The Congressional Budget Office (CBO) recently released a thorough and interesting report on how the tax code treats capital income. The goal of the report is to show how the tax code applies differently to various forms of capital. It also offers possible policies that would reduce those disparities.
The report finds that the average effective tax rate on all forms of capital is 18 percent. An effective tax rate (ETR) is the tax paid divided by the income earned by capital, after deductions, exemptions, and credits. However, C-corporation’s equity-financed capital is taxed at a whopping 38 percent. Pass-through businesses’ capital income from equity is taxed at an also high 30 percent. Debt-financed income has a -6.0 percent effective rate for C-corporations and an 8 percent rate for pass-throughs. There are also differences across industries and other forms of capital, such as owner-occupied housing.
The CBO finds such low rates on debt-financed capital income because it errs in how it measures the rate. The low rate is largely a function of businesses being able to deduct their interest expenses. But the CBO forgets that lenders pay tax on the interest businesses pay them, and that the lenders pass that tax on to borrowers in the form of higher interest rates. A deduction is therefore necessary to make sure taxes do not influence borrowing decisions. It also means that the CBO needs to account for that tax when calculating the ETRs. Furthermore, the CBO fails to account for the recapture of tax when businesses sell assets before they are entirely depreciated.
This leads to the first key improvement the CBO should make. If it remedied these two errors, it would find that the tax rate on debt-financed capital is much higher, and certainly not negative. Therefore, the disparity between debt and equity financing would be appreciably less.
To its credit, the CBO includes in the report the correct policy options for reducing the differing ETRs on capital: eliminating the double taxation of corporate income by abolishing capital gains and dividends taxes and allowing businesses to immediately deduct (expense) the cost of their capital acquisitions.
Once those policies are in place, the largest remaining tax on capital is the corporate tax rate, which would apply to above-normal returns on capital. The CBO also includes in its possible policy prescriptions a lower corporate rate, which would reduce that remaining tax.
In addition to the correct policy proposals, unfortunately, the CBO includes a host of policies that would reduce the difference in ETRs on capital, but would increase the cost of capital. A higher cost of capital would hurt economic growth, job creation, and wage growth. Those harmful policies include moving to economic depreciation, taxing capital gains and dividends as ordinary income, disallowing the use of 401(k)-type savings plans, eliminating the deductions for mortgage interest and property taxes while simultaneously lowering individual tax rates, and limiting business interest deductions while reducing individual and business rates.
The CBO’s narrow focus on lessening differing ETRs on capital income leads it to propose these damaging policies. The second key improvement to strengthen the CBO report is for it to propose policies that would both seek to equalize ETRs across various forms of capital and reduce the cost of capital, instead of only the former.
A lower corporate tax rate, the abolition of double taxation, and the establishment of expensing would fit that more growth-enhancing bill. They would cause ETRs to be much closer across industries, business forms, and financing types, while at the same time driving the ETR on capital closer to zero, which is where it should reside.