Taxing Capital Income: Effective Rates and Approaches to Reform

In the United States, roughly 60 percent of federal receipts derive from what are termed income taxes—either the individual income tax or the corporate income tax. Income taxes generally include income generated by capital as well as labor. A number of analysts argue that taxing capital income imposes significant costs on the overall economy because such taxation affects investment and the allocation of that investment. As a result, proposals for comprehensive tax reform at the federal level typically include options such as value-added taxes, retail sales taxes, and the so-called flat tax—none of which tax capital income—as possible replacements for income taxes.

Despite their nominal characterization, the individual and corporate income tax systems already possess a number of features that exempt some capital income from taxation. In effect, those features render the current system a hybrid—a mix of treatments that fully taxes some capital income while fully or partially exempting the rest. The system’s hybrid nature and recurring interest in changing it lead to questions about the degree to which capital income is actually taxed under the present federal income tax system and the extent to which various alternative steps—such as providing for tax-exempt savings accounts or permitting the expensing of capital purchases—would move the system entirely away from the taxation of capital income.

In addition to analyzing the level of taxation currently applied to capital income, CBO considered the composition of capital income taxes: how uniformly capital is taxed under the present system and how potential steps toward eliminating the tax on capital income would affect that uniformity. A lack of uniformity can signal the potential for distortion in economic decisions.

The analysis detailed in this study informs those issues by computing effective tax rates for a broad range of investments in tangible capital. CBO’s findings are summarized below:

• Under a tax regime that assumes the indefinite extension of provisions in place in 2008 (the base case), the overall effective tax rate on income from capital is 13.8 percent, about midway between the zero percent tax rate under a consumption tax or a wage tax and the average statutory marginal rate in the current income tax (approximately 27 percent for noncorporate business income).
• Effective tax rates on capital income under the base case are highly uneven. For instance, whereas the effective tax rate on debt-financed corporate investment is -6.4 percent, it is 36.1 percent on equity- financed corporate investment. Using typical mixes of debt and equity financing, the effective tax rate on corporate investment is 5.7 percentage points higher than that on noncorporate investment, and the rate on tenant-occupied housing is 23.3 percentage points higher than that on owner-occupied housing. Effective tax rates also differ significantly across different asset types.
• Eliminating individual-level taxes on capital income and allowing businesses to expense new investments would produce an effective tax rate of -15.1 percent because of the continued deductibility of interest by businesses and homeowners. Thus, instead of taxing the return on capital investment, the tax system would, on balance, subsidize it.
• The above combination would also alter the unevenness of capital taxation. Not taxing capital income at the individual level would reduce the difference in tax rates that exists between corporate and noncorporate investment but would increase the difference between equity-financed and debt-financed corporate investment and between tenant-occupied and owner-occupied housing. Furthermore, adding the full expensing of the acquisition cost of capital assets would significantly increase the difference in rates between equity-financed and debt-financed corporate investments, although it would eliminate the variance across asset types.
• Eliminating the deduction for interest expenses in tandem with the above combination would set effective tax rates on all capital income to zero and achieve complete uniformity.