CFO: Cap Gains Hike >> Small Biz Selloff?

This article on CFO.com is a good example of the distortions and dislocations that follow in the wake of harmful tax changes. Ideally, business owners sell assets when someone else can make better use of them, and/or when they can make better use of the monetized value (eg, by investing in projects that offer a higher return on capital). This is how markets work to optimize the allocation of capital in an economy. Allowing capital gains tax rates to rise, even by a seemingly small 5-10%, raises an owner’s future required returns by several magnitudes.

Although the national elections are still more than a year away…there have been rumblings in Congress to raise the tax rate on long-term capital gains for corporations and higher-tax bracket individuals from the current 15 percent to 20 or 25 percent.

If that happens, some owners of smaller businesses may want to dispose of their companies before a hike in the capital gains rate eats into deal proceeds…A recent analysis by CMF shows that if the capital gains rate rose to 25 percent in 2009, a business owner would have to generate 24 percent more value in his company over the next two years to match the after-tax value of the company if it was sold today under the 15 percent rate…"…additional capital gains taxes and…foregone investment income provide a strong incentive to sell your business today if you believe that tax rates will be increasing in the future."

If capital gains rates rise, and the real federal funds rate remains relatively unchanged, a recession could be in the cards some time after 2008. If there’s a silver lining, that could be supportive of the U.S. dollar…although one might ask the Japanese if they would have traded their long recession and bear market for a weaker Yen…

Laffer: Attacking the “Onslaught”

Art Laffer’s begins his rebuttal to Jonathan Chait with a good counter offensive ("The Onslaught from the Left, Part I: Fact Vs. Fiction"). See our full review, "Wing Nuts Unite!", at http://www.symmetrycapital.net/idlespeculation/2007110701.pdf

ACCF’s Bloomfield: Tax Cuts, 1978

We came across this interesting July op-ed in The Hill ("A Lobbying Lesson for Tax Cuts, from 1978") by Michael Bloomfield, President of the American Council for Capital Formation, in which he offers his recollection of the 1978 federal tax legislation, and a hopeful (wishful, perhaps) assessment of the current tax debate:

Thirty years ago, the seemingly impossible occurred when President Carter’s populist proposal to tax capital gains as ordinary income, nearly doubling the rate in some cases, morphed into a dramatic tax cut from 49 to 28 percent, helping to usher in a progrowth era.

He then asks the obvious question, to which he provides a concrete answer:

Today, when populism seems to be overwhelming pro-growth policies, is it wishful thinking to try to repeat the story of 1978, which turned the focus of tax policy to competitive job creation, strong economic growth and better living standards? Only if a business community that is normally balkanized because of parochial interests and competitive advantage speaks in unison for a strategy that benefits the overall American economy. Can the business community once again step up to the plate?

Bloomfield’s prescription lines up well with our own, made back in August ("Turning The Tax Debate, Part II"). Here’s an excerpt of what we wrote then: 

It may not be outside the realm of possibility that, for example, Representative Rangel and Senator Levin will grasp this as an opportunity for tax simplification, but they would probably bear plenty of political risk–perceived risk, anyways–by saying so forthrightly. Better for the people providing testimony to Congress to take the lead on this. Rather than point out how this kind of measure will harm a particular corporate form in a particular industry, they should instead point out the wide range of private and public benefits that would flow from a more equitable and globally competitive U.S. tax code applied to all domestic enterprises! In other words, admit that you’ve got it good, and then explain why that should be the rule, and not the exception.

Tax Foundation: Guess Who Pays (For) Corporate Taxes?

The Tax Foundation has recently issued some compelling analyses of where the burden of corporate taxation in the U.S. falls. In one study, they’ve estimated that the average household burden from corporate taxes is $2,757, and they offer this critical observation in the press release:

…the United States’ top statutory corporate tax rate is the 2^nd highest in the industrialized world and is one of only two OECD countries to have not cut its rate since 1994.  Five countries cut their corporate income tax rates in 2006, seven more will have cut their rates by the end of this year, and Germany recently announced a planned cut on January 1, 2008.  U.S. lawmakers should consider enacting a substantially lower federal corporate income tax rate. Taking into account state-level corporate income tax rates (which don’t exist in most other nations), the cut would have to be at least 10 percentage points to get the U.S. rate down to the OECD average.

The following excerpts are from a related article on the study:

New research is indicating that in a global economy, where capital is highly mobile but workers are not, labor is bearing the brunt of corporate taxation. In a working paper for the Congressional Budget Office, William Randolph asserts that 70 percent of the burden of corporate taxes falls on domestic workers while the remaining 30 falls on shareholders.

Randolph’s 70/30 estimate parallels current estimates of the "factor incomes" of labor and capital in neo-classical growth models, which is intuitively appealing–if government extracts a certain amount of corporate income, the burden should be allocated in line with how the income itself is allocated. However, he argues that because capital is more internationally mobile than labor, labor actually bears a heavier share of the corporate tax than its share of income. His paper is a technical one, but a good read for econo-geeks: "International Burdens of the Corporate Income Tax" (pdf). His argument certainly lends support to the Tax Foundation’s case excertped below:

…low-income households bear a startlingly large share of the corporate tax burden…Geographically, households in largely urban congressional districts and metropolitan areas bear a disproportionate share of corporate income taxes today and, thus, would receive a significant boost in living standards if the corporate tax burden were reduced…

…cutting the corporate income tax will benefit low-income wage earners far more than is generally expected…Despite the desire of many lawmakers and candidates to cut income taxes for lower- and middle-income taxpayers, most of these taxpayers have little or no income tax liability to reduce further. Therefore, these taxpayers would benefit much more from a cut in the corporate tax rate. Research has found that wages are very sensitive to corporate tax rates, so it is likely that these workers would see higher wages as a result of a cut in the corporate tax rate…

From an economic standpoint, these claims are reasonable. But they are certain to be controversial in the political realm. Courage and candor required, as always…

Tax Reports: Ways & Means, Private Equity

The Tax Foundation has posted an overview and initial thoughts on Rep. Rangel’s proposed tax bill, which we recently wrote about:

Most true tax reform consists of broadening the tax base in order to lower rates. Rangel does achieve this principle on the corporate side, but it is not realized on the individual side.  At the end of the day, the scheduled expiration of the 2001 Bush tax cuts is the 800-pound guerilla in the room.  They interact heavily with almost all of Rep. Rangel’s proposals, and they dramatically impact the tax liabilities of American families.

TaxAnalysts have posted an accurate and reasonably balanced assessment of the debate over the taxation of "carried interest" in private equity and other partnerships, another issue we’ve written about:

Shifting ordinary income into capital gains income is what Eugene Steuerle, a former Treasury deputy assistant secretary for tax analysis and now at the Urban Institute, calls "tax arbitrage" that allows the recipient of the income to take advantage of the different tax treatment that applies to different types of income. As long as the capital gains rate is lower than the ordinary income rate, there is an incentive to engage in this type of arbitrage. (Capital gains receive a secondary benefit because, unlike ordinary income, gains are taxed only when realized and thus gain the benefit of deferral so that the effective capital gains rate is significantly lower than the statutory tax rate.)

In testimony before Congress, Steuerle said tax arbitrage opportunities reduce national income, drive talented individuals into less productive jobs, and add substantially to the debt in the economy. He also noted that regardless of one’s political view, reducing tax differentials across types of income helps promote a "more vibrant and healthy economy."

Despite this bipartisan agreement on the adverse effects created by rate differentials, the differentials are essentially a permanent feature of the tax code…

…Congress has heard seemingly endless hours of testimony and received reams of reports on how to treat carried interests. No clear consensus has emerged because there is no clear consensus.

How should the tax authorities react in the face of this uncertainty? A responsible step might be for private interests and the politicians to work together to draft a bill that would narrow or eliminate the gap between the taxation of capital gains and that of ordinary income. Whether this step involves increasing one rate, decreasing another rate, or splitting the difference remains to be determined. Other attempts to modify the tax treatment of private equity may be just as likely to introduce more complexity and controversy into the system than exists now. This step would require modifying tax rules that have existed for decades.

Of course, Prof. Steuerle’s claims about "tax arbitrage" raise an obvious point for tax authorities and politicians at all levels of government: if this practice is so harmful to economic efficiency, should politicians give up altogether the well entrenched practice of using tax codes to influence the behavior of individuals and organizations?