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

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 1

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 2

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 prop erty 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 3

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 4

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 5

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 6

Trends in capital income: dollar value of income Source: CRA Income Statistics ECON551: Lecture 9c 7

Trends in capital income: proportion with any income Source: CRA Income Statistics ECON551: Lecture 9c 8

Trends in capital income: share of total income Source: CRA Income Statistics ECON551: Lecture 9c 9

ECON551: Lecture 9c 10

Cumulative distribution of capital income types Source: Survey of Labour and Income Dynamics, pooled 2001-2011 ECON551: Lecture 9c 11

Avg dollars of capital income types across income distribution Source: Survey of Labour and Income Dynamics, pooled 2001-2011 ECON551: Lecture 9c 12

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 13

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 W 0 .  Tax rate t .  Two assets available: o m is risk-free asset (think money): return is 0. o a is risky asset with stochastic return r , with pdf f(r) . o So, budget constraint is: 𝑋 0 = 𝑏 + 𝑛 ECON551: Lecture 9c 14

Analytical Result: Domar Musgrave  Return to risky asset is taxed at flat rate t .  So, this makes his terminal wealth equal to: 1 = 𝑏[1 + 𝑠(1 − 𝑢)] + 𝑛 𝑋 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 15

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: 1 )𝑠(1 − 𝑢) (𝜖𝑏 ∗ 0 = 𝐹 [𝑉 ′′ (𝑋 𝜖𝑢 𝑠(1 − 𝑢) − 𝑏 ∗ 𝑠) − 𝑉 ′ (𝑋 1 )𝑠] ECON551: Lecture 9c 16

Analytical Result: Domar Musgrave 1 )𝑠(1 − 𝑢) (𝜖𝑏 ∗ 0 = 𝐹 [𝑉 ′′ (𝑋 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 ∗ 𝑏 ∗ 𝜖𝑢 = (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 17

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 one-sided bet. He shares the gains but not the losses. The results depend crucially on 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 18

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 19

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 are n’t being considered  Corollary: be very careful of tax predictions predicated on astute taxpayers and perfect capital markets…. ECON551: Lecture 9c 20

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 21

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 22