Taxing Corporate Capital Gains
Posted: 2 Mar 2006
Prof. Desai notes that a missing element in current debates over the appropriate taxation of capital income is the puzzling treatment of corporate capital gains. Given the rising importance of corporate capital gains and the unique distortions associated with them, he finds the oversight surprising. He notes that the taxation of corporate capital gains is associated with two types of economic distortions. First, the realization-based taxation of corporate capital gains discourages value-enhancing asset reallocation by creating a significant lock-in effect. Because unrealized U.S. corporate capital gains exceed $800 billion, there is a sizable economic cost associated with that lock-in effect.
Second, such taxation discourages corporate investments by imposing a third layer of tax on top of the corporate income tax and the personal income tax on corporate income distributed to shareholders. Those distortions, he believes, are all the more notable because of the relief available for analogous transactions in other parts of the tax system. For example, he notes, capital gains earned by individuals are currently taxed at lower rates than apply to ordinary income and dividends received by corporations are afforded relief through the dividends-received deduction. Among his suggested alternatives to taxing corporate capital gains at the same rates as ordinary income are exempting corporate capital gains from taxation altogether or taxing corporate capital gains at preferential rates. Several other countries exempt corporate capital gains from taxation. Reforms to the U.S. taxation of capital gains, he believes, have the potential for sizable efficiency gains relative to other alternatives, given the magnitude of preexisting distortions from the current system of capital taxation. He calculates that a reduction of the corporate capital gains tax rate from 35 percent to 15 percent would be associated with $17 billion per year in efficiency gains.
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