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Written by: Eugene Steuerle
The rich have never paid much individual income tax on their capital income, and neither have the non-rich. For the most part, taxing capital income requires taxing it as earned, which requires corporate-level reporting and taxation.
While Congress sets Individual tax rates higher for those who report higher levels of reported income, much capital income does not appear on individual tax returns—and never has. However, corporations and other large businesses have strong financial incentives unrelated to taxes to calculate their capital income, wages, and other payments accurately. Modern government relies upon these businesses, not the tax collectors of old who essentially went “door-to-door,” to be the primary agents for reporting income and collecting taxes.
Efforts to tax the wealthy and multinational corporations—two of the most highly contentious areas of taxation—require understanding how the government partners and depends upon businesses.
Why does so little income from capital show up on individual income tax returns? Traditional corporations pay out only limited amounts of their total earnings as dividends. Recently, they have distributed even smaller portions this way, preferring to buy back corporate shares. In this way, taxpayers can decide whether to sell, making any tax on distributions a voluntary event.
Even then, Congress has always limited the tax rate on capital gains and, since early this century, on corporate dividends. A taxpayer can avoid a capital gains tax by not selling the related property. Congress further provides investment incentives for many business activities, whether corporate or not.
Most of the assets of the non-wealthy are owner-occupied homes and retirement assets. The law assesses no income tax on homes or the rental savings they provide to their owners, while retirement savings typically receive special treatment that effectively eliminates any tax on capital income.
Individuals and businesses also engage in elaborate forms of “tax arbitrage,” which effectively results in the most highly taxed assets being held by nontaxable entities and the assets with the lowest tax rates—for instance, assets whose income comes mainly in the form of accrued capital gains—being held by the rich and those in the highest tax brackets.
In 1985, I published the first book on how taxpayers can multiply tax arbitrage opportunities, mainly through the leverage provided by borrowing. Borrowers dramatically overstate the real, non-inflationary cost of their loans. For instance, if inflation is 3 percent and the interest rate is 6 percent, the borrower deducts twice the real cost of borrowing. On the other side of the ledger, receipts from interest or property bought with borrowed funds often avoid tax for the reasons noted above. Commercial real estate provides a prime example of a heavily leveraged sector with meager rates of income taxation.
None of this is new. See, for instance, this 1980 report.
What is new is the massive growth in international trade and the income generated by multinational corporations, along with sophisticated, generally legal, tax shelter schemes that involve one type of tax arbitrage—getting deductions in high-tax countries and receipts in low-tax ones. Multinational corporations succeed in reducing taxes partly by locating activities, intangible property like patents, and headquarters in low-tax countries. Over recent decades, Congress and foreign legislatures have attempted to attract investment by engaging in tax competition to lower statutory corporate tax rates. The Tax Cuts and Jobs Act of 2017 provides only the latest example for the U.S.
Over 140 countries have very recently adopted a new global minimum tax to limit the erosion of tax collections on capital income. This brilliant reform attempts to penalize countries that do not participate by letting other countries collect the taxes that non-participants fail to collect. While the Biden Administration has proposed joining this effort, Congress has not acted so far.
With all these incentives to avoid taxation, how and why do governments depend upon larger businesses to report on and collect taxes? Complex businesses with multiple owners want to accurately calculate and report their income, not for tax authorities but for their managers and owners. Their financial accounting serves not only to avoid ledger errors and catch cheaters but also to provide invaluable information on allocating resources.
Consider the thousands of important decisions a complex business makes each year regarding what to produce, by whom, and where. To allocate resources effectively, managers need a way to discover which activities marginally provide the highest and least profit rate.
Moreover, to please shareholders, business managers want to report rising earnings. This incentive for managers to overreport financial income to owners counters the tax incentive to underreport income to tax authorities. Businesses also want to get deductions for the compensation they pay; hence, they find it difficult to bargain with workers to underreport that income.
The set of balanced incentives applies less to the self-employed and small businesses, where the IRS reports very high rates of noncompliance. Their shareholders, managers, and workers are one and the same. The government could collect little income tax if we were still a nation of farmers.
I have not touched on many of the difficulties associated with collecting taxes on capital income—for instance, how to reconcile different accounting systems across countries and some of the particular issues that apply to non-corporate businesses.
My main point is simple: the government’s ability to collect income taxes on capital income depends significantly upon the accounting practices required for other purposes within almost all large businesses. Accordingly, attempts to tax capital income require a corporate-level tax, a business-level withholding of individual taxes on profits, or taxation of business income reported to individuals. Mucking around only with tax rates on capital income, as currently reported on individual income tax returns, will not get the job done.
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