Paul L. Caron

Friday, December 9, 2016

Weekly SSRN Tax Article Review And Roundup

This week, Daniel Hemel (Chicago) reviews a new paper by Edward D. Kleinbard (USC), The Right Tax at the Right Time.

HemelEdward Kleinbard’s newest paper lays out the case for a “Dual Business Enterprise Income Tax,” or “Dual BEIT,” as an alternative to the existing patchwork of federal taxes on business income. Readers familiar with Kleinbard’s past work know that he is a powerful analyst and a crystal-clear writer, and this paper is no exception. For reasons I explain below, I am not sure that a Dual BEIT is the “right tax” for our time, but all can agree that Kleinbard’s proposal is an important contribution to the business tax policy debate.

In a prior paper, Kleinbard explained why he thinks the United States should tax capital income annually at a flat rate; the latest installment explains why he thinks a Dual BEIT is the best way to achieve that result. In brief, a Dual BEIT would consist of a flat-rate entity-level tax on profits and a flat-rate investor-level tax on “normal returns.”

The first component, the entity-level tax, would look much like the current corporate income tax, with three major changes: (1) the tax would apply to all business entities, not just C corporations; (2) interest, rent, and royalty expenses would no longer be deductible (though depreciation still would be); and (3) firms would be granted a “Cost of Capital Allowance” (COCA), which would be equal to a statutory rate multiplied by the amount of the firm’s business capital. The statutory rate would be equal to the yield on one-year Treasury bills plus a spread that reflects the typical firm’s cost of funds.

The investor-level tax would be calculated in a similar fashion: investors would be taxed at a flat rate on an “includible amount,” which would be calculated by multiplying the COCA rate by the investor’s tax basis. The investor’s tax basis would grow each year at the COCA rate minus any cash distributions. Kleinbard envisions that the entity-level and investor-level rates would be the same, that the entity-level tax would apply to the worldwide income of U.S. enterprises minus their COCA, and that foreigners would be exempt from the investor-level tax. Nonbusiness debt instruments (including Treasury securities) would continue to be taxed as under current law.

What benefits would a Dual BEIT bring? First, since a Dual BEIT does not discriminate between corporations and other business entities, the tax system would no longer distort choice of form. Second, a Dual BEIT would eliminate the incentive for debt financing baked into the current corporate tax system. Third, a Dual BEIT would ameliorate (though not eliminate) the “lock-in” effect generated by the existing realization-based capital gains tax. (This list of benefits is not exhaustive, and Kleinbard goes on to note several others.

But a Dual BEIT would also carry considerable costs, three of which I’ll highlight here. First, a Dual BEIT would impose no tax on the normal returns to equity capital invested by tax-preferred pension plans, tax-exempt organizations, and foreigners. (A Dual BEIT also would exempt normal returns to debt capital supplied by these same sources, but the existing regime effectively exempts normal returns to debt-financed investments by pensions, charities, and foreigners already.) Pensions, charities, and foreigners own an estimated $17 trillion of U.S. corporate stock, or about three quarters of total U.S. corporate equity. A Dual BEIT would narrow the tax base considerably by excluding normal returns on those assets. (Of course, the tax preferences for pensions and charities might be repealed as part of a shift to a Dual BEIT, but that outcome seems politically implausible even if desirable.)

Second, a Dual BEIT runs into what one might call “the Jeff Bezos problem”: the nontaxation of entrepreneurs on the sale of stock before their companies turn profitable. Bezos’s basis in his Amazon stock is a tiny fraction of the stock’s value, and the annual investor-level tax under a Dual BEIT is keyed to basis. If Bezos sells his stock and spends the proceeds or holds them in cash, he could avoid any tax—now or down the road—on billions of dollars of income. To be sure, the existing regime also allows an entrepreneur to reduce tax by donating appreciated stock and by delaying realization until death. But a Dual BEIT takes this a step further: an entrepreneur could realize gains during her life while paying only a pittance in income tax.

Third, financial derivatives present a threat to the integrity of a Dual BEIT. A Dual BEIT works best when investors take equity and debt positions via ordinary stocks and bonds. But an investor can, for instance, create a position essentially equivalent to a stock by buying a riskless zero-coupon bond and a call option while selling a put option. Under the basic version of the Dual BEIT proposal, this investor would pay less in tax than the outright owner of a stock: the combination investor would pay tax on the return to the riskless bond, while the stockholder would pay tax on the higher COCA amount. Perhaps the Dual BEIT could be amended to prevent this sort of arbitrage, but that would require a set of complicated rules that detract from the elegant simplicity of Kleinbard’s proposal.

Kleinbard, to his credit, acknowledges that a Dual BEIT is imperfect. The relevant question is whether a Dual BEIT is less imperfect than the status quo or any of the alternative business tax reform proposals on the table. I won’t attempt to answer that question here, except to say that regardless of whether a Dual BEIT wins the contest, it’s now a contender—thanks entirely to Kleinbard’s thoughtful and impassioned advocacy.

Here’s the rest of this week’s SSRN Tax Roundup::

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