The release of Mitt Romney's tax returns has drawn attention yet again to the disparity between the rates paid on ordinary income and those paid on capital gains. It is being argued in some quarters that the 15% rate on capital gains vastly underestimates the effective tax rate paid by those whose income comes largely from financial investments, on the grounds that corporations pay a rate of 35% on profits. Were it not for this tax, it is argued, dividends and capital gains would be higher, and so would the after-tax receipts of those who derive the bulk of their income from such sources.
Romney himself has made this argument recently, claiming that his effective tax rate is closer to 50%:
There is no doubt that the presence of the corporate tax depresses the price of equities, but it does so both at the time of purchase and at the time of sale. If there were no corporate tax, dividends and capital gains per share would certainly be higher, but an investor would have paid substantially more per share to acquire his assets in the first place. As a result he would be holding fewer shares for any given initial outlay, and his after-tax income (holding constant the rate paid on capital gains) would not be substantially different.
To see why, it is useful to think about what determines the price of equities. Three factors are especially important: the current earnings of a firm (after payment of interest and taxes), the rate at which these earnings are expected to grow, and the riskiness of the security, which itself is linked to the degree to which the firm's earnings are correlated with broader market movements. Securities that are riskier in this latter sense tend to appreciate faster on average because investors would otherwise avoid them, depressing their prices and raising their expected returns until such returns are viewed as adequate compensation for the greater risk of holding them. This risk is routinely expressed as a market capitalization rate, interpreted as the expected return that investors require in order to hold the security. Airline and automobile stocks, for instance, have higher market capitalization rates than do shares in utilities.
The manner in which these factors interact to influence prices may be illustrated by considering the simplest possible case of a firm with constant expected earnings growth and a fixed dividend payout ratio. In this case, for reasons discussed in any introductory finance textbook, the fundamental value of the security is given by the simple formula D/(k-g), where D is the current dividend forecast (a constant share of the earnings forecast), g is its expected rate of growth, and k is the market capitalization rate. Shares in a debt-free firm that pays 20% of its earnings as dividends, is currently earning $10 per share annually, is expected to grow at 10%, and has a market capitalization rate of 12% would then have a share price of $100. After a year (assuming no change in these parameters) the share price would be $110 and the dividend payout $2. An investor would have made $12 on a $100 investment, a percentage return precisely equal to the market capitalization rate. All this is with no corporate tax.
Now suppose that a 35% corporate tax is in place, so after-tax earnings per share are $6.50 instead, with no change in other specifications. Dividends are then $1.30 per share and the initial share price is $65. After a year this rises to $71.50. Adding dividends and capital gains, an investor makes $7.80 for each share purchased at $65, again earning precisely 12%. Each share results in lower revenues to the investor, but since more shares can be purchased at the outset, aggregate income is no different.
None of this should be in the least bit surprising. Note, however, that if the corporate tax were to be eliminated today, there would be a sharp rise in the price of equities and current asset holders would enjoy a windfall gain. Similar issues arise with respect to the mortgage interest deduction: eliminating this would result in an immediate decline in home values, severely punishing those who purchased recently at prices that reflected the anticipated tax savings over the duration of the mortgage.
This does not necessarily mean that eliminating the corporate tax while simultaneously raising the rate on capital gains is necessarily a bad idea, or that elimination of the mortgage interest deduction is necessarily bad policy. A case could be made for both initiatives. The corporate tax is not uniformly applied due to the broad range of loopholes and exemptions, and the mortgage deduction is regressive and inhibits both neighborhood integration and labor mobility. But any such changes will have major distributional effects that must be taken into account in any comprehensive evaluation of the policy. Doing so properly requires a clear distinction between stocks and flows, and an analysis that goes a little deeper than simple arithmetic.
Update: Follow-up post here.
Romney himself has made this argument recently, claiming that his effective tax rate is closer to 50%:
One of the reasons why we have a lower tax rate on capital gains is because capital gains are also being taxed at the corporate level. So as businesses earn profits, that's taxed at 35 percent. Then as they distribute those profits in dividends, that's taxed at 15 percent more. So all total, the tax rate is really closer to 45 or 50 percent.The absurdity of this claim is clearly revealed if one considers capital gains that accrue to short sellers, who pay rather than receive dividends while their positions are open. Following the logic of the argument, one would be forced to conclude that short sellers are taxed at an effective rate of negative 20%, thereby receiving a significant subsidy due to the existence of the corporate tax. The flaw in this reasoning is apparent when one recognizes that asset prices are lower (relative to the zero corporate tax benchmark) not only when a short position is covered, but also when it is entered.
There is no doubt that the presence of the corporate tax depresses the price of equities, but it does so both at the time of purchase and at the time of sale. If there were no corporate tax, dividends and capital gains per share would certainly be higher, but an investor would have paid substantially more per share to acquire his assets in the first place. As a result he would be holding fewer shares for any given initial outlay, and his after-tax income (holding constant the rate paid on capital gains) would not be substantially different.
To see why, it is useful to think about what determines the price of equities. Three factors are especially important: the current earnings of a firm (after payment of interest and taxes), the rate at which these earnings are expected to grow, and the riskiness of the security, which itself is linked to the degree to which the firm's earnings are correlated with broader market movements. Securities that are riskier in this latter sense tend to appreciate faster on average because investors would otherwise avoid them, depressing their prices and raising their expected returns until such returns are viewed as adequate compensation for the greater risk of holding them. This risk is routinely expressed as a market capitalization rate, interpreted as the expected return that investors require in order to hold the security. Airline and automobile stocks, for instance, have higher market capitalization rates than do shares in utilities.
The manner in which these factors interact to influence prices may be illustrated by considering the simplest possible case of a firm with constant expected earnings growth and a fixed dividend payout ratio. In this case, for reasons discussed in any introductory finance textbook, the fundamental value of the security is given by the simple formula D/(k-g), where D is the current dividend forecast (a constant share of the earnings forecast), g is its expected rate of growth, and k is the market capitalization rate. Shares in a debt-free firm that pays 20% of its earnings as dividends, is currently earning $10 per share annually, is expected to grow at 10%, and has a market capitalization rate of 12% would then have a share price of $100. After a year (assuming no change in these parameters) the share price would be $110 and the dividend payout $2. An investor would have made $12 on a $100 investment, a percentage return precisely equal to the market capitalization rate. All this is with no corporate tax.
Now suppose that a 35% corporate tax is in place, so after-tax earnings per share are $6.50 instead, with no change in other specifications. Dividends are then $1.30 per share and the initial share price is $65. After a year this rises to $71.50. Adding dividends and capital gains, an investor makes $7.80 for each share purchased at $65, again earning precisely 12%. Each share results in lower revenues to the investor, but since more shares can be purchased at the outset, aggregate income is no different.
None of this should be in the least bit surprising. Note, however, that if the corporate tax were to be eliminated today, there would be a sharp rise in the price of equities and current asset holders would enjoy a windfall gain. Similar issues arise with respect to the mortgage interest deduction: eliminating this would result in an immediate decline in home values, severely punishing those who purchased recently at prices that reflected the anticipated tax savings over the duration of the mortgage.
This does not necessarily mean that eliminating the corporate tax while simultaneously raising the rate on capital gains is necessarily a bad idea, or that elimination of the mortgage interest deduction is necessarily bad policy. A case could be made for both initiatives. The corporate tax is not uniformly applied due to the broad range of loopholes and exemptions, and the mortgage deduction is regressive and inhibits both neighborhood integration and labor mobility. But any such changes will have major distributional effects that must be taken into account in any comprehensive evaluation of the policy. Doing so properly requires a clear distinction between stocks and flows, and an analysis that goes a little deeper than simple arithmetic.
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Update: Follow-up post here.
If I understand this correctly, what you're saying is that the after-tax return on a stock is entirely demand-determined. That is, a stock with a level of risk that requires a 12% after-tax return will have a 12% expected after-tax return no matter what the tax rate, because, if the expected after-tax return is lower, there will be excess supply (not enough buyers), and if the expected after-tax return is lower, there will be excess demand (too many buyers). Therefore, the after-tax return always gets bid to the same level no matter what the tax rate.
ReplyDeleteBut in aggregate, stock returns are not entirely demand-determined. The reason a certain level of risk requires a 12% expected after-tax return is that, given the available set of assets, and given the risk-return tradeoffs that investors have made, that expected return is the one that clears the market. If you change the available set of assets (for example, by changing the corporate tax that applies to all stocks, not just the one in question), then the equilibrium expected return for a given level of risk will change.
Ultimately, it's a difficult tax incidence problem, where part of the corporate tax falls on shareholders while part falls on various other parties. But the same is true of the individual income tax. It's not obvious to me that the figure produced by adding the two together is any less meaningful than the the figure produced by simply ignoring the corporate tax.
Don't forget that PE investments are usually structured to mask corporate net profits to dodge that tax - preferred dividends and management fees come out to equity owners before taxes, debt is added to provide a tax shield, and in Romney's day, goodwill was still amortizable.
ReplyDeleteAndy, you're right that a change in the tax code will alter market capitalization rates for all securities but I can't imagine that this effect would be very large. Otherwise we would see vastly different returns to equity holdings in countries with different codes. Still, point taken.
ReplyDeleteI don't like the "tax incidence" perspective on this because it focuses on flows and neglects stocks; the differential effects on current versus future shareholders of a change in policy is therefore concealed. This effect is very large.
gp123, thanks for the comment. I was not really thinking of PE or even Romney really while writing this - just trying to figure out what Warren Buffett may have meant.
I agree that, when contemplating a change in policy, one has to consider the large differential effect on current vs. future shareholders. But I didn't think we were talking about a change in policy. Romney refers to the capital gains rate that we "have," not the rate that we "should have" or "did have" or "might have in the future." So I thought we were talking about a steady state, and you were trying to argue that Romney's logic doesn't apply in a steady state, whereas I still think it does, at least to some extent.
ReplyDeleteIn a closed economy, without institutional frictions and without the option of debt finance, it presumably wouldn't matter at all (in a steady state) whether you taxed profits at the corporate level or at the individual level. If investors demanded a 12% after-tax return on a given type of stock, the relevant "after tax" concept would be "after all taxes," not just after corporate taxes. If investors are rational, then whatever caused them to sell the stock when the expected after-tax return went below 12% because of a higher corporate tax rate would also cause them to sell it when the expected after-tax return went below 12% because of a higher individual tax rate. The distinction between corporate and individual capital taxes would be an arbitrary institutional distinction (although, of course, outside the steady state, shifts from one to other would affect current stockholders).
Now in reality, we live in an open economy with institutional frictions and the option of debt financing, so there clearly is a difference between taxing corporations and taxing their owners. Nonetheless, as a baseline, it seems at least as reasonable to me to aggregate the two taxes as to ignore the corporate tax.
Andy, if you think it's reasonable to aggregate the two taxes then let me ask you this: what is the effective tax rate that short sellers are paying? They pay dividends on borrowed shares to match what long investors are getting. Every dollar decline in dividends is a dollar less paid by the shorts. Are they also taxed at 50%? Or is it negative 20% since the corporate tax reduces dividend payouts? What about capital gains on put options, or from the writing of calls? Are all these income sources double taxed to a first approximation?
ReplyDeleteHi Rajiv, very interesting post. I agree with your logic. I would just add that the math gets more interesting for longer holding periods than one year, and in most such cases the investor's return will actually be higher if there is no corporate tax.
ReplyDeleteIf the company is paying out 100% of earnings as dividends, then it doesn't matter and the investor makes the same return whether or not there is corporate tax. But if the company is retaining some portion of its earnings (as most companies do), then for longer holding periods there would be tax deferral on these retained earnings.
Take the example of a company that doesn't pay any dividends at all. Each year, all earnings are retained and add to book value as well as the following year's earnings power (i.e., the company's ROE remains the same). The investor pays no taxes until he sells the shares, at which time he pays tax on all the value that has been created over prior years via retaining and compounding of earnings. That value will have compounded into a higher amount due to this tax deferral, just like it does in an IRA or 401K account, so the investor comes out ahead. Over long holding periods, this benefit can be quite large.
When looking at just the one-year example, one might conclude that getting rid of corporate tax won't benefit investors, other than via the one-time windfall gain you highlighted. However, looking at various examples over longer holding periods makes it clear that getting rid of corporate tax (or even reducing it) would create lasting tax deferral advantages for investors, who are disproportionately the wealthy, thereby increasing inequality.
I think I see Andy's argument.
ReplyDeleteWhen the corporate tax goes into effect, say 0% to 30%, then the required after-tax rate of return for a given level of investment risk of a stock might go down.
Why? Because existing stocks compete with totally new investments and investment ideas. Suppose there are lots of ideas for new companies of risk amount 5 that yield a $10 expected profit for every $100 invested. Then, if existing stocks of risk amount 5 don't give a 10% return too, they will tend to not be purchased.
Now, take these new ideas/projects/companies and tax their profits at 30%. Assuming there's no pass on to employees and customers, then the expected profits go to $7, and for existing stocks to compete they only have to yield 7% after tax.
But, there probably will be a lot of passing on of the tax to employees and customers. So regular people who work for corporations and buy from them, and don't make a bazillion dollars per year, can also say their taxes are really higher, perhaps as much or moreso than Romney. And regular people can also say their tax rates are far higher as a percentage compared to the Romneys when including payroll taxes, sales taxes, and state and local taxes.
With regard to short selling, when the corporate tax first hits (or becomes known to hit), they'll get a windfall, but then their expected returns (of the short sales people actually choose to take) will adjust to the new norm for their risk. It's not like short selling opportunities that pay a fair market risk adjusted return always exist, anyway. When they do, it's largely not a reward for the capital, but for the information that the stock is an overpriced bad deal.
It is complicated though, if people are just stubborn and won't accept less than 10% after-tax for an investment of level 5 risk, then there's just going to be less new companies/projects funded, only the ones that can still generate 10% even after the new tax.
ReplyDeleteBut with regard to Romney and his pay at Bain, disregarding boards and insiders ripping off shareholders (see Bebchuck's Pat without Performance), a higher corporate tax would be offset, at least largely, by a higher cut of the gains for managers like Romney, to competitively attract the best dealmakers.
In other words, the existence of the corporate taxes justified and led to him getting a higher percentage of the gains.
Re. Any Harless' "it seems at least as reasonable to me to aggregate the two taxes [corporate and personal] as to ignore corporate tax":
ReplyDeletePerhaps asset prices tend toward what makes sense for the preponderance of income tax-exempt investors: 401(k), pension fund, endowment fund, etc. Then investor-level tax may tend to simply reduce what taxable investors can expect from investments vs. non-taxed counterparts, without impacting asset prices. Then:
(1) Corporate-level tax may be seen to fall on customers or employees, not investors, per the author's example.
(2) Capital gains tax may be counter-productive from the standpoint of maximizing long-term collectible tax or enterprise capitalizations (and thereby fundraising ability) only if it motivates excessive consumption and materially cramps investment; otherwise it just lowers taxable investors' attainable returns relative to non-taxed investors'.
(3) Our income tax may be seen to be a consumption tax insofar as unconsumed savings enter tax-deferred or tax-exempt vehicles such as 401(k)s, while the balance of capital gains may be seen to merit ordinary income treatment as gains arising from (a) investment as business, when big money is run like any other business endeavor, or (b) inheritance, when big money is run incompetently but contra the principle that money should reflect balance of efforts and debts among the living.
The upshot: why not tax capital gains, outside existing retirement schemes, as ordinary income?
Andy, Raj, Richard and Noam, thank you for your comments. I'll need to give them some thought before I respond, perhaps in a follow-up post.
ReplyDeleteI think we can agree on two things at least: (i) the adding-up approach to effective tax rates does not work for short sales and related derivative positions, and (ii) elimination of the corporate tax would result in a sharp rise in the price of equities and a windfall gain for existing long investors, while the gains to future investors are more modest and uncertain.
It is certainly true, as Richard pointed out, that profits to short positions are rewards for information and not capital. But the same is also true to some degree for long positions. In fact, the essence of Buffet's investment strategy is to identify underpriced companies in which to take long (and long-term) positions. A clear separation between long and short positions on this criterion is just not there.
Here's another thought experiment: suppose company A manages to avoid the tax altogether by exploiting loopholes and exemptions while company B pays the entire tax. Is it the case that only investors in the latter are double taxed? Obviously not, since they all have the option of investing in the former, and price adjustments will bring the risk-adjusted ater-tax returns on the two securities to parity. But what then is the effective tax rate paid by investors in the former firm, which pays no corporate tax?
Part of the purpose of this blog is to throw out half-formed ideas to get some response and help me think through interesting questions, so I appreciate the time, effort and courtesy with which you have all commented.
In fact, thinking about this further, I drew a supply and demand graph for level 5 -- or level c -- risk financial assets.
ReplyDeleteYou put after-tax return on the vertical axis and quantity in dollars on the horizontal.
I have the demand curve as very vertical as I've read the demand for investments (the level of savings) is very inelastic (for example Gruber's Public Economics, and Bernanke's Macroeconomics textbooks).
And I drew a pretty diagonal supply curve for level 5 investments, then a lower S prime curve to account for the new tax.
It does pretty much come out of expected return on level 5 investments. However, my other caveats apply. The tax can be passed on to employees and consumers, so they can claim their total tax rate is higher too -- and then when you add in regressive taxes like payroll and sales, it looks even worse for the Romneys of the country. And, in Romney's job, less capital gains could mean a higher commision/bonus percentage of them to attract the best deal makers.
It's interesting to think about. When the tax first hits there's a bargaining between buyers and sellers of the stocks to see who will compromise. Will the new buyers holdout until the price of the stock drops enough so that they can still get the old expected after-tax return, say 10%. Or will the old holders refuse to sell at a lower price. Or something in between. But even if the new buyers completely win and get prices to drop enough that they still maintain their old after-tax return of 10%, in 20 years the economy will grow a lot, and so will the level of desired savings. For those savers 20 years from now to get the same expected after-tax return of 10%, the economy will have to generate lots of new projects/companies that generate 10% after-tax in real profits, and that's a lot harder to do when the corporate tax rate is 30% than when it's zero. The supply of such projects when there's this added hurdle will be substantially less. Thus, the supply curve is shifted down from the tax.
Rajiv,
ReplyDeleteThe elimination of corporate income taxes should be accompanied by an increase in the tax rate on dividend income received by investors.
The idea would be to preserve after tax dividend income received by investors, assuming the same dividend payout ratio executed at the corporate level.
This is exactly what’s happening in Canada, which is currently phasing in a 3 year reduction in corporate income tax rates. Dividend tax rates are being change commensurately, in order to achieve approximately the same dividend income, after both taxes, and assuming the same payout ratio.
So, in your final example, where the initial dividend drops from $ 2 to $ 1.30, the final after-tax dividend amount would be the same.
So if the growth rate of dividends and the market capitalization rate for after-tax dividends remain the same, the share price should be invariant to corporate income tax rate changes. And that assumes also that the capital gains rate remains unchanged, I think.
It seems to me that this severs the issue of capital gains taxes from dividends per se.
Now as to the rationalization for the capital gains tax rate per se, that also seems like a separate issue to me. And I’m not sure what that rationalization is. But I think that linking it to the corporate income tax rate seems wrong to begin with. And I’m not sure why a share price that reflects anticipated after-tax dividends isn’t enough without any capital gains tax at all. Seems like a tax on capitalism as much as a tax on capital gains.
Finally, I’m not sure why short selling should enter into it at all – any more than tax loss selling enters into it. I think the general idea from a systemic perspective is to tax cumulative capital gains on a net basis – not repeated capital gains on a gross basis.
P.S.
ReplyDeleteI said above,
“And I’m not sure why a share price that reflects anticipated after-tax dividends isn’t enough without any capital gains tax at all.”
That’s almost certainly wrong.
There’s an after-tax benefit to the investor from the tax-shelter effect of corporate retained earnings. Using a combined tax rate of 50 per cent, that benefit would be maximized if the corporate tax rate were zero and the dividend tax rate were 50 per cent. It’s neutralized if the corporate tax rate is 50 per cent and the dividend tax rate is zero.
I haven’t worked through the math rigorously here at all. The main point I wanted to make above is that counterfactual corporate tax rates and dividend tax rates require some synchronization by assumption, before going on further.
JKH, the idea of taxing dividends but not capital gains seems a bit strange to me, since both are derived from earnings. Firms with strong internal growth opportunities will retain earnings, slow growing but profitable firms will pay out large dividends. Apple hasn't paid a dividend since 1995, Con Edison currently has a 4% dividend yield. Shareholders in the former type of firm get all their realized returns through capital gains, those in the latter get most of it through dividends. Why should these returns be taxed differently?
ReplyDeleteIf you have data for the Canadian tax reform would you post it here? It would be interesting to see if it really does satisfy the "adding up" approach to effective tax rates.
Your short sellers' example is flawed. When a stock pays a dividend it said to to trade "ex-dividend" and the price of the previous day's close is reduced by the dividend amount. Thus the short sellers payment is given back to him in the open market. Also, remember there is a difference between short term and long term capital gains. Short term is taxed as regular income. In addition please take a step back here and think of the lower tax in long term capital gains as a subsidiary for people willing to keep their money in play for a longer time. Consider it grease for the economy. That grease is applied to hand of the rich so it slips into the hands of the needy.
ReplyDeleteAlso to eloborate on the comments I wish to keep it simlpe , as you can already see. To that end and to keep things grounded in reality I would point out the following:
the current political debate that focuses on Romney and what Warren Buffet has said does not advocate a higher long term capital gains tax. Even Buffet would be appalled at that. And if it turns into that it serves him right for making his comments. What is being advocated by the President and democrats is an alternative minimum tax on people who collect more than $1 million a year. Never would they or could they change the long term capital gains tax to a much higher rate without grave consequences to capital markets. We also need to remember that very smart people run corporations also hire very smart lawyers. They will evolve with what ever the politicians throw at them and that evolution would not be good for the rest of us. It could mean that companies move to other countries wether it is the headquarters or production. Then jobs leave and the ability to tax goes out the door as well. This has already happened.
Short sellers are usually short term players which means they pay regular income rates. Long term short sellers are quit savvey players. They do take advantage of bad tax law or at least they did. I am not sure if there loophole was ever closed. What would happen is that if/when the stock that was shorted went bankrupt or sometimes just out of business they could have the shares zeroed out and their borrowed deemed returned. However they would continue to show an open short position and carry a long term gain so as not to pay ANY taxes on that position. Only upon the dissolution of the account would the taxes be paid.
In addition, you all seem to believe in the efficient market hypothesis. Sure sometimes the market is efficient but sometimes it isn't as we have recently seen. Some investors will apply methods advocated within this discussion and other will just speculate. No company has to pay a dividend. There are other methods , such as stock repossession.
To conclude, I want make an observation about the game we find ourselves in. There are winners and loosers and new players always waiting to get on the court to see if their skill can grant them a win. However if you change the rules in the middle of the game nobody wants to play and/or finish that game. The skills you have and your desire to play becomes meaningless.
Cornette, regarding short sales, I think you can still avoid paying the higher (short term) rate by buying identical shares to lock in gains while keeping the short position open. What you can't do any more is to short shares identical to those you already own to lock in gains without realizing them for tax purposes.
ReplyDeleteActually, I do think that corporate taxes subsidize short sellers. Of course a short sale is on average a losing proposition, but it is less of a losing proposition if corporate taxes reduce the after tax profits of corporations, thereby reducing either the trend price growth rate or the dividend that a short seller will have to pay. There is a general cost that short sellers pay hoping to profit from special circumstances. The corporate tax reduces their cost.
ReplyDeleteRajiv,
ReplyDeleteI corrected myself re capital gains tax in my comment just preceding your response. But I’m still not clear on it, in that a fair capital gains tax rate would seem to depend on the corporate/personal tax rate split.
Regarding tax rate synchronization, I’ve always found it very difficult to find a coherent explanation of this. But here’s a link to a Price Waterhouse report on the 2009 Ontario budget
About 2/3rds the way down the document, there is a section title “Dividend tax rates”.
The synchronization objective is stated clearly in the final paragraph:
“The increasing effective tax rates after 2009 on eligible and non-eligible dividends are intended to ensure that combined corporate and personal tax on business income earned through a corporation is roughly the same as the tax payable by an individual who earns that income directly.”
(The synchronization works (in Ontario) according to combined federal/provincial tax rates.)
In the first panel in that section, you can see the bottom line showing the top combined effective tax rate on gross dividends of the “eligible” kind (most dividends, those paid by public corporations). The effective personal tax rate on gross dividends increases from 2009 @ 23.06 per cent to 2012 @ 29.54 per cent. That corresponds to a decline in the corporate federal income tax rate in 3 stages, from 2010 to 2012.
That’s a 28 per cent increase in taxes payable on the same dividend, due to a decrease in corporate taxes.
http://www.pwc.com/ca/en/tax/budgets/2009/ontario.jhtml
Andy, do you think that the implicit subsidy provided to short sellers by the corporate tax is comparable in magnitude to the implicit tax paid by Romney? If not, why not? If so, then do you concede that effective tax rates between long investors and short sellers would be equalized if that latter had to pay an 85% tax on capital gains, instead of the current 15%? Or if the former received a subsidy of 55% instead of paying a 15% tax? I think that this is a logical implication of the adding-up approach to computing effective tax rates but it seems an absurd conclusion to me.
ReplyDeleteRajiv,
ReplyDeleteAfter reading Mankiw's blog and links related to double taxation, I came to the conclusion that they are missing the stocks and flows of how the real world works (as opposed to their imaginary pass-through taxation). Today, I see your blog (thanks to Economist's View) and you have put most of my thoughts into words. Great job.
I do think there is one aspect that still needs to be stressed in this argument ... corporations still have to be taxed! Why? Because corporations reap great benefits from our society, such as the court system to enforce contracts, patents and patent protection, infrastructure for supply/logistics, access to human capital, on and on. These are benefits that a corporation receives directly from our society and therefore should be paid directly by the corporation. Any argument related to zero corporate taxes is flawed since it will distort incentives; meaning that, corporations become "free riders" on the system and everyone else will disproportionately pay the price (don't argue that shareholders will pay it all - they won't ... that is only a theoretical device[they have lobbyists]).
Finally, this double taxation argument (presented by Mankiw and others) should be called "The Great Tax Obfuscation" scam. It attempts to use rudimentary analysis to obfuscate the true intent of its purpose which is to further lower corporate and capital gains tax rates.
Rajiv,
ReplyDeleteI corrected re capital gains tax in my comment just preceding your response. But I’m still not clear on it, in that a fair capital gains tax rate would seem to depend on the corporate/personal tax rate split.
Regarding tax rate synchronization, it's difficult to find a coherent explanation of this. But here’s a link to a Price Waterhouse report on the 2009 Ontario budget.
About 2/3rds the way down the document, there is a section titled “Dividend tax rates”.
The synchronization objective is stated clearly in the final paragraph:
“The increasing effective tax rates after 2009 on eligible and non-eligible dividends are intended to ensure that combined corporate and personal tax on business income earned through a corporation is roughly the same as the tax payable by an individual who earns that income directly.”
(The synchronization works (in Ontario) according to combined federal/provincial tax rates.)
In the first panel in that section, you can see the bottom line showing the top combined effective tax rate on gross dividends of the “eligible” kind (most dividends, those paid by public corporations). The effective personal tax rates on gross dividends increase from 2009 @ 23.06 per cent to 2012 @ 29.54 per cent. That corresponds to a decline in the corporate federal income tax rate in 3 stages, from 2010 to 2012.
That’s a 28 per cent increase in taxes payable on the same dividend, due to a decrease in corporate taxes.
http:
//www.pwc.com/ca/en/tax/budgets/2009/ontario.jhtml
JKH thanks... your comment initially failed a spam screen (not sure why) so I had to manually publish it. Hence the delay.
ReplyDelete