Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin - - PowerPoint PPT Presentation

ECON551: Lecture 9c 1

Econ 551 Government Finance: Revenues Fall 2019

Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 9c: Capital Gains Taxation

ECON551: Lecture 9c 2

Agenda

• 1. Defining and taxing capital gains
• 2. Taxing risky assets: Domar-Musgrave (1944)
• 3. Avoidance strategies
• 4. Capital taxation case study: income trusts

ECON551: Lecture 9c 3

What is a capital gain?

Conceptual Definition: Gain from the sale of an asset. Capital gain = sales price less purchase price less relevant costs. CRA Definition: “Usually, you have a capital gain or loss when you sell or are considered to have sold capital property.” Capital property: “includes depreciable property, and any property which, if sold, would result in a capital gain or a capital loss. You usually buy it for investment purposes or to earn income. Capital property does not include the trading assets of a business, such as inventory.”

ECON551: Lecture 9c 4

Important questions about capital gains

Administrative Questions:  Which assets? What’s a ‘capital property’? Housing?  Accrual or realization  What are ‘relevant costs’?  What happens to unrealized gains at death?  What happens to unrealized gains if donated?  What about inflation? Tax Policy Questions:  What rate should apply?  Does CG taxation affect distribution?  Does CG taxation affect investment decisions?  How sensitive are realization to the rate?  Does CG taxation raise much revenue?

ECON551: Lecture 9c 5

Often used as political ‘litmus test’ or signal

Some policies take on political importance out of scale to their true economic weight.  Voters have imperfect information on candidates.  Candidates use positions on certain policies to ‘signal’ overall policy position.  Minimum wage is sometimes like this.  In 1990s, capital gains taxation was like this too. Book by Len Burman “The Labyrinth of Capital Gains Tax Policy”  warned that capital gains tax discussion often resulted in “Caveman Tax Policy”  “I’m just an unfrozen caveman, but I know that lowering the capital gains tax rate will unleash untold volumes of economic growth”

ECON551: Lecture 9c 6

CG tax policy overview

In Canada:

 Partial inclusion: get to exclude x% from taxation; the included part goes into line 150.  Inclusion rate is now 50%; was previously up to 75%.  Only offset against losses; can carry forward losses indefinitely.  Deemed realization at death.  Canadian Controlled Private Corporation $866, 912 (2019) lifetime exemption.  Charitable donations of much appreciated property now fully exempt. (Changed in 2006/07/08)

In United States:

 Full inclusion, but on different rate schedule. {0%,15%,20%} approx. half…  Short-run vs. Long-run distinction (holding period >1 year)  Stepped up cost-basis at death; no taxation.  Can offset against $3,000 of ordinary income.  Donated assets get full deduction plus exemption of gains.

ECON551: Lecture 9c 7

Trends in capital income: dollar value of income

Source: CRA Income Statistics

ECON551: Lecture 9c 8

Trends in capital income: proportion with any income

Source: CRA Income Statistics

ECON551: Lecture 9c 9

Trends in capital income: share of total income

Source: CRA Income Statistics

ECON551: Lecture 9c 10

ECON551: Lecture 9c 11

Cumulative distribution of capital income types

Source: Survey of Labour and Income Dynamics, pooled 2001-2011

ECON551: Lecture 9c 12

Avg dollars of capital income types across income distribution

Source: Survey of Labour and Income Dynamics, pooled 2001-2011

ECON551: Lecture 9c 13

Agenda

• 1. Defining and taxing capital gains
• 2. Taxing risky assets: Domar-Musgrave (1944)
• 3. Avoidance strategies
• 4. Capital taxation case study: income trusts

ECON551: Lecture 9c 14

Analytical Result: Domar Musgrave

This result was first studied in Domar and Musgrave (1944); generalized by Stiglitz (1969) Idea: See what happens to risky investment when we tax the return. Setup:  Total initial wealth is W0.  Tax rate t.  Two assets available:

• m is risk-free asset (think money): return is 0.
• a is risky asset with stochastic return r, with pdf f(r).
• So, budget constraint is:

𝑋

0 = 𝑏 + 𝑛

ECON551: Lecture 9c 15

Analytical Result: Domar Musgrave

 Return to risky asset is taxed at flat rate t.  So, this makes his terminal wealth equal to: 𝑋

1 = 𝑏[1 + 𝑠(1 − 𝑢)] + 𝑛

Assume that agent maximizes expected utility 𝐹𝑉(𝑋

1) = ∫ 𝑉[𝑋 0 + 𝑏𝑠(1 − 𝑢)]𝑔(𝑠)𝑒𝑠 ∞ −1

Find First Order Conditions wrt choice of a: 0 = 𝐹[𝑉′(𝑋

1)𝑠(1 − 𝑢)]

ECON551: Lecture 9c 16

Analytical Result: Domar Musgrave

We can pass (1 − 𝑢) through the expectations because it is constant. Divide both sides by (1 − 𝑢) leaves us with: 0 = (1 − 𝑢)𝐹[𝑉′(𝑋

1)𝑠] = 𝐹[𝑉′(𝑋 1)𝑠]

Implicitly, this defines a value for a* (chosen so the expectation equals zero). Let’s now take the derivative of the FOC to see how it changes when t changes: 0 = 𝐹 [𝑉′′(𝑋

1)𝑠(1 − 𝑢) (𝜖𝑏∗

𝜖𝑢 𝑠(1 − 𝑢) − 𝑏∗𝑠) − 𝑉′(𝑋

1)𝑠]

ECON551: Lecture 9c 17

Analytical Result: Domar Musgrave

0 = 𝐹 [𝑉′′(𝑋

1)𝑠(1 − 𝑢) (𝜖𝑏∗

𝜖𝑢 𝑠(1 − 𝑢) − 𝑏∗𝑠) − 𝑉′(𝑋

1)𝑠]

The last bit we know is equal to zero from the FOC. The middle bit must equal zero, since nothing else will. 0 = (𝜖𝑏∗ 𝜖𝑢 𝑠(1 − 𝑢) − 𝑏∗𝑠) ⇒ 𝜖𝑏∗ 𝜖𝑢 = 𝑏∗ (1 − 𝑢) > 0 Since this is greater than zero, the optimal allocation into the risky asset is increasing in the tax rate t.

ECON551: Lecture 9c 18

Comments:

 Similar results (with some conditions) hold in more general frameworks—e.g. safe asset has positive return, progressive taxation, etc.  Intuition: government is like a ‘silent partner’ in the enterprise. It shares in losses and shares in gains. This makes you want to take on more risk.  Very key assumption: symmetric loss offset. Without it, your ‘partner’ is making a

• ne-sided bet. He shares the gains but not the losses. The results depend crucially
• n this assumption. Economists focus a lot on the nature of loss offsets w.r.t.

business losses, self-employment, capital gains.  But who bears the risk? The government can’t bear risk—it shares risk. Is government well suited to pool risk? Yes, if all risk is idiosyncratic; no if it is systemic since risk will have to be borne by taxpayers.

ECON551: Lecture 9c 19

Agenda

• 1. Defining and taxing capital gains
• 2. Taxing risky assets: Domar-Musgrave (1944)
• 3. Avoidance strategies
• 4. Capital taxation case study: income trusts

ECON551: Lecture 9c 20

Avoidance strategies

Stiglitz (1985) suggested that using tax avoidance strategies, all capital income taxation could be avoided. From the working paper version of the paper…. The fact that the tax system raises revenue is attributed to lack of astuteness of the taxpayer and/or lack of perfection of the capital market. Accordingly, models which attempt to analyze the effects of taxation assuming rational, maximizing taxpayers working within a perfect capital market may give misleading results.  Since people do report capital income, they must be ill-informed, irrational, or there are barriers to tax avoidance aren’t being considered  Corollary: be very careful of tax predictions predicated on astute taxpayers and perfect capital markets….

ECON551: Lecture 9c 21

Avoidance strategies

Stiglitz argues that all avoidance can be put in one of three categories:  Tax deferral.  Interpersonal arbitrage—individuals facing different rates.  Arbitrage across types of income. We’re going to look at two techniques of avoidance that make use of capital gains taxation.  Short against the box.  Estate freeze.

ECON551: Lecture 9c 22

Short against the box

This was a strategy that was popular for decades: From the NY Times:

Estée Lauder Companies went public in 1995, and Ronald Lauder and his mother cashed in hundreds of millions of dollars in stock but managed to sidestep paying tens of millions in federal capital gains taxes by using a hedging technique known as shorting against the box. Together, Mr. Lauder and his mother borrowed 13.8 million shares of company stock from relatives and sold them to the public during the offering at $26 a share. Selling borrowed shares in this way is referred to as a short position. Since the Lauders retained their own shares, the maneuver allowed them to have a neutral position in the stock, not subject to price

• swings. Under I.R.S. rules at the time, they avoided paying as

much as $95 million in capital gains taxes that might otherwise have been due had they sold their own shares.

 Cut down in 1997 with some tax rule changes by the IRS.  Lauder eventually did pay some taxes

ECON551: Lecture 9c 23

Short against the box

The problem: You have an appreciated asset, but want access to the value without realizing gain. Strategy:  Borrow the same stock from someone else. Sell the stock. You have the cash.  When loan term is up, you can buy back the shares and close the short position.  You have to pay some interest, but that’s cheaper than paying the capital gains.  When you die, the appreciated stock escapes all capital gains.

ECON551: Lecture 9c 24

Estate freeze

Situation: you have some kind of family-owned business. Want to pass it on to your children in tax efficient way.  Create a class of non-voting shares in your corporation. Issue them to your children.  These shares are issued at today’s value of the firm. If firm wraps up tomorrow, it won’t have helped. You’ve just frozen the value at today’s value.  Parents maintain control of corporation with a class of voting shares.  Any future appreciation of the firm will go into the value of the shares owned by kids.  When kids sell, they can take advantage of the CCPC $867K lifetime exemption. If you have 2 kids and a spouse, you’ll get an extra 2.6 million tax exempt capital gain growth.

ECON551: Lecture 9c 25

Empirical Evidence on Avoidance and Capital Gains Taxation

Auerbach, Burman, and Siegel (2003) “Capital Gains Taxation and Tax Avoidance: New Evidence from Panel Data.”  Use a panel of high income taxpayers through the 80s and 90s.

• This allows them to get around some of the lifecycle / timing issues that plague
• ther empirical research on capital gains.

 Focus of the paper is on tax avoidance: Can high earners avoid CG taxation? Is it a ‘tax on the stupid?”  Because of the $3K per year loss offset, a ‘perfect’ avoider would realize exactly $3K of losses every year. Most of the paper sets about uncovering evidence that this does or does not occur.

• This is pretty small potatoes for a top 1% wealth person though…

ECON551: Lecture 9c 26

ECON551: Lecture 9c 27

Defining different ‘regions’ based on short- and long-run rates

 Region A is for people with positive gains in both long and short categories. They face the long and short rates.  Region B is for people with losses in both, or short run gains and long run losses. In all cases, the relevant marginal rate is the short-run (ordinary) rate as long term losses have to be netted against short run gains.  Region C is for those with net total losses at $3K or more. They face zero tax rate on marginal gains.  Region D is for those with short term losses, but larger long term gains. They pay tax at the longterm rate.

ECON551: Lecture 9c 28

Who makes it to Region C? Can they stay there?

Sophisticated definition: have ever engaged in trading options, short-sales, and other more complex financial transactions.

ECON551: Lecture 9c 29

Are high income people better able to reach Region C?

When you break it down by permanent income group, you find a similar thing – yes, the higher income guys do better at reaching C, but still they don’t do terribly well.

ECON551: Lecture 9c 30

Are people good at sticking in Region C?

The estimated hazard suggests that around 50% of those who are in region C leave region C in the next year alone. This suggests that a lot of the region C is not planned but accidental.

ECON551: Lecture 9c 31

Overall summary of findings:

Auerbach, Burman, and Siegel (2003)  Even using permanent income, most gains are realized by high income earners.  Sophisticated investors do a bit better than unsophisticates, but still only 20% reach Region C. Also, high income guys do better than low income guys.  Stays in Region C are quite short—50% leave after one year.  Some evidence of avoidance, but it is not widespread.  The effective tax rate is therefore very close to the statutory rate.

ECON551: Lecture 9c 32

Agenda

• 1. Defining and taxing capital gains
• 2. Taxing risky assets: Domar-Musgrave (1944)
• 3. Avoidance strategies
• 4. Capital taxation case study: income trusts

ECON551: Lecture 9c 33

Accrual equivalence capital gains tax rates

Capital gains are taxed at realization. This is advantage over annual taxation of accruals for holding periods greater than one year. Rate of return r Holding period a Tax rate 𝜐 [(1 + 𝑠)𝑏 − 1](1 − 𝜐) > [1 + 𝑠(1 − 𝜐)]𝑏 − 1 ∀ 𝑏 > 1 Question: What accrual-equivalent tax rate (𝜐𝑏𝑓) would set after-tax return with taxation

• f accruals equal to after-tax return of taxation at realization?

[(1 + 𝑠)𝑏 − 1](1 − 𝜐𝑠) = [1 + 𝑠(1 − 𝜐𝑏𝑓)]𝑏 − 1 This might be the best tax rate to compare to dividend or interest taxation

ECON551: Lecture 9c 34

Accrual equivalence

Holding Pre-tax Post-tax Accrual Equivalent Realization Period Gross Gross tax rate tax rate 1 1.050 1.039 0.230 0.230 2 1.103 1.079 0.226 0.230 3 1.158 1.121 0.222 0.230 4 1.216 1.166 0.217 0.230 5 1.276 1.213 0.213 0.230 6 1.340 1.262 0.209 0.230 7 1.407 1.313 0.206 0.230 8 1.477 1.368 0.202 0.230 9 1.551 1.425 0.198 0.230 10 1.629 1.484 0.194 0.230 15 2.079 1.831 0.177 0.230 20 2.653 2.273 0.162 0.230 25 3.386 2.837 0.148 0.230 50 11.467 9.060 0.099 0.230

ECON551: Lecture 9c 35

Accrual equivalence

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 1 6 11 16 21 26 31 36 41 46 Holding Period Accrual Equivalent tax rate Realization tax rate

ECON551: Lecture 9c 36

Balance conditions

Dividend Tax Credit Example 2005 Regime 2006 Regime Capital wages/

• ld

regime new regime rate gains interest dividends rate dividends Corporate profit before tax 100 100 100 100 Corporate tax paid 33% 33 33 33% 33 Amount available for distribution 67 100 67 67 dividend gross up 125% 83.75 145% 97.15 capital gain exclusion 50% 33.50 50% taxable personal income 33.50 100.00 83.75 97.15 Personal income tax (BC) 43.70% 14.64 43.70 36.60 43.70% 42.45 Dividend tax credit (BC) 18.43% 15.44 30.97% 30.08 personal taxes paid 14.64 43.70 21.16 12.37 total taxes paid 47.64 43.70 54.16 45.37

Notes: Federal DTC=13.33333. BC DTC=5.1%. Fed CIT rate 21%. BC CIT rate 12%. New regime: Gross up rate 45%, Federal DTC = 18.9655%, BC DTC=12%.

ECON551: Lecture 9c 37

Flow-through entities

A regular corporation looks like this:

DIVIDENDS CORP TAXES AFTER-TAX INCOME

• PERS. TAXES

SHAREHOLDER X CORP

ECON551: Lecture 9c 38

An Income Trust added to the mix looks like this:

INTEREST, ROYALTIES, LEASE PMTS AFTER-TAX INCOME

• PERS. TAXES

SHAREHOLDER X CORP X TRUSTCO LOAN NO TAXES: FLOW - THROUGH DISTRIBUTIONS

ECON551: Lecture 9c 39

Comments:

 Trust loans the corporation a huge chunk of money in exchange for the rights to the cash flow of the firm.  Firm pays out the interest on the loan.  Since interest is deductible, pre-tax profit goes to close to zero. No corporate taxes.  Units of X Trustco are held by individuals. No tax is levied on the trust. It is a ‘flow-through’ entity.  Shareholder pays tax on distributions from trustco.  The taxes paid depend on the form of income into X Trustco. In this example, it is entirely interest so the tax is on interest income. However, if there was some profit

• r some return of capital, it would be taxed as dividends or not at all, respectively.

 This structure is most attractive if personal taxes are less than corporate/dividend taxes.

 Note that this doesn’t allow the firm to retain any earnings. It therefore may affect

its ability to invest if it can’t easily access capital markets.

ECON551: Lecture 9c 40

The Fix:

Step 1: November 2005 Finance Minister: Ralph Goodale Serious enhancement of dividend tax credit  Gross up-rate from 125% to 145%.  Dividend tax credit rate from 13.33% to 18.97%. But…in 2006 continued conversions into trusts. $70B at least. Step 2: October 31, 2006 Finance Minister: Jim Flaherty The “Halloween Massacre” Special penalty tax on income trusts.

ECON551: Lecture 9c 41

Recent evidence: Moon (2019)

“Capital Gains Taxes and Real Corporate Investment” Looks for evidence that capital gains tax affects corporate investment.  Analyzes a Korean tax change that affected shares in smaller corps.  Finds substantial investment response.  More among cash-constrained firms.  This is most consistent with ‘traditional view’ models.