Edward D. Kleinbard (USC) presents An American Dual Income Tax at Loyola-L.A. today as part of its Tax Policy Colloquium Series. Lily Kahng (Seattle) is the commentator. Here is the abstract:
Recent economic and political trends make it likely that in the near future the United States will reduce the statutory corporate income tax rate and increase the maximum individual income tax rate. The result will be to break the parity in those rates that has existed (at least approximately) since 1982. The result will be a return to tax planning techniques last employed a generation ago, in which the taxable “C” corporation will become a tax shelter.
This paper proposes that the phenomenon of the corporation as a tax shelter comprises two elements: “capital stuffing,” in which investment capital is placed into corporate solution to earn a superior “all-in” after-tax return, and “labor stuffing,” in which owner-managers understate their compensation incomes in order to reduce their aggregate tax liabilities. In the future tax rate environment hypothesized in the paper, labor stuffing would behave much like capital stuffing.
The paper analyzes the Internal Revenue Code’s existing mechanisms for curbing capital stuffing (e.g., the personal holding company regime and the accumulated earnings tax) and finds them inadequate to the task. Similarly, the paper considers the Code’s mechanisms for identifying unreasonably low compensation income when earned by an owner-manager of a business, and finds those to be almost wholly undeveloped.
The best response to the allocative inefficiencies that would follow from capital stuffing in the new rate environment is to lower the tax burden on personal capital income (e.g., interest income earned by an individual) to the corporate rate. Doing so completely eliminates the impulse for capital stuffing without the need for unreliable administrative anti-abuse rules, moves the tax system closer to one that does not discriminate against deferred consumption, and holds out the prospect of greater allocative efficiency through a more constant burden on capital income, however earned. Raising toll charges (dividend and capital gains taxes) is the wrong move, because doing so has negative economic efficiency consequences, including exacerbating lock-in effects, and because the higher toll charge will not offset the benefits of capital stuffing for all investment time horizons.
Lower taxes on personal capital income require a mechanism for teasing apart the labor and capital income of the owner-manager of a closely-held business, so that each component can be taxed at the appropriate rate. But as already described, the United States has no such mechanisms. The paper therefore considers in detail the experience of the Nordic “Dual Income Tax” regimes, which (in their ideal form) tax all capital income at one low flat rate, and labor income at progressive rates, up to a maximum rate well in excess of the capital income rate. The basic mechanism adopted by the Nordic countries is to grant a formulary rate of return on the capital invested by an owner-manager in her business, and to deem the remainder a return to labor inputs.
The United States can make a virtue of necessity by adopting dual income tax principles. There are important efficiency benefits to making capital income tax rates consistent across different forms of investment, in making those rates proportional rather than progressive, and in setting those rates lower than labor rates, to reflect their different supply elasticities in response to tax. The Nordic experiments have not been an unqualified success, but can be revamped. In any event, the Nordic dual income tax approach appears superior in every dimension to the hodgepodge of anti-abuse rules on which the United States has relied in the past.
