Tax all (capital) income the same way

Let’s get the moral indignation stuff out of the way first. It is indeed outrageous that a multi-millionaire private equity wizard is assisted in his attempt to become a multi-billionaire private equity wizard by having to pay just a 10 percent tax rate (in the UK) on that part of his private equity income that can be classified as ‘carried interest’ – a form of lightly taxed capital gains designed to favour the venture capital industry. Nick Ferguson, Chairman of SVG capital was right when he questioned whether it make sense that some of his industry's richest men paid tax at a lower rate - the 10 percent capital gains tax on carried interest - than their office cleaners, who would pay the 22 percent UK basic rate of income tax. It made no sense and it is indeed outrageous – the unacceptable face of capitalism. The arguments in defense of this ludicrously unfair and distortionary tax arrangement are self-serving twaddle. There is nothing specially meritorious about capital gains as opposed to dividends, interest or any form of capital income. Venture capital or private equity is not more meritorious or wealth-creating than any other form of capital. All these references to seed-corn, founts of growth are hogwash. It is true that private equity investors often buy into an illiquid investment that is held for many years to yields an uncertain return. They get rewarded for making illiquid and risky investments by earning the appropriate risk-adjusted rate of return. There is no need for a helping hand from the rest of the tax payers.

Moral indignation at a blatantly unfair, regressive and distortionary tax anomaly can, however, be a poor guide to policy. The knee-jerk response to the observation that some private equity fund owner/managers pay too little tax is: let’s increase the tax burden on private equity. It makes a lot more sense to stand back a bit and ask how capital income should be taxed. The question should be, what do the three key considerations of (1) equity (fairness), (2) efficiency (incentives) and (3) administrative feasibility (enforcement) suggest about the taxation of capital income in all its manifestations. This will then also teach us how the taxation of ‘carried interest’ can, along with the taxation of all other forms of capital income, be brought into conformity with these principles of fair and efficient taxation.

All capital income is fungible…. A newly -founded company issues $10 million worth of equity, uses that $10 million to buy some recently bottled wine, plus a wine cellar to store it in. For the next ten years no further costs are incurred, nor are any payments made to the shareholders. At the end of the ten years the wine and the cellar are sold, say for $15 million, and the company is liquidated. The money made from the sale of the assets is returned to the shareholders, who have all hung on to their shares.

The money can be returned to the shareholders in a number of ways. At the end of the ten years, the company could make a single $ 5 million dividend payment to its shareholders and buy back the ex-dividend shares from its shareholders at the original issue price, $ 10 million. Alternatively, the company could repurchase the stock from the shareholders, paying them $15 million for it. Of that, $5 million would be capital gains. From a substantive economic point of view, paying dividends to shareholders or returning money to shareholders through capital gains are equivalent. Clearly, if capital gains were taxed more lightly than dividends, the company would return the money as capital gains. If dividends were taxed more lightly than capital gains, shareholders would obviously prefer to be paid dividends.

If interest income were taxed more lightly than dividends and capital gains (or if interest costs were deductible from the corporate profit tax base), the company could obtain its initial $10 million by, say, only issuing stock worth $ 1 million and borrowing $ 9 million from its shareholders. At the end of the 10-year period, the $15 million gross revenue could be returned to the shareholders either as capital gains, as dividends or as interest income, so as to minimize the total tax burden on its shareholders.

This simple example can be elaborate and made more realistic in a million different ways. The conclusion remains the same. A company can, by changing its financial structure (debt vs. equity) and/or by changing its dividend pay-out or retention policy, seamlessly and at little or no cost transform dividend payments into interest payments and/or capital gains. To avoid undermining and in the limit destroying the capital income tax base, it is therefore obviously necessary that all forms of capital income – interest, capital gains and dividends, be taxed in the same way – at the same rate.

Let me repeat that the frequently-heard argument that capital gains, especially capital gains on risky, illiquid investments held for a long period, are uniquely meritorious and should be taxed at a lower rate than other capital gains (and than dividends or interest income) is self-serving hogwash. If I own a piece of God-given, unimproved land, I can enjoy its (uncertain) capital gains or losses, without ever lifting a finger to do honest work or exercising a single brain cell in productive risk-taking entrepreneurial activity. I am sure that managers of private equity funds like their ‘carried interest’ to be taxed at ten percent rather than the forty percent they would pay if carried interest was considered dividend income, but such preferential or discriminatory tax treatment would be distortionary and inefficient as well as grossly unfair.

Likewise, the notion that our legislatures can determine which investment activities (those undertaken by small owner-managed firms, SMEs in general, investments held for at least X months, investments in specific industries, sectors, regions or whatever) are subject to obvious externalities that drive a wedge between the social and private rates of return, is fatuous. Let me summarise this as follows:

The iron law of capital income taxation: because trivial financial engineering can transform any form of capital income into any other, all capital income – dividends, capital gains, interest or whatever – should be taxed in the same way.

How to turn labour income into capital income (& vice versa) The conclusion that all forms of capital income should be taxed at the same rate, because each one can be easily transformed into any other does not imply that this common capital income tax rate should be the same as the tax rate on labour income – or indeed that capital income should be taxed at all. There are indeed almost-respectable arguments for having a zero capital income tax rate, at least in the long run (lest owners of capital get too excited about this, the same analysis, due to Christophe Chamley http://www.bu.edu/econ/faculty/chamley/index.html , with some later elaborations by Nobel laureate Robert E. Lucas http://home.uchicago.edu/~sogrodow/ ) also show that in the short run, capital should be taxed at the highest administratively feasible rate – confiscation would be best! The question than becomes whether, in real time, we are in the short run or the long run).

The argument for taxing capital income and labour income the same way is not that simple financial engineering can turn capital income into labour income. It is rather that while capital income and labour income remain conceptually distinct, there is an important group of economic actors - small businesses where the shareholders and the labour force coincide - for which the information required to determine which part of the income of the business represents a return to capital and which part a return to labour, is private information of the owners/employees of the firm.

Basically, at the end of each tax year, the owners/employees sit down with their accountants and ask: how much of the value added of the firm last year shall we pay ourselves as wages and how much as dividends? The owners/employees know what’s what, but the tax authorities do not. Only the total value added of these small enterprises is verifiable by outsiders, not their breakdown between wages and profits. The decision on how to report the company’s income is therefore purely tax-driven (including national insurance/social security considerations, corporate pension and health plan contribution issues etc.). Setting up a small limited company in the UK is cheap, fast and easy and can all be done on the internet.

With just about every government in the known universe keen to improve its ranking in the World Bank’s Doing Business Survey (http://www.doingbusiness.org/ ), the day will soon come when every individual worker will have his or her own limited company, with the former wage paid to the company under some contract as fee income or whatever. The company can then pay what used to be the wage bill to its sole shareholder/employee as dividends or wage income, depending only on tax/benefit considerations. Both fairness and the desire to preserve any kind of income tax base at all therefore point towards taxing labour income and all forms of capital income the same way.

Let me summarise this as follows:

The iron law of income taxation: Tax in the same way any income tax bases/forms of income that can be easily transformed into each other or whose distinct nature cannot be observed and verified easily by outsiders (third parties) including the tax authorities.

So the tax structure could be simplified greatly: first, all forms of capital income should be taxed in the same way; simply add them all together and apply a single tax rate or tax schedule to them. Thus dividends, interest and capital gains should all be taxed at the same rate. There should also no differentiation by industry or sector, by size or corporate organisational form of the enterprise or venture that produces the capital income, by whether it is distributed or retained. Clearly, capital income should only be taxed once, in the sense that only the beneficial owners of the capital should pay capital income taxes. It may be administratively convenient to collect some of the capital income taxes at the level of the corporation rather than at the level of the natural persons who are the ultimate beneficial owners of the corporation, but there should be full offset of any taxes collected at the corporate level against the taxes due from the ultimate owners.

For reasons of space I will not here go into the complications created by multiple (national) fiscal jurisdictions, and the distinction between residence based and source-based capital income taxation, questions of domicile and residence etc. These issues are great fun as well as serious mind-benders, and I hope to deal with them at some later date.