Table Of Content∗
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.
