreover, economic research has shown us that, even under ideal circumstances with regard to measurement and collection, we might wish not to have capital income taxes at all, especially in the long run, because of their extreme distortion of saving decisions, and that we don’t necessarily need to use capital income taxes to satisfy the requirements of equity and social justice. It might seem, then, that modifying our current system simply by eliminating capital income taxes would be desirable.

This outcome, however, is not likely, nor is it particularly desirable. Capital income has different pieces, including returns to risk-taking, prior investments and firm-specific economic rents. Only a small portion of the measured return to capital represents the normal return to new saving that our theories tell us not to tax. Eliminating all taxes on capital income gives up much more revenue than simply eliminating the tax on the normal return to new saving, and does little for the cause of equity, in fact and in appearance. Further, having no tax at all on capital income while maintaining a tax on labor income puts considerable pressure on the distinction between labor and capital income.


About ozidar

I'm an Assistant Professor of Economics at the University of Chicago Booth School of Business and a Faculty Research Fellow at National Bureau of Economic Research. You can follow me on twitter @omzidar.
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