How should fortune and work be treated in the General Tax Code?
At the end of last week, President Joe Biden published an article review its tax proposals, contrasting them with the tax ideas of President Donald Trump. A major theme of this article can be summarized in the title: “A Tale of Two Tax Policies: Trump Rewards Wealth, Biden Rewards Work”.
Biden raises an important question about how labor (referring to labor income) and wealth, i.e. returns on capital investments such as capital gains and dividends, should be taxed. Although “taxing wealth like labor” can be an effective campaign slogan, it ignores the fact that the current tax treatment of capital income is the product of difficult trade-offs related to neutrality, economic efficiency, the ease of administration and the way we tax C corporations in the US
A major element of the federal tax code is the preferential tax rate for eligible dividends and long-term capital gains (that is, gains held for more than a year). Under current law, these sources of capital income are taxed at preferential rates, with a maximum rate of 23.8% including the net investment income tax (NIIT). Some argue that preferential rates are unfair because labor income is taxed at higher levels in our progressive income tax system, up to 37%.
Additionally, owners of assets with accumulated capital gains can defer the payment of capital gains tax until the gain is realized, or even avoid tax altogether when they bequeath the asset to an heir on a grossed-up basis. Critics of this tax treatment argue that it leads to lower effective tax rates for the highest incomes, as economists Gabriel Zucman and Emmanuel Saez argued in their book. The triumph of injustice Last year. This perception of unfairness motivated several of Biden’s tax proposals, including his idea of taxing capital gains as ordinary income for those earning more than $ 1 million and repealing the base increase.
Preferential tax rates for capital gains and eligible dividends exist in part to mitigate the double taxation of corporate stock returns, which are taxed once at the corporate level at 21% before being again taxed when shareholders receive dividends or realize a capital gain (see Figure 1). In addition, returns on savings are not taxed in a neutral way, as both capital and returns are taxed. This encourages consumption rather than saving (deferring consumption), which reduces investment and income. This is especially true for the remittance sector, which may not have as much access to international capital markets to compensate for reduced domestic savings.
Finally, deferring capital gains has a strong administrative rationale, as the taxation of gains as they accumulate faces many challenges, including how to deal with losses and how to value sources. of illiquid returns. A mark-to-market system would help reduce the foreclosure effect, as investors could no longer avoid taxable events, but at the cost of reduced national income and higher administrative costs.
While preferential tax rates for investment income can help mitigate double taxation, they create opportunities for investors. tax evasion whether taxpayers have the option of reclassifying labor income taxed at the ordinary rate into capital income taxed at preferential rates.
Income from wages and salaries is a simple example of labor income, and it is difficult to find ways to reclassify this income to obtain a preferential tax rate. However, the income earned by the self-employed can be more difficult to assess, as this income can include both a labor and a capital component. Entrepreneurs, for example, who “work for themselves” earn both labor income and profit (capital income).
There are many rules in the tax code to govern how, for example, owners of S corporations divide their income into salary subject to regular rates and business profits subject to lower rates. However, the application of these rules is difficult and there are vigorous debates on how to treat certain sources of income, such as interest.
In addition, new research suggests that the human capital owned by the owners generates a large part of the profits of the transfer firms, which means that the returns of the transfer firms are not simply the product of the financial capital (thus complicating both the way of taxing transfer companies and measure inequalities).
These problems show that taxing capital and labor income alike is an elusive goal and comes with real trade-offs that policymakers must take into account when proposing tax changes. There are opportunities to reduce evasion incentives in the tax code, fortunately, by ensuring that effective tax rates between business forms and the sources of funding are as neutral as they can be, in addition to strengthening the rules related to taxes on self-employment. Biden’s tax plan, however, go the other way by accentuating the bias in favor of debt financing and non-business investment.
Fundamental tax reforms could also simplify the corporate tax regime. A tax on corporate treasury valued in all forms of business, for example, would ensure that the tax system does not discriminate on the basis of type of business or types of investment.
Unless there is deeper reform, however, policymakers and political candidates must consider how trade-offs and opportunities for avoidance change when they alter the taxation of wealth and labor.