CAPITAL GAINS TAXATION AND TAX REFORM**€¦ · of capital gains taxation. It would con- capital gains tax reform. tinue to allow capital gains taxes to be The next section briefly

CAPITAL GAINS TAXATION AND TAX REFORM**

ALAN J. AUERBACH*

1. Introduction policy would represent a Pareto improve-ment. Therefore, its regressive distribu-

SCARCELY two years after the Tax tional consequences would lose signifi-Reform Act of 1986 raised tax rates on cance: no one need be made worse off. Even

long-term capital gains, there is consid- those favoring more fundamental revi-erable support for President Bush's pro- sions of the capital gains tax structureposal to reduce the maximum rate of tax ought to favor such a Pareto improve-on long-term gains from 33 percent to 15 ment, while perhaps seeking furtherpercent. While seeking to change the rate changes. Therefore, it is important to knowof tax, the Bush plan would preserve other how likely a permanent revenue increasesignificant characteristics of our system is before turning to other approaches toof capital gains taxation. It would con- capital gains tax reform.tinue to allow capital gains taxes to be The next section briefly reviews theeluded entirely at death, would provide empirical evidence to date, arguing thatno indexation of asset bases to account for a permanent revenue increase is unlikelyinflation and would maintain limits on the enough to be discarded as a reason for re-deductibility of capital losses. Capital ducing the capital gains tax rate. The fol-gains would still be taxed only upon re- lowing sections discuss the distortions as-alization. sociated with capital gains taxation, how

Under a Haig-Simons income tax, cap- these would be affected by a reduction inital gains would be indexed for inflation capital gains tax rates, and the other pol-and taxed on accrual, with gains and losses icies available to lessen such distortions.treated symmetrically. The treatment ofgains at death would lose significance be-cause gains would already have been taxed 11. Recent Empirical Evidenceas they accrued. Many of the distortionsassociated with the present system of The responsiveness of capital gains re-

capital gains taxation result from its de- alizations to tax rate changes has been the

viation from the Haig-Simons approach. subject of spirited debate for over a de-

These deviations may have historical ex- cade. A review of this literature in Auer-

planations but their persistence is hard to bach (1988a) reached several conclusions:

rationalize from an economic perspective. (1) Previous cross-section studies have,

It is therefore disappointing and puzzling by their very nature, been unablethat the debate about capital gains taxes to distinguish temporary from per-continues to focus almost exclusively on manent responses to capital gains

tax rates rather than on tax structure. tax rate changes.Like past debates about the effects of (2) Previous panel studies have found

changing capital gains tax rates, the cur- a significant part of the cross-sec-rent one has been characterized by a fix- tion responsiveness to capital gainsation on the prospect of a free lunch, on tax rate differences to be associatedthe possibility that a reduction in capital with temporary deviations of tax

gains tax rates might actually raise rev- rates from their longer-run values.

enue. It is useful to consider the impli- (3) Studies using cross-section data and,

cations of a permanent increase in reve- to a lesser extent, panel data, iden-

nue. Since those facing capital gains tax tify responsiveness to tax rates us-rates would be better off and the govem- ing behavioral differences among

ment would collect more revenue, the individuals facing different tax ratesat the same time under the same tax

*Univemity of Pennsylvania, Philadelphia, PA 19104 regime. If individuals facing differ-

and NBER. ent tax rates also differ in unob-

391

392 NATIONAL TAX JOURNAL [Vol. XLII

served ways (such as their attitudes measured by the Federal Reserve Boardtoward risk) that influence the pro- (1989)), PGNP is the GNP deflator, NYSEpensity to realize gains, then the in- is the New York Stock Exchange Index,ferences are invalid. MTR is the current average marginal tax

(4) Previous time series studies, shar- rate (as measured by the Congressionaling the advantage of being based on Budget Office (1988)), dMTR(+l) is theresponses to actual tax rate changes change in the marginal tax rate one yearand the inherent disadvantage of ahead, and CG(-I) is the lagged level ofaggregation, have been flawed by capital gains realizations. All variablesinattention to econometric prob- except the marginal tax rates entef inlems and a lack of structural mod- logarithmic form and the equation itselfelling. No previous time series study is estimated in first differences to avoidwould have predicted the doubling the econometric problems of nonstation-of capital gains realizations that oc- arity.curred in 1986 because none rec- Except for minor differences, equationognized the need to account for an- (1) is the same as the final equation re-ticipated changes in capital gains ported in Auerbach (1988a). One sourcetax rates. When anticipations are of these differences is various data revi-taken into account, there is essen- sions. Another is the original use of two-tially no measurable permanent re- stage least squares, with the future taxsponse of capital gains realizations rate change treated as endogenous andto changes in capital gains tax rates. instruments chosen from the current in-

To illustrate this last point, it is useful formation set. The justification for thisto consider the following equation, esti- procedure was that the predictable, rathermated for the sample period 1956-86 by than the actual, future tax rate changeordinary least squares (with t-statistics in ought to be relevant for current decisions.parentheses): Inserting the actual tax rate change could

therefore lead to a downward, errors-in-d log(CG) 0.14 + 2.09 variables bias.

(-2.10) (2.13) While this logic appeared to hold ford log(PGNP) + 0.41 d log (RCE) earlier sample periods, subsequent inves-

(2.03) tigation has revealed that for the sampleperiod ending in 1986 the first stage

+ 3.64 d log(RGNP) regression predicting the future tax rate(2.95) change has very little predictive power.

+ 0.72 d log(NYSE) Apparently, even though it was fully an-

(2.52) ticipated beforehand, the very large taxchange that occurred in 1987 could not be

- 0.05 d MTR predicted very well using instruments in-(-0.03) cludedin thedataset.Giventhat this most

+ 3.55 d2MTR(+ 1) recent tax change and many previous oneswere legislated in advance, the errors-in-

(3.85) variables argument favoring the use of- 0.09 d log (CG(- 1)) instruments is further weakened. Al-

(-0.77) though including the actual tax rate ratherthan its predicted value has little impact

R2 = .72 on the coefficients themselves, it reducesD-W statistic = 2.14 standard errors considerably, with all

variables except the current tax rate andIn equation (1), CG is the aggregate the lagged value of capital gains being

value of long-term gains in excess of short- statistically significant.'term losses reported by households on all Equation (1) indicates that anticipatedtax returns. RGNP is real GNP, RCE is tax rate changes have an important im-the real value (using the GNP deflator) pact on economic behavior. For example,of corporate wealth held by households (as at an initial tax rate of 20 percent, a per-

No. 31 ALAN J. AUERBACH 393

centage point decrease in next year's cap- implied elasticity of capital gains with re-ital gains tax rate would decrease real- spect

3to a permanent tax rate change is

izations by 7 percent today. However, it -.49. Vv'hile this elasticity is still signifpredicts essentially no permanent re- icantly smaller than that used by thesponse thereafter, and hence a consider- Treasury in its recent revenue estimatesable revenue loss. (U.S. Treasury 1989) for the Bush plan,

How robust is this result? Preliminary the change in the regression result showsestimates of capital gains realizations for how empirically significant the recent ex-1987 allow the extension of the sample perience has been. Although the sampleperiod by one year. After reaching a high contains over thirty observations, thereof 318.8 billion dollars in 1986, long-term really have been very few importantgains net of short-term losses were aD- changes in the tax treatment of capitalproximately 138.0 billion dollars in 1981.2 gains during the past few decades. AnIncluding this observation, with the (cor- "experiment" of the recent magnitude in-rect) assumption that no tax rate change creases the available information consid-would occur in 1988, one obtains the fol- erably, as the change in cciefficients shows.lowing version of (1): Without more evidence, we must ap-

proach even these more recent estimatesd log(CG) = -0.16 with considerable caution.' At the same

(-2.27) time, one should recognize that there has

+ 2.20 d log(PGNP)yet to be a serious empirical estimatebased on time series data suggesting a

(2.11) long-run elasticity close in absolute value+ 0.52 d log(RCE) to one, roughly the value necessary for the

(2.52) free lunch.Given this lack of robustness, one should

+ 4.44 d log(RGNP) also consider other implications of var-(3.55) ious degrees of responsiveness of realiza-

+ 0.55 d log(NYSE) tions to tax rate changes. Since realiza-(1.90) tions must be generated by some

underlying processof asset turnover, one- 2.85 d MTR may ask by how much turnover behavior

(-1.92) must be altered to deliver a given pro-

+ 3.86 d2MTR(+ 1) portional change in capital gains realiza-

(3.98) tions.For example, the Treasury (1989) esti-

- 0.17 d log (CG(- 1)) (2) mates that, even in the long run, realiza-(-1.39) tions would increase by more than enough

R2 = .80 to offset the lost revenue from the Bushtax cut.' Given the size of the tax cut, this

D-W statistic = 2.24 suggests nearly a doubling of realiza-tions. What change in behavior would a

D-W statistic = 2.24 doubling of realizations require?To answer this question, we take an ap-

The addition of just one year increases the proach similar to that found in BaileyR' noticeably. While the anticipated tax (1969), considering a simple model of as-rate change is slightly _more important set turnover. Suppose that a certain frac-than before, the current tax rate has be- tion, say f, of all assets never face capitalcome considerably more important, atgains taxes, being passed on or given awaytaining marginal statistical significance. and receiving a stepped-up basis in theAt a tax rate of 20 percent, roughly half- process. Of the assets that are ever real-way between the currently estimated CBO ized, suppose that a fraction 8 of all suchtax rate of 25.4 percent and the likely av- assets are sold each year. Let at be theerage marginal tax rate of slightly less nominal value of assets sold at date t, andthan 15 percent under the Bush plan, the suppose that all such assets as well as the


value of output grow in nominal value at cent values. For G/a, we use the ratio ofa constant rate g. Then, at date t, the level gains to sales for all assets calculated byof realized gains will be: Clark and Paris (1985) from the 1981

+ g)2Capital Assets Survey, .303.' The implied

Gt = gBat-I + [(l values of 8 and f are .23 and .53, respec-

8(l - B)at-2 + (3) tively. That is, the model suggests thatabout half of all eligible assets never face

In a long-run steady state, a, = (I + g)at-I capital gains taxes, and that about a= (1 + g)2at-2, and so on, i.e., the level of quarter of those that do are sold each year.

assets realized each year must grow at the These results are surprisingly consistent

economy's growth rate. With this condi- (given the simple methodology) with Bai-

tion, (3) becomes: ley's original findings.Now, consider the changes in 8 and f

G/a = gl(g + 8) (4) needed to raise the ratio of gains to assetsfrom .033 to .066. Expression (7) provides

which relates gains to sales at each date.the various combinations (8, f) that would

The total value of assets that are ever sold succeed in doing so. A considerable change

equals those last realized one year ago, at in behavior would be necessary. For ex-

current value, (1 + g)at-1, plus those last ample, even if all assets ever realized were

realized two years ago, at current value,turned over every year (b = 1), the frac-

(1 + g)2(l - 8)at-2, and so on. Given thetion never realized would have to drop

steady state condition, the sum equal@ atroughly in half (f = .274). If half of all

+ (1 - 8)at + ... = at/b. Since a fraction assets were sold each year (b = .5), the

f of all assets are never realized, this re-fraction never realized would have to dropto just over one-fifth (f = .208). If the rate

sult and (4) together imply that the ratio of realization, 8, did not change, the frac-of gains to amets each year is: tion never realized would have to fall

G/A = (1 - f)gb/(g + 8). (5)nearly to zero (f = .053).

While changes of this sort are not

One cannot observe f and 8 directly. How- strictly impossible, it is worth noting that

ever, given observations on the nominal a ratio of gains to assets, (G/A), of at least

rate of return, the ratio of gains to sales, .066 has occurred only once in the period

and the ratio of gains to assets, one may 1954-87, in the very atypical year 1986.

estimate these two unobservable param-(The second highest annual value was

." .041.) To expect such behavior every yeareters. That is, (4) and (5) may be rewrii;- seems rather optimistic, whatever the re-ten: sults of any given empirical elasticity cal-

8 g(l - G/a)/(G/a) (6) culation.

f 1 - (G/A)(g + 8)/gb. (7) 111.TheDistortionsofCapitalGains

Tocalculatetheratioofgainstoassets,Taxation

oneneedsa measureof thesizeofassets While a capital gains tax cut appearsin the category subject to individual cap- unlikely to increase revenue, the ob-ital gains taxes. For this, we use the Fed- served responsiveness of realizations to taxeral Reserve Flow of Funds (1989) mea- rate changes indicates that a sizeable ratesure of household equity in corporate and reduction would certainly alter individ-noncorporate business.' Because a long-run ual behavior. Since taxes distort behav-calculation is necessary, we take the av- ior, this suggests the possibility that aerage value of G/A for the last ten years capital gains rate reduction, even if lead-for which data are available, 1978-87. The ing to a revenue loss, might neverthelessresulting value is .033. We choose a nom- be a welfare-increasing policy through itsinal return, g, of .1, consistent with re- reduction of various distortions. This sec-


tion briefly reviews the distortions asso- tion is not manifested by either firm hav-ciated with capital gains taxation. ing "too much" capital.

How large are the social costs from the

A. The "Lock-In" Effectinefficient portfolios induced by the lock-in effect? This is a question that has re-

Since capital gains are not taxed until ceived little attention.'they are realized, owners of appreciatedassets can defer taxes at zero interest cost B. Tax Arbitrageuntil realization occurs. The deferral en-efit relates to the size of the accrued cap- The strength of the lock-in effect de-ital gain. Because the benefit increases as pends on the size of the locked-in gain. Ifdeferral continues, the investor is said to this gain is negative, i.e., if the positionbe "locked-in," that is, willing to accept a shows a loss, the investor's incentive is tolower before-tax rate of return to com- avoid deferral and realize immediately; thepensate for the deferral advantage. This lock-in effect becomes a "lock-out" effect.choice of assets by the investor is the dis- This leads to the further possibility thattortion associated with the lock-in effect. investors can engage in tax arbitrage,

The effects of this portfolio choice dis- selling losers and holding winners whiletortion are often misunderstood in dis- maintaining a balanced portfolio. Follow-cussions of the lock-in effect. It is a dis- ing such a strategy allows the investor totortion to the distribution of assets across reduce taxes with little distortion to hisinvestors, not to the overall composition underlying portfolio (see Stiglitz 1983).of assets. When an investor chooses to hold This suggests that the direct distortionsor sell shares in a company, this decision caused by the lock-in effect may be min-has no direct impact on the size of that imal, as investors hedge locked-in posi-company; it simply affects the ownership tions through inexpensive portfolio ma-of the company's shares. The lock-in ef- nipulations. The social distortion isfect does not lead to aggregate overin- reduced in magnitude to that of thevestment in firms whose investors have transaction costs of these portfolio manip-locked-in positions, simply overinvest- ulations.ment in these firms by those individuals.' While such arbitrage clearly occurs,There is no foregoing of high social re- evidence on the matching of gains andturns in other firms because some firms losses suggests that most realized gainshave too much capital invested. are not offset by losses and nearly half of

The lower effective before-tax rates of all losses realized provide no current taxreturn that investors suffer when being reduction (Auerbach 1988a). The costs oflocked in come not from the company tax arbitrage behavior are apparently notachieving below-normal rates of return, trivial, indicating that the lock-in effectbut from a lack of adequate portfolio di- remains relevant.versification on the part of investors. Forexample, suppose there were two inve.s- C. Inflationtors, one holding appreciated shares inIBM and the other holding appreciated Capital gains are taxed on a nominalshares in General Motors. Each investor basis, making it possible for invegtors tomight prefer to hold a diversified portfo- pay taxes on gains that represent nothinglio with shares in each company, but this more than price level increases. Indeed,would necessitate the payment of capital nominal gains and real losses could co-gains taxes. Thus, each may elect to exist. The distortion associated with thismaintain an inefficiently specialized phenomenon is that it makes that burdenportfolio, foregoing the social benefits of of capital gains taxation dependent uponportfolio diversification. This is a social the rate of inflation. It also increases thecost: there are net gains to society from extent of the lock-in effect, which dependsportfolio diversification. But the distor- on the nominal rate of return. Inflation


is often used to justify a reduction in cap- erations would call for the widening of thisital gains taxes, just as it has been used difference associated with a reduction inin other contexts to support reductions in the rate of capital gains taxation.the tax burden, via accelerated deprecia-tion, for example. E. Debt-Equity Ratios, Corporate

There are two points worth making here. Financial Policy and the Cost of CapitalFirst, the inflation problem is not uniqueto the capital gains tax. Interest income Like other capital income taxes, capitaland deductions are also taxed on a nom- gains taxes raise the cost of capital for eq-inal basis. Given that capital gains are uity-financed firms, also widening the gapalready favored by deferral, the increase between the costs of equity and debt cap-in the tax burden due to inflation is ac- ital. Lowering the capital gains tax ratetually greater for fully taxed assets. Sec- would decrease the net tax advantage fromond, to the extent that a capital gains tax issuing debt instead of equity.rate reduction (or base exclusion) is used This improvement of the relative posi-to offset inflation, the rate reduction tion of equity is sometimes seen as re-should decrease with holding period ducing the incentives to replace equity(Brinner 1973): as the holding period in- with debt via corporate share repurchasescreases, the fraction of gains attributable and cash-financed acquisitions of otherto inflation declines (assuming the real firms. However, there are two offsettingrate of return is positive). effects here and the net effect is uncer-

tain. As already stated, a capital gains tax

D. Venture Capital and Risk-Takingreduction would reduce the net tax ad-vantage of debt over equity. Some tax ad-

Capital gains tax rate reductions are vantage would remain, since the top in-often supported as a means for encour- dividual rate at which interest paymentsaging venture capital enterprises and risky are taxed, 33 percent, is below the rate,investments in general. In an efficient 34 percent, at which equity earnings arecapital market, there is no argument a taxed at the corporate level even beforepriori for encouraging risk-taking; risk is account is taken of the additional taxesa real social burden for which those bear- on dividends and capital gains. Moreover,ing it should be compensated (Arrow and the tax cost of replacing equity with debt,Lind 1970). When deductibility of capital equal to the capital gains tax liability onlosses is severely limited, as is presently redeemed shares, would also be reduced.the case, risky investments may be pen- Thus, the benefits and the costs of re-alized. Such loss limitations may be quite placing equity with debt would each berational because of the voluntary nature reduced.of realizations and the possibility of tax To see how these effects would com-arbitrage, but they also discriminate pare, consider the following example.against very risky assets likely to land an Suppose a firm must decide whether toinvestor in a position with significant net redeem its equity with debt. The equitylosses. In lieu of an increase in the de- has a basis of 1, the interest rate is i, andductibility of losses, a reduction in the tax the firm's future cash flow after corporaterate on capital gains would help such as- taxes will be constant at a value x. Thus,sets. the value of debt that can be supported by

A related point here is that a signifi- this cash flow stream iscant part of the capital gain from venturecapital operations may actually be a re- Vb = X/li(l - t)] (8)turn to entrepreneurship, compensationfor a founder's labor income. Given that where t is the corporate tax rate at whichthis compensation is tax-favored by de- interest payments are deductible. Thus, ifferral relative to straight wage and sal- the firm redeems its equity, the share-ary income, even if capital gains are fully holders' net wealth after capital gainstaxed, it is unclear that efficiency consid- taxes (at rate c) will be


Wb = Vb - C(Vb - l)- (9) Finally, a capital gains tax reduction islikely to encourage corporate retentions,

If the firm keeps its equity, the share- given empirical estimates on the dividendholders' wealth equals the value of the behavior of corporations (e.g. Poterba andstream x, discounted at the appropriate Summers 1985). Since corporations saveequity discount rate. This rate must take a much higher fraction of their earningsinto account the possibility of future cap- than households, this transfer of fundsital gains realizations. Since deferral re- from households to corporations is oftenduces the effective tax rate on capital seen as a way to increase private savings.gains, let K equal the accrual equivalent However, differences in average savingstax rate based on c and the pattern of de- propensities need not lead to any netferral, with @L< c. To place an upper bound change in the level of savings. If house-on the size of the benefits to equity of a holds receive lower. distributions fromtax cut, assume that all equity returns are firms, they might simply offset these re-taxed at the capital gains tax rate. Then, ductions, "piercing the corporate veil" toif r is the required return to equity after maintain a given level of consumption.all taxes, the firm's flows must be dis- Recent evidence on this question (Auer-counted at r/(l - K), yielding a value of bach and Hassett 1989) fails to provideequity equal to support for the view that such a change

in dividend policy would alter the level ofV. = x/lr/(l - @L)I. (10) private savings.

Even if private saving does increaseNow, consider a change in the capital somewhat as a result of increased corpo-gains tax rate c, which brings with it a rate saving, household saving would al-change in the accrual-equivalent tax rate most surely drop to some extent. Thus, aii. Using (8) - (10), we may calculate the lesser amount of new capital would bechanges in shareholders' wealth in each available in the market for new venturescase: not having access to retained earnings. In

this sense, the capital gains tax prefer-dWb/dc -(Vb - 1) ence would lead to a distorted allocation

of capital among uses, with existing en-dV./dc -V,/(l - li) * dR/dc. (12) terprises being favored over new ones."

It is ironic that the very enterprises oftenUnder normal circumstances dK/dc will seen as the main beneficiaries of a capitalbe positive but less than one. gains tax reduction would suffer from this

Each value of shareholders' wealth behavioral response to such a change inwould increase if capital gains taxes were tax policy.cut, but which would increase more? Ifthere is a sufficiently small locked-in gainin existing shares (Vb exceeds 1 by very IV. Alternatives to a Reduction inlittle) then the increased value of equity Capital Gains Tax Rateswill exceed the reduced cost of convertinginto debt. If basis is very low, on the other The previous section identified severalhand, the opposite ranking will result. In distortions associated with capital gainsthe extreme case with zero basis, a suf- taxation, some of which (e.g. the lock-inficient condition for this to occur would be effect, the disincentive to invest) would bethat dIL/de < 1 - R, since Vb exceeds V,. alleviated by a reduction in capital gainsThis sufficient condition is almost surely tax rates but others of which (e.g. tax ar-satisfied, given the very low value typi- bitrage, the incentive to retain earninlys)cally estimated for K. Thus, one cannot would be worsened. This section considersreach general conclusions regarding a variety of options aimed at similar ob-whether a capital gains tax cut will re- jectives but, in many ways, having ad-duce or increase the existing incentive to vantages relative to a simple reduction inconvert equity into debt. capital gains tax rates.


A. Indexing ital gains tax liabilities at death. If theThere is little argument against and calculations given in Section II are ac-

little complexity to the idea of indexing curate, then perhaps half of all taxable

capital gains for inflation. Investors would capital gains are never taxed. Taxing gainssimply gross up an asset's basis for inter- at death would therefore raise consider-vening changes in the price level before able revenue, while at the same time re-

calculating capital gains. The Treasury ducing the lock-in effect. Like any in-

(1984) tax reform proposal included such crease in capital gains taxes, it would,crease the tax burden on equity-fi-• provision for indexation, which is clearly "

• more direct and accurate correction than nanced investment. However, there is• reduction in tax rates for the distortions scant evidence on the responsiveness ofto the tax base that inflation causes. bequests to the level of taxation at death,

In other respects, too, indexation would and one must wonder whether they weighas heavily on investors as taxes paid dur-be superior to a rate reduction. Since it .

would maintain the same tax rate, it would ing their lifetimes.

not encourage the conversion of ordinary How much revenue would such a pro-

income into capital gains that is part of vision raise? To get a rough sense, con-

the tax arbitrage problem. For the same sider once again the model used above.reason, it would not increase the incen- Suppose a fraction f of all assets is never

tive to convert dividends into capital gains sold, and is transferred only at death. Forvia corporate retentions. simplicity, assume that all investors face

the same probability of death, P. Then aB. Special Provisions for Venture fraction P of all assets held for estates is

Capital transferred each year. Let bt be the nom-inal value of assets transferred at date t,

Indexing would do little to encourage and suppose, as before, that all assets asventure capital operations, characterized well as the value of output grow in nom-by the uncertain prospect of very large real inal value at a constant rate g. Then, atgains over a relatively short period of time. date t, the level of gains on transferredThe special problem of small, risky en- assets accumulated since these assets' mostterprises is already dealt with by a pro- recent previous transfers will be:vision of the tax code allowing the deduc-tion of up to 100,000 dollars on a joint Dt = gpbt-, + [(l + g)2 _ 1]return on the loss from a sale of "smallbusiness corporatioif' (Section 1244) stock. P(l - P)bt-2 + (13)To qualify for such treatment, corpora-tions may not have a total equity base in In a long-run steady state, bt = (I + g)bt-,excess of 1 million dollars. = (1 + g)2bt-2, and so on, i.e., the level of

An expansion of this rule would rep- assets transferred each year must grow atresent a much more direct attack on the the economy's growth rate. With this con-venture capital problem than an across- dition, (13) becomes:the-board cut in capital gains taxes, sinceonly about 0. 1 percent of outstanding cor- D/b = g/(g + P) (14)porate stock is associated with venturecapital operations (Treasury 1985). At the which relates gains to transfers at eachsame time, an expansion of this special date. The total value of assets that aretreatment for certain classes of corpora- never sold equals those last transferredtions might induce attempts by larger one year ago, at current value, (I + g)bt-1,corporations to reorganize their opera- plus those last transferred two yeas ago,tions in order to qualify. at current value, (1 + g)2 (I - P)bt-2, and

so on. Given the steady state condition,C. Taxation of Capital Gains at Death the sum equals bt + (1 - P)bt + ... =

Surely one of the main causes of the bt/o. Since a fraction f of all assets arelock-in effect is the absolution of all cap- never realized, this result and (14) to-


gether imply that the ratio of gains on and indeed the Bush proposal has cen-transferred assets to all assets each year tered. It is unclear why so simple a so-is: lution has received so little attention.

The problems associated with accrualD/A = fgp/(g + P). (15) taxation apply primarily to other assets,

for which market values may not beA comparison of (15) and (5) gives the known, and taxpayers may lack the liq-

ratio of gains transferred to gains real- uidity to pay taxes on an asmes accruedized in a given year: gains and be unable to sell only part of

the asset to do so. Even in such cases, theD/G = fP(g + 6)/[(l - f)b(g + (16) problems may be overstated (Shakow 1986)

and an alternative exists that would pre-Inserting the values f = .53 and 8 = .23 serve the incentive effects of accrual tax-estimated above, continuing to let g = .1, ation but would overcome its liquidity andand letting p equal .01, roughly the ag- information problems by delaying the taxgregate mortality probability in the United payment (with interest) until realizationStates, we obtain a value of D/G = .15. and imputing the pattern of accrued gainsGiven current levels of realizations and in a particular way (Auerbach 1988b).capital gains tax rates, this would sug-gest an annual revenue increase of about E. Dividend Relief5 to 6 billion dollars, ignoring behavioralresponses." As suggested above, a reduction in cap-

ital gains taxes is not guaranteed to dis-

D. Accrual Taxation of Capital Gainscourage conversions of equity into debt.One must consider the impact not only on

The lock-in effect exists only because the return to equity capital but also oncapital gains are taxed upon realization. the costs of converting equity into debt.Were capital gains taxed on accrual, there One policy that affects only the latter iswould be no incentive to delay the real- dividend relief, a reduction in the totalization of gains and no problems caused corporate and individual tax burden onby the selective realization of capital dividends.losses. Moreover, accrual taxation would Two simple and straightforward ap-automatically solve the problem of assets proaches, already practiced in manytransferred at death, because the gains on countries, are a deduction for dividendsthese assets would already have been paid (also called a split-rate system) andtaxed. a shareholder credit (also called an im-

Without a reduction in the marginal tax putation system). The problem with suchrate on capital gains, a move to accrual plans is also simple: they are very expen-taxation would, of course, raise the effec- sive. The Treasury's 1984 tax reform pro-tive tax burden. However, a rate reduc- posal cited above included partial divi-tion would be possible because of the dend relief in the form of a 50 percentelimination of deferral and basis step-up deduction for dividends paid. It was thenat death. As already discussed, we ob- estimated that this plan would cost theserve a ratio of realized gains to assets of Treasury $30.9 billion in fiscal year 1990.around .033, a fraction of the rate of re- Little has happened since that would al-turn that would be taxed even under an ter this estimate substantially. Such par-indexed system of taxing capital gains on tial dividend relief, and certainly moreaccrual. complete relief, is entirely impractical at

Accrual taxation has already been present. Even a 20 percent dividends paidadopted for some financietl instrument5 deduction would cost roughly $6.7 billionthrough so-called "mark-to-market" rules, during fiscal year 1990, according to theand could easily be applied in cases of estimates presented in the president's 1985publicly traded common equity, the class tax reform proposals.of assets on which most recent discussion These proposals are expensive because


they would create windfalls. Most divi- discourage or encourage conversions ofdends paid during the next few years will existing equity into debt. This would become from income on assets already in true in spite of the new tax on nondivi-place. Reducing the taxes on all such in- dend distributions because this tax (or thecome is a very inefficient and (to the re- ordinary tax on dividends) would apply tocipients of such income) overly generous any distributions a corporation made inmethod of correcting the distortion be- the future. Thus, the tax should be de-tween debt and equity finance. There are ferred (with interest, since distributionsdifferent ways to make this policy more would be greater in the future) but not re-efficient, but each has its drawbacks. duced in value, and so, like the tax on ac-

The most straightforward approach cumulated earnings and profits, could notwould combine a dividends paid deduc- be avoided.tion with an offsetting tax on some mea- The ALI plan is a more elaborate waysure of current dividend capacity, such as of achieving the tax on windfalls. In ef-accumulated earnings and profits. For ex- fect, the corporation rather than the gov-ample, a 50 percent dividends paid de- emment decides when the tax is paid; theduction would be combined with a 17 per- unpaid balance accumulates interest. Un-cent (50 percent of the 34 percent corporate like the immediate tax on windfalls, how-tax rate) tax on accumulated earnings and ever, its effectiveness depends on taxpay-profits. The windfall tax could be made ers believing that its provisions arepayable over several years. The logic of permanent. A permanent tax on distri-this policy is that it would eliminate the butions may not affect the timing of suchnet benefit of the deduction for all divi- distributions, but a temporary tax would.dends paid out of past earnings and prof- Given the frequency with which tax pro-its; it would provide a net reduction only visions change, any tax on distributionsfor dividends generated by new equity may be perceived as a temporary one. Incapital. Depending on the timing of the this case, the ALI plan could strongly dis-windfall tax, the total package could raise courage share repurchases, leveragedrevenue for a number of years. The dis- buyouts and other cash acquisitions. Itadvantage of this policy is primarily po- might even discourage dividends, if cor-litical. The president's 1985 proposals in- porations anticipated that dividend reliefcluded a similar provision (to reduce the would be made available to all dividendswindfalls arising from the corporate rate in the future.reduction) that proved to be extremely Another set of alternatives would dis-unpopular. pense with an attempt to tax windfalls and

A more elegant way of limiting wind- combine more modest dividend relief withfalls is provided by a proposal circulated some reduction in the tax benefits of bor-by the American Law Institute (ALI). The rowing (e.g. Graetz 1989).recent version (dated November 1988)would provide a dividends paid deduction V. Conclusionsbased on the extent of new equity contri- The behavioral effects of capital gainsbutions, and would at the same time im- taxes are too uncertain for precise reve-pose an alternative minimum tax of 28 nue calculations, but there is very littlepercent on nondividend corporate distri- reason to expect that a reduction in cap-butions, withheld at the corporate level ital gains tax rates would raise revenue.and credited against shareholder tax lia- Viewed as a potential tax reform ratherbility on the distributions. than a free lunch, such a policy is hard to

The ALI proposal is intended to limit justify as the appropriate solution to anywindfalls by excluding existing equity from economic problem, in light of the range ofdividend relief. Under certain assump- practical alternatives presently available.tions, this approach would provide thesame incentives as the combination of full ENDNOTESdividend relief and a windfalls tax. Nei- **I am grateful to the Institute for Law and E

Ico-

ther the tax on accumulated earnings and nomics of the University of Pennsylvania for finan-profits nor the ALI proposal would either cial support.

No. 31 1 ALAN J. AUERBACH 401

'In the original specification, the current and fu- Auerbach, Alan J., 1988a, "Capital Gains Taxation inture tax rate variables had coefficients of -0.25 and the United States," Brookings Papers on Economic3.26, respectively, with t-statisties of -0.08 and 1.09. Activity, 2, pp. 595-631.

'Because there is no longer any distinction on tax Auerbach, Alan J., 1988b, "Retrospective Capital Gainsreturns between long-term and short-term gains, this Taxation," NBER Working Paper No. 2792, Decem-total is not directly measurable for 1987, but may be ber.imputed with considerable accuracy given past be- Auerbach, Alan J. and Kevin Hassett, 1989, "Cor-havior patterns and the insignificance of short-term porate Saving and Shareholder Consumption," Uni-gains. The Joint Committee on Taxation, in April 1989, versity of Pennsylvania mimeo.estimated the net gains on Schedule D to be 140.0 bil- Bailey, Martin J., 1969, "Capital Gains and Incomelion dollars. Multiplied by the ratio of this measure Taxation," in A. C. Har;berger and M. J. Bailey, eds.,for 1986 taken &om the final Statistics of Income es- The Taxation of Inconu from Capital (Washington,timates (323.6 billion dollars) to the 1986 level of long- Brookings), pp. 11-49.term gains net of short-term losses, the 140.0 billion Board of Governors of the Federal Reserve System,dollar estimate is reduced to 138.0 billion. 1989, Balance Sheets for the U.S. Economy 1949-

3This value equals the tax rate coefficient divided 1988, May.by 1 plus the coefficient of lagged capital gains, all Brinner, Roger, 1973, "Inflation, Deferral and themultiplied by the tax rate itself, consistent with the Neutral Taxation of Capital Gains," National Taxsemilog specification. Journal, December, pp. 565-74.

'Indeed, lack of robustness carries over the panel Clark, Bobby and David Paris, 1985, "Sales of Capitaldata, as recent work by Slemrod and Shobe (1989) Assets, 1981 and 1982," Statistics of Income Bul-shows. letin, Winter, pp. 65-85.

'For 1999, the last year for which estimates are Congressional Budget Office, 1988, How Capital Gainsprovided, the revenue lost on existing realizations is Tax Rates Affect Revenues: the Historical Evidence,projected to be 23.5 billion dollars, while 24.5 billion March.dollars of revenue from new gains is anticipated. These Congressional Budget Office, 1989, Reducing the Def-gains do not include those associated with eliminat- icit, Spending and Revenue Options, February.ing certain assets with lower estimates tax rate elas- Graetz, Michael J., 1989, "The Tax Aspects of Lever-ticities from the proposal. aged Buyouts and other Corporate Financial Re-

'This measure excludes household pension fund structuring Transactions," Tax Notes, February 6,wealth and includes, via noneorporate business wealth, pp. 721-6.such items as rental residential and nonresidential Kovenock, Daniel J. and Michael Rothschild, 1987,real estate. It excludes consumer durables, owner-oc- "Notes on the Effect of Capital Gains Taxation oncupied housing and financial assets besides corporate Non-Austrian Assets," in A. Razin and E. Sadka,equities. eds., Economic Policy in Theory and Practice (Lon-

'A very similar fraction results from calculations don, Macmillan) pp: 309-339.based exclusively on sales of common stock. Poterba, James M. and Lawrence Summers, 1985, "The

scapital gains taxes may affect the aggregate tax Economic Effects of Dividend Taxation," in E. Alt-mix of investment if they increase retained earnings man and M. Subrahmanyam, eds. Recent Advancesby firms. This is discussed further below. in Corporate Finance, pp. 229-84.

'For further discussion of the portfolio distortions Shakow, David, 1986, "Taxation without Realization:and the lock-in effect, see Kovenock and Rothschild A Proposal for Accrual Taxation," University of(1987). Pennsylvania Law Review, June, pp. 1111-1205.

'oIt should be stressed that this effect is distinct from Slemrod, Joel and William Shobe, 1989, "The Taxthe lock-in effect discussed above, relating to the pref- Elasticity of Capital Gains Realizations: Evidenceerential treatment of capital gains rather than their from a Panel of Taxpayers," University of Michi-being taxed on realization. gan, mimeo.

"A similar revenue estimate is arrived at in Sitglitz, Joseph E., 1983, "Some Aspects of the Tax-Congressional Budget Office (1989). ation of Capital Gains," Journal of Public Econom-

ics, June, pp. 267-294.U.S. Treasury, 1984, Tax Reform for Fairness, Sim-

REFERENCES plicity and Economic Growth, November.U.S. Treasury, 1985, Report to Congress on the Cap-

American Law Institute, 1988, Subehapter C (Sup- ital Gains Tax Reductions of 1978, September.plemental Study). Part I. Distribution Issues, No- U.S. Treasury, 1989, General Explanations of thevember 3. President's Budget Proposals Affecting Receipts,

Arrow, Kenneth J. and Robert C. Lind, 1970, "Un- February.certainty and the Evaluation of Public Investment U.S. President, 1985, The President's Tax ProposalsDecisions," American Economic Review, June, pp. to the Congress for Fairness, Growth and Simplic-364-78. ity, May.

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CAPITAL GAINS TAXATION AND TAX REFORM**€¦ · of capital gains taxation. It would con- capital gains tax reform. tinue to allow capital gains taxes to be The next section briefly