by Gene Steuerle

In his latest economic perspective column, Tax Notes economic consultant Gene Steuerle continues his series on the imposition of zero tax rates on new capital, focusing this week on corporate taxes and investment incentives.

Date: Sep. 9, 9-96

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In his latest economic perspective column, Tax Notes economic consultant Gene Steuerle continues his series on the imposition of zero tax rates on new capital, focusing this week on corporate taxes and investment incentives.

Gene Steuerle is a senior fellow at the Urban Institute and an economic consultant to Tax Notes.

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ZERO TAX RATES ON NEW CAPITAL

PART 2: CORPORATE TAXES AND INVESTMENT INCENTIVES

[1] Zero-tax theories imply that it is possible to impose windfall taxes on old capital or other investments made in the past without distorting current decisions. Early applications of zero-tax theories were used both to support an unintegrated corporate tax and to support investment incentives and higher rates of income taxation.

Integration of Corporate and Individual Tax

[2] While today zero-tax theories are used primarily to favor consumption taxes and the elimination of tax on some investment income, an important early use essentially went in the opposite direction: it supported a second layer of tax on some capital income. A classic case in both tax and finance literature had been that paying two taxes -- a corporate tax on earnings and an individual tax on dividends -- distorted financial decisions. It led corporations to favor retained earnings over dividends and debt over equity. Franco Modigliani and Merton Miller argued, to the contrary, that corporate share values could not be affected by such choices. Their approach was extended in later research to what is now called the "new view" of dividends or dividend taxation -- that at the margin the taxation of dividends has no effect on the cost of capital to the firm. In effect, the extra layer of tax is like a zero tax.

[3] How does one reach this conclusion? Well, the basic argument is that the corporate manager can pay dividends now or can pay them later. Either way a second layer of tax eventually will be paid. This second layer of tax acts like a toll charge to get money out of corporate solution. If the manager pays the toll charge now, then all future investment will pay only one layer of tax -- either on interest income if the firm floats bonds or on noncorporate business income if shareholders invest elsewhere. If, on the other hand, the manager decides to finance new investment out of retained earnings, only one tax will be paid on the new investment until it is eventually paid out to corporate owners.

[4] To simplify matters, suppose the decision to pay out a dollar of dividends or to retain a dollar of earnings is being made for only one period of time. In the first case, where the toll charge is paid up front, total wealth eventually equals $(1-t)[1+r(1-t)]. When the toll charge is instead paid at the end of the period, total wealth eventually equals $[1+r(1-t)](1-t). Thus, the final value (and present value) of the two streams of taxes and rates of return is equivalent as long as the dividend tax rate is equal to the corporate rate of tax.

[5] This new view of dividends relies on the notion that the assessment of a corporate tax really occurred in the past. There is no double tax on new investments since a firm can always establish itself in noncorporate form or simply borrow to finance investment. Yes, there's a second layer of tax collection but it applies only to capital "trapped" in the corporate sector. The tax essentially attached itself to old capital when the corporate tax was first assessed, even if the cash payment to the government was deferred until later. Old capital in the corporate sector is essentially "zapped" in a way that purportedly leaves unaffected new investment decisions.

[6] This additional tax -- the liabilities to the government that are due, but not yet paid -- should be reflected in market prices. Once trapped in the corporation, the value of corporate shares should decline to reflect the weakened value of old corporate capital versus new noncorporate capital. Rates of return to shareholders will be the same for corporate and noncorporate capital mainly because the corporate capital has declined in value relative to its replacement value or its value in the noncorporate sector. The original owners of corporate shares will pay the tax; if they sell in the stock market, new owners will buy at a price that will be reduced enough to offset the value of this second layer of taxes that was owed, but not yet paid.

[7] Obviously, this theory is disputed by many. Critics note that it ignores the ability of the corporation to distribute capital, rather than just income, to shareholders in a way that avoids taxation. While the new theory may explain why dividends are paid, it does not explain why new corporate shares are issued by firms. It dodges issues of lower rates of tax applying to pensions and low-rate taxpayers, who avoid a second layer of tax both on dividends and capital gains. Corporations can remove money from corporate solution by buying back shares. Finally, as an empirical matter, corporate share values are often not below what we would measure as replacement cost. Yet if old capital really is zapped, then it should be reflected in the value of the stock market. Like so many of the "zap old capital" theories, the theory never deals with what happened in the Garden of Eden and whether taxpayers today can now ignore government's attempt to zap this old capital, or, instead, they change their expectations and become wary that government again may try to zap later investments that in turn have become "old capital."

[8] Lest one think that this theory is so abstract as to have little influence, it played a primary role in the 1986 tax reform debate. Opponents of tax reform did not want to spend any money on integration of corporate and individual income taxes. They often adopted the new view of dividends and ran models showing a much higher cost of capital than if the more classical view were maintained.

Investment Incentives

[9] The notion that one can zap old capital is also used to support investment incentives and the higher rates of income taxation necessary to support these incentives. Here the argument is that incentives should apply only to new investment, not to old investment or the returns to old investment. While proponents usually focus on the gains from the additional investment, the theory in fact argues that when investment incentives are first applied in the Garden of Eden, old capital will suffer from a windfall loss.

[10] As a simple example, suppose that a piece of equipment cost $1 in the market. Suppose a firm spends $1 to buy $1 worth of equipment today. Then the government announces that tomorrow it is going to provide an investment incentive of 10 cents for each $1 spent on similar equipment purchases. Another firm can now buy $1 worth of equipment for a net cost of 90 cents and can also sell output from that equipment more cheaply than if it had paid the full $1 in cost. The firm that received no investment incentive suddenly has to sell its output cheaper also, and the equipment that it owns is reduced in value to 90 cents. Once again, old capital is zapped.

[11] Note that with investment incentives it is possible to offset almost any tax rate that might be nominally imposed on returns to capital. During the debate over tax reform in 1984 to 1986, Martin Feldstein at the Council of Economic Advisers and others argued that existing investment incentives should be maintained even though they required higher rates of taxation. Treasury countered that if existing investment incentives should be supported by higher rates of tax, why not raise tax rates even more so that new investment incentives could be provided and old capital zapped even more? Others argued that if tax rates were to be lowered and a "windfall" gain applied to old capital, then some offsetting tax should be assessed on this old capital. But such an offsetting tax was almost impossible to design in a way that was considered fair and administrable.

Next week: Consumption Taxes and Human Capital Investment

Tax Analysts Information

Jurisdiction: United States
Subject Area: Business Tax Issues
Legislative and Policy Issues
Index Terms: investment incentives
Author: Steuerle, Gene
Institutional Author: Tax Analysts
Tax Analysts Document Number: Doc 96-24764 (2 pages)
Tax Analysts Electronic Citation: 96 TNT 176-72
Cross Reference: