Wednesday, June 19, 2013

A question of incentives

Some of my recent thinking has been about tax policy in the US, and what I would consider to be the ideal policy with respect to capital taxes.  I will freely admit that my thinking has been influenced by others.  To summarize:
  • I have turned decisively against any support of 401(k)s plans and tax-advantaged retirement accounts,
  • After researching the pros and cons of corporate taxation, I am now considering favoring their rollback (not quite abolition) provided that capital gains are taxed at a much, much higher rate

The first one is easy to justify.  I've turned against IRAs and 401(k)s because they are highly regressive since those in higher tax brackets get the largest implicit subsidy, and the benefit is conditional on having disposable income for saving, which still further increases how regressive they are - anyone who has less than $5500 of savings a year receives only as much benefit from an IRA as they are able to save, and that's only if they want to defer that savings until retirement.  A 401(k) plan also depends on deferred income.  In both cases, someone who can save nothing gets... nothing!

There are other problems with the programs individually as well.  401(k) matching plans are a problematic implicit wage benefit that, like tax-exempt employer healthcare benefits, end up making the labor market a squirrelier and more screwed up place.  Moreover, people don't treat these plans as part of their wages, which hampers the efficient functioning of markets by allowing companies to implicitly cut wages by suspending matching and not get the same result as an explicit pay cut.  The advent of the 401(k) plan has been a boon for sophisticated investors but more or less allows unsophisticated investors to be hoodwinked by financial products that charge high rates of overhead.  Additionally, IRAs have failed to increase retirement savings as they were intended, instead largely displacing after-tax savings.

Tzimiskes makes this case eloquently and frequently.  

As for the latter case, I'm on somewhat less firm footing, but my recent thought has focused on justifications for why the corporate and capital gains taxes exist.

More or less, corporate taxation exists for the same reasons that corporate personhood exists.  If a legal entity can own property and have an income, it can be taxed as an owner of that property, the same as an actual person.  The justification for capital gains taxes are that they are also a form of income, provided that only the gain and not the principle is taxed - a tax on both is a wealth tax, a punitive disincentive to save.

In light of the fact that most corporations are owned by actual people, however, and their valuations are based on the income that can be received from their sale, I have begun to reconsider my positions on this issue.  The argument that triggered it is this: if both the corporate income tax and the tax on capital gains and/or dividends is applied, the money is taxed twice.  This is the source of the "double taxation" argument that Cato likes to use, among others.  Not only is this inefficient, but it is also ethically dubious.  I have found aspects of this argument convincing, but have some objections to it.

Those of us who live in the real world know that by with creative accounting that the corporate income tax is widely evaded.  Not only is tax evasion a part of corporate culture, but it is colossally wasteful of resources that might be better devoted to investment or returning income to shareholders.  So let's be honest: for a large number of companies, any money you receive in a given distribution has been taxed only once, as capital gains or as a dividend.

This has lead me to believe that the capital gains tax is a necessary bulwark against corporate tax avoidance.  But in thinking about a way to mitigate efficiency concerns lead me to internally debate a second proposal: taxing capital gains at the same rate as other forms of income (or perhaps setting it quite high by compounding the corporate tax and the capital gains tax), and completely abolishing the corporate income tax.

First, the good: from the perspective of the investor, presumably valuations will increase as the pool of available dividends grows larger from companies that do not (or are too small to) avoid taxation.  Those companies that hide their incomes will receive basically no benefit.  Eliminating a corporate income tax does not eliminate the burdens of financial disclosure or fraud; there is no reason to believe that investors will be hoodwinked about a global company's revenues in the same way a domestic tax authority constrained by law will be.  All of that is good.  And naturally, it also eliminates the ethical/efficiency problem posed by Cato and others.

I initially only looked at the unambiguously positive aspects of this type of policy, but after some thought I'm now focusing on the way the incentives work out.  First, consider a toy economy with closed capital flows.  What does eliminating the corporate income tax do?

All things being equal, I would expect the following things to happen:
First, a large increase in fringe benefits, both taxable and nontaxable, especially from companies that offer stock or use the carried-interest tax rate exemption to jack up salaries.  Companies will find it more profitable to provide non-financial benefits than pay in shares.  Not only would clearly non-taxable fringe benefits increase, it would also encourage gifts and other forms of taxable compensation since these forms of income are harder to track and easier to hide than straight income. The line between what constitutes a de minimis fringe benefit - i.e., nontaxable - and what constitutes a taxable fringe benefit is often fuzzy.

I would expect to see something of a revolution in corporate behavior and, possibly, corporate management, connected with share buybacks. A prima facie reading of this type of deregulation might suggest that it would encourage additional levels of investment of corporate income, but that assumes that a company has sufficient opportunities for investment that it deems to have an acceptable level of risk and profitability.  In my mind it's a mystery whether this type of policy will result in more net investment or, instead, a greatly increased rate of share buybacks and not much else.  It is, after all, in the interest of the corporation to maximize its own value while distributing as little as possible to the shareholders; a share buyback when one company reckons it is undervalued will perform better as an investment than many other types of initiative and maximize the dividend per share (and thus the stock's value) by reducing the number of slices of the pie.

A big reason that this might happen is due to corporate management incentives that tie compensation to a set of metrics connected to the number of shares, e.g. average dividend per share.   In companies where voting stock is concentrated in the hands of a few and share buybacks will fall on non-voting, typically ordinary investors, smaller investors might lose out.  Or they could wise up and force pay incentives to be decoupled from share buybacks, however that might be accomplished.  My reading of corporate inertia is that the former is more likely to happen, at least in the short run.

An interesting scenario that also occurred to me is the idea that people might set up corporations that receive their income and use it, tax-free, to store their wealth.  This effectively allows people to save without having to worry about capital gains until they extract their value from their personal corporation, and is probably a lot more tax-efficient in some ways if one's required personal upkeep is lower than what total earnings would be in a given year.  Not sure about the value of this kind of scheme, but it would become a lot more common.  edit: Further research reveals that the capital gains tax would, as now, also apply to corporations.

Finally, if we step outside the toy economy and look at where the tax avoidance incentives go, we can see that the incentives for tax evasion now fall on individuals even more than before.  Individuals will seek to have companies listed outside of the United States and to pay dividends or trade in those countries in order to hide income, while benefiting from increased investment and other practices that come from having a haven that is free of a corporate tax.  And that I am sure is unambiguously worse than having to chase down corporations.  So in terms of tax collection efficiency, this is a downside.  It's also why I didn't mention revenue:  in the long run, a policy like this may end up being a revenue destroyer rather than a revenue increaser.

On the other hand, it's also sure to attract much more investment and capital relocation to the US, in much the same way that this is true of Ireland among different national jurisdictions and true of Delaware relative to the rest of the US.  So it's a bit ambiguous.

Either way I think on balance I'd be in favor of, at the very least, cutting the corporate tax rate and raising the capital gains tax rate.  Not sure if it's a good idea to go all the way.

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