Taxation of Supernormal Returns
25 Pages Posted: 24 Apr 2009
In the last ten to fifteen years, a number of articles have been written on the differences between a normative income tax system and a normative consumption tax system, with much of the discussion focusing on the taxation of the risk-free rate of return and the risk premium from an investment. As is generally accepted, under certain assumptions an accrual income tax system taxes the risk-free rate of return on capital but does not tax the risk premium, while a cash-flow consumption tax system (or a wage tax system) taxes neither the risk-free rate of return nor the risk premium. As a result, the only difference between the two tax systems is the tax treatment of the risk-free rate of return on capital. Brief forays into supernormal returns have seemed to indicate that these returns are taxed under an accrual income tax or a cash-flow consumption tax, but not under a wage tax.
In this Article, we begin with a brief discussion on the taxation of capital income. We then discuss the taxation of supernormal returns on investments. The literature has treated supernormal returns as one of the three elements of the return on capital (along with the risk-free rate of return and the risk premium). Our thesis is that a supernormal return is not a return on capital but rather a return on skill or labor or, in some cases, simply a windfall. The implications of treating supernormal returns as due to skill or as a windfall can be quite enlightening and startling. For example, if Congress were to adopt a wage tax system, supernormal returns would need to be taxed under such a system. To compare the various tax bases, the following discussion assumes flat tax rates, full loss offsets, and no inflation.
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