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Taxing Capital Income.

Article Excerpt
Taxing Capital Income. Edited by C. Eugene Steuerle, HENRY J. AARON, and LEONARD E. BURMAN. Washington, D.C.: The Urban Institute Press, 2006, pp. 336.

The taxation of capital income is at the forefront of tax policy issues as we begin the 21st century. The inherent difficulties associated with taxing capital income under an income tax system coupled with an increasingly globalized world economy and many new and complex financial instruments have prompted increasing calls for reforming the taxation of capital income. Proponents of consumption--based taxation of capital income argue that taxing capital income is counterproductive since it reduces incentives to save and invest at the margin, creates tax incentives to invest in certain assets, and introduces substantial compliance and administrative costs. Others argue that capital income taxation is necessary to reduce inequality and that most of the benefits of switching to consumption--based taxation of capital income could be achieved by reforming the current income tax system, which includes elements of income and consumption tax treatment of capital income.

This volume provides a valuable overview of the current taxation of capital income, the arguments for and against consumption--based tax reform, the potential for reforming the current income tax to achieve a more efficient tax structure, and the potential for both types of tax reform proposals to survive the policy process.

In the first chapter, Joel Slemrod examines the taxation of capital income under the U.S. income tax in recent years. The proper level and structure of capital income taxes depends on how capital income taxes affect individual saving and investment decisions and the distribution of income. However, measuring the level and distribution of capital income taxes is not straightforward. The discussion in this chapter examines three measures of the extent of capital income taxation and the differences in the taxation of different types of capital. The three measures that Slemrod examines are a tax--collections--based measure, a hypothetical--project--based measure, and the GKS measure named after its creators Gordon, Kalambokidis, and Slemrod (2004). The tax--collection--based measure is calculated as the ratio of capital income taxes paid to capital income. Slemrod notes that the major advantage of this measure is that it accounts for institutional characteristics of the tax system, such as lax enforcement and evasion. He also notes several disadvantages of the tax--collections--based measure, such as the difficulty of measuring capital income taxes, capital income, and payments for risk and above normal profits. Using this measure, Slemrod estimates that the effective tax rate on capital income at the federal level is 24.1 percent. He argues that this measure is a useful check on other measures but that it is suspect as a stand-alone measure because it is based on crude estimates of capital income taxes and is backward looking. Next, Slemrod discusses how the hypothetical--project--based measure is used to examine the potential effects of capital income taxes on saving and investment. Unlike the tax--collections--based measure, this measure does not account for the institutional characteristics of the current tax system and requires a number of important parameter assumptions to yield accurate estimates of the marginal effective tax rate. Slemrod describes the methodology used by the Congressional Budget Office (2005) and Gravelle (2005) to estimate the effective tax rates on capital income. He reports estimates of the aggregate marginal effective tax rate on capital income that range from 13.8 to 23 percent. He also reports disaggregated marginal effective tax rates that range from 32 percent for corporate capital to -5.2 percent for owner-occupied housing capital.

An alternative approach is the GKS measure, which calculates the difference in taxes collected under the current income tax system and a theoretically pure consumption--based tax system that allows expensing and denies interest deductions at the business level and exempts capital income at the individual...

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