Taxing capital income

Taxing capital income

†

John G Head and Richard Krever*

Abstract This paper provides an overview and assessment of alternative methods of taxing capital income. We begin by considering why, and to what extent, capital income should be taxed. Having established a reasonably robust case for such taxation, we then review the difficulties of taxing capital income within the comprehensive income tax framework. We acknowledge that the comprehensive income tax approach could be problematic and review newer business tax initiatives, including the dual income tax, the comprehensive business income tax, and the various types of cash flow business taxes, including the allowance for corporate equity. These approaches mostly place heavier reliance on the business tax rather than the personal tax as the vehicle for capital income taxation. The cash flow taxes can be combined in various ways with personal taxes on consumption and wage income. We find that the different approaches to taxing capital income have their own particular advantages and disadvantages.

†

This paper was prepared for the Personal Income Tax Reform project undertaken by the Australian School of Taxation (Atax), UNSW. It was externally refereed and accepted for publication on 6 June 2007.

*

Taxation Law and Policy Research Institute, Monash University. We are indebted to Patricia Apps, Richard Bird, Michael Brooks, Neil Brooks, Paul Flanagan and John Freebairn for helpful comments and suggestions. The views expressed in the paper remain the responsibility of the authors. 81

82

I.

(2007) 22 AUSTRALIAN TAX FORUM

Introduction

The taxation of capital income (and saving) has long been recognised by public finance economists as the Achilles heel of the comprehensive income tax. Reform in this area has proved to be extremely difficult and politically controversial. When substantial reforms have been achieved – as in the U.S. Tax Reform Act of 1986 or in the post-Summit reforms in Australia of the same year – the pressures on the weak points, such as capital gains and company tax, have proved too great and the reform has soon unravelled. In other difficult areas, notably owner-occupied housing, reform has always seemed out of reach and has hardly been attempted. As a result the income tax systems of industrialised countries have remained an uneasy compromise, a hybrid of income and consumption tax elements. This hybrid system frequently appears barely sustainable. Indeed there is clear evidence for some countries that the inclusion of capital income along with labour income in the tax base – most notably in the personal income tax area – yields little or no revenue and threatens the revenue from the taxation of earned income. As Harvard tax lawyer William Andrews argued in an influential paper over 30 years ago, the income tax systems of most developed countries are stranded awkwardly about halfway between the consistent taxation of income and the consistent taxation of consumption. From where we then were – or now are – it would arguably be no more difficult, indeed easier, to move to a progressive consumption tax than to the comprehensive income tax. The practical arguments of Andrews echoed strongly at the time with tax economists, many of whom were already exploring the consumption tax option. Early findings of very large efficiency gains and a massive boost to savings in life‑cycle models have, however, been pruned back considerably in subsequent and more realistic modelling. In spite of its obvious limitations, the simple life-cycle model (in which labour supply is fixed and people have perfect foresight and save purely for future consumption) has never really lost its grip as a benchmark for economists in which the purest feasible consumption tax is the ideal. Following the difficulties and reverses in the area of income tax reform, many leading tax economists (especially in the United States) – at least in their hearts – would seem to have given up on the income tax as a realistic reform option. The feasibility issues in moving in either direction remain, however, essentially unresolved. Comprehensive reform on the income tax principle presents a truly

See generally RH Gordon and J Slemrod, “Do We Collect Any Revenue from Taxing Capital Income?” (1988) 2 Tax Policy and the Economy 89-130; RH Gordon, L Kalambodikis, and J Slemrod, “Do We Now Collect Any Revenue from Taxing Capital Income?” (2004) 88 Journal of Public Economics 5; J Becker and C Fuest, “Does Germany Collect Revenue from Taxing the Normal Return to Capital?” (2005) 26 Fiscal Studies 491-511. WD Andrews, “A Consumption-Type or Cash Flow Personal Income Tax” (1974) 87(6) Harvard Law Review 1113-1188.


83

formidable challenge in a democratic society – but so does the personal consumption tax alternative. As recognised from the outset by Bradford and by the Meade Committee, existing wealth accumulations pose a huge transitional problem under a shift to consumption tax. If, in order to avoid double taxation, these accumulations are treated as registered and tax exempt under a personal consumption tax, the expected gains in terms of efficiency and equity may well be very small indeed. The alternative of unregistered treatment is, however, almost unthinkable. As a result of these and related difficulties, Bradford and others went on to propose a “pre-paid consumption tax” alternative under which a progressive tax on wage income would replace the progressive expenditure tax. Under this proposal a cash flow business tax would replace the familiar corporate income tax as a supplement or backstop to the personal tax on wage income. Here again, however, complications arise in the transition, as income accounting procedures would have to be retained for some time under the business tax. Changes in tax rates could also pose serious problems for savings and investment. Most importantly, the cash flow business tax would not fit comfortably into the prevailing international tax framework.

II.

Should capital income be taxed?

Setting these administrative and practical issues aside for the moment, it is clearly of fundamental importance to consider whether consumption taxation is, in principle, really the ideal. Traditionally it has been argued by supporters of the consumption base that comprehensive income taxation on Haig-Simons principles involves double taxation of saving. Such a tax generates intertemporal inefficiency and horizontal inequity and discriminates against the saver. In the simple life-cycle model this argument is correct and results from the inclusion of capital income in the tax base. The simple model assumes, however, that labour supply is fixed, people have perfect foresight and all saving is for future consumption. These assumptions are obviously unrealistic and must be relaxed. With appropriate modifications, is it possible that the life-cycle model could justify some measure of capital income or wealth taxation? Early research on the case for capital income taxation in infinite-horizon life-cycle models was far from encouraging. Judd and Chamley found that the optimal rate of capital income taxation would necessarily be zero in the long run, though positive

In his report prepared for the US Treasury: US Treasury Department, Blueprints for Basic Tax Reform (Washington, DC: Government Printing Office, 1977). Institute for Fiscal Studies (committee chaired by J Meade), The Structure and Reform of Direct Taxation (Meade Report) (London: Allen and Unwin, 1978). DF Bradford, Untangling the Income Tax (Cambridge, Mass: Harvard University Press, 1986); DF Bradford, “A Tax System for the Twenty-First Century” in AJ Auerbach and KA Hassett (eds), Toward Fundamental Tax Reform (Washington, DC: AEI Press, 2005). KL Judd, “Redistributive Taxation in a Simple Perfect Foresight Model” (1985) 28 Journal of Public Economics 59-83. C Chamley, “Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives” (1986) 54 Econometrica 607-22.

84


rates might be justified in the short run. The assumptions of such models are, however, very restrictive. Very large efficiency gains and a substantial boost to savings from the complete elimination of capital income taxation are likewise to be found in the somewhat more plausible framework of the overlapping-generations model. This is particularly the case in the early work of Summers, though more modest gains have been found in subsequent modelling such as that of Auerbach and Kotlikoff and Fullerton and Rogers.10 In order to analyse these issues a clear distinction needs to be drawn between different components of the return to capital, notably the normal risk-free real return, the inflation premium, the return to risk, and economic rents or supernormal profit.11 It is also necessary to recognise that while consumption and wage taxes exempt the normal return and the inflation premium, only wage taxes exempt risk and supernormal profit – though any distorting impact on risk under consumption (or for that matter income) taxes may not be too significant provided loss-offset provisions are adequate. Where labour supply is variable in the life-cycle model, a variety of secondbest considerations would seem to support some taxation of the normal return to capital.12 These arguments apply in the context of personal income taxation imposed in a closed economy (or under a fully enforceable residence-based system in an open economy). In this setting the case for the pure consumption tax is known to depend on the relative complementarity of present and future consumption with leisure.13 After a long period of agnosticism, it has recently been strongly argued by Erosa and Gervais that future consumption must be more complementary with leisure under any plausible parameterisation of the life-cycle model.14 This would suggest that some additional taxation of saving or capital income is required. 10 11

12 13 14

LH Summers, “Taxation and Accumulation in a Life Cycle Growth Model” (1981) 71 American Economic Review 533-54. AJ Auerbach and LJ Kotlikoff, Dynamic Fiscal Policy (Cambridge, UK: Cambridge UP, 1987). D Fullerton and DL Rogers, “Lifetime Effects of Fundamental Tax Reform” in HJ Aaron and WG Gale (eds), Economic Effects of Fundamental Tax Reform (Washington, DC: Brookings Institution, 1996) 321-47. See RG Hubbard, “Would a Consumption Tax Favor the Rich?” in AJ Auerbach and KA Hassett (eds), Toward Fundamental Tax Reform (Washington DC: AEI Press, 2005) 81-94; N Brooks, “An Overview of the Role of the VAT, Fundamental Tax Reform, and a Defence of the Income Tax” in R Krever and D White (eds), GST in Retrospect and Prospect (Wellington: Thomson Brookers, 2007) 597-658 at 609-617. See PB Sorensen, “Can Capital Income Taxes Survive? And Should They?” (Working Paper No 1793, CESifo, 2006). Revised version available at author’s site: at 19 June 2007. See AB Atkinson and JE Stiglitz, “The Design of Tax Structure: Direct Versus Indirect Taxation” (1976) 6 Journal of Public Economics 55-75. A Erosa and M Gervais, “Optimal Taxation in Life-Cycle Economies” (2002) 105(2) Journal of Economic Theory 338-69.


85

A further justification for capital income taxation rests on the important observation that labour supply elasticity increases with age.15 Since an age-dependent labour-income tax favouring older taxpayers may not be politically feasible, the same result may instead be achieved indirectly by imposing a tax on the normal return to capital. This will raise the relative price of consumption and leisure in future periods and thus increase labour supply at older ages. Where the full cost of education or human capital investment is not deductible, a capital income tax can also be used to offset the depressing effect of a labour income tax on human capital investment.16 If the government could observe all educational investments and their opportunity costs, educational subsidies would be the best solution. Where, however, this is not possible, an appropriate level of capital income taxation can be justified to balance up the burden on financial capital. A more fundamental argument for the taxation of saving or capital income in this setting is that, for those with large wealth accumulations, wealth as such yields utility and may yield more utility than consumption at the relevant margin. The motives for saving therefore include an accumulation motive, over and above the more familiar economic motives of present consumption, future consumption and bequests. In a tradition extending back from the Meade Committee,17 through Musgrave18 and Kaldor19 to Simons20 and Guillebaud,21 it has been argued that savings yield satisfaction in terms of power, prestige, influence, opportunity, and security, beyond any benefits deriving from consumption, whether present or future and whether personally or by heirs. This line of argument has recently been powerfully redeveloped in a more modern framework by Carroll.22 More generally it must also be recognised that some measure of wealth or capital income taxation may be justified to take the pressure off the more elastic categories of labour supply. Empirical evidence strongly suggests (for the closed economy) that the relevant savings and intertemporal substitution elasticities are very low23 – and well below the labour supply elasticity for second earners (mostly women).24 Efficiency gains may therefore be achieved by reducing marginal and average rates of tax on second earners at low to middle income levels and making up the revenue by increasing the weight of tax on capital income. These gains may indeed extend beyond 15 Erosa and Gervais, above n 14. 16 See AL Bovenberg and B Jacobs, “Human Capital and Optimal Positive Taxation of Capital Income”, (Discussion Paper No 5047, CEPR, May 2005). 17 Meade Report, above n 4. 18 RA Musgrave, The Theory of Public Finance (New York, NY: McGraw-Hill, 1959). 19 N Kaldor, An Expenditure Tax (London: Allen and Unwin, 1955). 20 HC Simons, Personal Income Taxation (Chicago, Ill: Chicago UP, 1938). 21 CW Guillebaud, “Income Tax and Double Taxation” (1935) 45(179) Economic Journal 484-92. 22 C Carroll, “Why Do the Rich Save So Much?” in J Slemrod (ed), Does Atlas Shrug?: The Economic Consequences of Taxing the Rich (New York: Russell Sage Foundation, 2000). 23 See, for example, CL Ballard, “Taxation and Saving” in JG Head and R Krever (eds), Taxation Towards 2000 (Sydney: ATRF, 1997) 537-563. 24 JJ Heckman, “What Has Been Learned About Labor Supply in the Past Twenty Years?” (1993) 83 American Economic Review, Papers and Proceedings 116-21.

86


labour supply to savings, since evidence clearly shows that the bulk of savings are made not by the wealthy but rather by two-earner households across a wide middle band of income.25 The argument that capital income taxation may relieve pressure on more elastic categories of labour supply is reinforced when the analysis is extended beyond the normal return to the taxation of the economic rent and risk components of capital income – and beyond personal to corporate or business taxes. In the closed economy a tax on economic rents or supernormal profit is completely non-distorting. The appropriate tax rate on capital income needs to be limited therefore only out of concern for the distorting effects of the tax as it applies to the normal return. In the open economy savings elasticities must generally be larger, but taxes on locationspecific rents remain completely non-distorting. The scope for capital income taxes is nevertheless somewhat reduced and rates must be adjusted downwards in order to protect investments generating firm-specific rents which may involve externalities such as technology transfer.26 As is well known from the early insights of Domar and Musgrave,27 capital income taxation can also be largely non-distorting as it applies to risk, provided comprehensive loss offsets are available. The government becomes in effect a partner in the business and shares in the risk premium on investments. In practice some asymmetry in the treatment of gains and losses is almost inevitable, especially under a progressive rate structure, and loss-carryover provisions are usually less than perfect. Substantial revenues can nevertheless be raised from the taxation of the risk component without serious distorting effects provided loss-offsets are attended to. Whether and to what extent these revenues should be discounted for risk remains, however, somewhat unclear.28 The same cannot be said for the inflation premium which is taxable under income taxation because of the failure to apply comprehensive inflation adjustment to the capital income base. This failure has long served as a pretext for roughly compensating concessional provisions in such areas as capital gains and depreciation allowances. By contrast, the inflation premium is exempt under a wage tax or consumption tax. The case for capital income taxation is further strengthened by vertical equity considerations. The ownership of financial capital is known to be heavily concentrated at high income and wealth levels. At a time of widening inequality there is accordingly a strong case for maintaining or increasing tax burdens at high wealth levels, either through progressive-rate taxes on capital incomes such as capital gains, interest, dividends, etc. or through corresponding taxes on wealth transfers or wealth as 25 See P Apps, “A Tax-Mix Change: Effects on Income Distribution, Labour Supply and Saving Behaviour” in JG Head and R Krever (eds), Taxation Towards 2000 (Sydney: ATRF, 1997), 103‑121. 26 See P Sorensen, above n 12. 27 ED Domar and RA Musgrave, “Proportional Income Taxation and Risk-Taking” (1944) 58 Quarterly Journal of Economics 387-422. 28 See Hubbard, above n 11, 87. For an analogous argument see L Kaplow, “Taxation and Risk Taking: A General Equilibrium Perspective” (1994) 47(4) National Tax J 789-798.


87

such. It would arguably be impossible to contain the growth of inequality through the consumption tax alternatives of progressive-rate taxes on expenditure or wage income. This is especially true in the case of the wages tax which completely exempts the full return to capital. Since higher rates of saving and capital accumulation raise the relative wages of skilled workers, it has been suggested that capital income taxation may be required on vertical equity grounds as a method of controlling the widening gap between the wages of skilled and unskilled workers.29 These arguments strongly suggest therefore that the purest feasible consumption or wage income tax may be far from ideal, even in the context of a (suitably generalised) life-cycle model. Additional taxation of saving or some appropriate measure of capital income taxation is arguably required. This will not generally correspond to the comprehensive income tax ideal, but in the present state of knowledge it cannot be precisely specified. Given the high global mobility of capital, it is probably safe to conclude that the rate of tax on capital income should lie below that on labour income.30 At the same time, however, a supplementary tax on wealth or wealth transfers may well be required for vertical equity reasons and/or to address the “extra benefits” from saving or wealth holding by the rich. This latter argument has figured prominently among supporters of consumption taxation such as Kaldor and the Meade Committee. Clearly, however, such a requirement would greatly detract from the much-touted advantages of this approach in terms of simplicity.

III. How can capital income best be taxed? There is a well established proposition in tax incidence analysis for a small open economy that a source-based tax on capital income, such as a corporate profits tax, by reducing investment domestically, will be fully shifted on to labour and will raise no revenue.31 The assumption here is that capital is perfectly mobile and the burden of tax must therefore fall on immobile labour. By contrast, a residence-based tax on capital income applying, say, under the personal income tax to dividends, interest, capital gains, etc. will fall on domestic savings. As we shall see, however, these are very broad propositions which are subject to important exceptions and reservations. Despite the ominous predictions of those who support this view, the fact is that the most important source-based tax, the company income tax, has not declined dramatically since the early 1980s under the influence of capital mobility and international tax competition. Statutory rates have fallen significantly, but corporate 29 See B Salanie, The Economics of Taxation (Cambridge, Mass: MIT Press, 2003), 143. 30 See PB Sorensen, “From the Global Income Tax to the Dual Income Tax: Recent Tax Reforms in the Nordic Countries” (1994) 1(1) International Tax and Public Finance 57-79. 31 RH Gordon, “Taxation of Investment and Savings in a World Economy” (1986) 76 American Economic Review 1086-1102; J Slemrod, “Effect of Taxation with International Capital Mobility” in HJ Aaron, H Galper and JA Pechman (eds), Uneasy Compromise: Problems of a Hybrid Income Consumption Tax (Washington, DC: Brookings Institution, 1988); A Razin and E Sadka “International Tax Competition and Gains from Tax Harmonisation” (Working Paper No 3152, NBER, 1991).

88


tax revenue as a proportion of GDP has actually risen in most developed countries.32 Rate reductions have thus been matched by base broadening and by an increase in the corporate share of profits. The company income tax thus continues to serve in developed countries as the cornerstone of the capital income tax system. In this respect Australia is certainly no exception. A major reason for the survival of the source-based company income tax in a world of increasing tax competition and capital mobility is the existence of locationspecific rents which can be taxed without driving capital away. Rich natural resource endowment, quality infrastructure, supplies of qualified labour and “agglomeration forces” may generate such location-specific rents. Limitations on capital mobility may also stem from the different risk characteristics of financial instruments issued in different jurisdictions. Further important reasons for imposing company tax include the “Inter-nation equity” rationale and the user-pays argument for source taxation of foreign-owned domestic companies.33 The company tax likewise serves as a crucial “backstop” to the personal income tax by preventing taxpayers from shifting income into corporations where it can accumulate tax-free. It also functions as a withholding tax on retention gains. Also helpful to the survival of the company tax has been the partial umbrella provided by the foreign tax credit systems of countries, such as the US, UK and Japan, which impose residence-based company income taxes. By contrast, the taxation of capital income (or savings) under the personal income tax remains a shambles in most developed countries. Gaps in the tax base (or so‑called “incentive provisions”) in such areas as capital gains, financial derivatives, negatively geared share and rental property investments, share repurchases, owner-occupied housing, employee share plans and occupational superannuation distort the allocation of investment and savings and can greatly reduce effective progressivity. And these gaps are enormously widened in many cases by uncontrolled nominal interest deductibility and tax arbitrage. As already noted above, there is clear evidence for some countries that no revenue whatever is raised from capital income taxation within the framework of the personal income tax system. There are, admittedly, serious technical difficulties in imposing the ideal accrual tax on some of these capital income components. In most cases, however, good technical solutions exist, but they have rarely been applied. Most importantly, methods of taxing capital gains, which combine full accrual taxation with other features such as comprehensive averaging or full inflation adjustment, have been devised by Vickrey, Helliwell, Bucovetsky, Auerbach and others.34 Where for political reasons some concession for capital gains is unavoidable, workable schemes for comprehensive 32 P Sorensen, above n 12. 33 See RA Musgrave and PB Musgrave, “Inter-nation Equity” in RM Bird and JG Head (eds), Modern Fiscal Issues: Essays in Honour of Carl S. Shoup (Toronto: University of Toronto Press, 1972). 34 W Vickrey, Agenda for Progressive Taxation (New York: Ronald Press, 1947); J Helliwell, “The Taxation of Capital Gains” (1969) 2 Canadian Journal of Economics, 314-18; MW Bucovetsky, “Inflation and the Personal Tax Base” (1977) 25(1) Canadian Tax Journal 77-107, AJ Auerbach “Retrospective Capital Gains Taxation” (1991) 81 American Economic Review 167-77. See further


89

interest quarantining have been developed which would limit the extent of distortions, inequities and revenue losses.35 There is certainly no excuse for a retrograde move to a fractional-inclusion or “discount” regime of the type adopted by Australia in 2000 which is wide open to abuse. Similarly it is quite obvious that most countries have simply made a political decision to exempt superannuation savings and owner-occupied housing from income tax. The resulting distortions, inequities and revenue losses could be avoided if the political obstacles could be overcome.36 The abolition in 1987 by New Zealand of concessions for occupational superannuation – and the introduction of accrual taxation for financial derivatives – suggests what can be done. Australia by comparison has made minimal progress on derivatives, and has moved massively backwards with the costly, ineffective, inequitable and unsustainable new exemption for superannuation payouts in last year’s budget.37 Comprehensive and consistent taxation of capital income and savings under the personal income tax is arguably feasible – given the political will and sufficiently skilful packaging. Some of the most important distortions and tax avoidance problems stem, however, from inadequate co-ordination of capital income taxation as it applies respectively under the personal income tax and the company income tax. Where the company income tax rate is relatively low, tax can easily be avoided by conducting business activities in the corporate form. This has long been a significant problem in most jurisdictions with significantly diverging personal and company income tax rates. Anti-avoidance measures, such as Australia’s “personal service income” regime, that look through interposed entities and attribute service income to the actual service providers have proved to be of limited efficacy as their integrity is undermined by various concessions and limitations on their scope.

IV.

Alternative approaches to the reform of capital income taxation

We have argued above that some measure of capital income taxation should ideally be applied within the framework of the personal income tax and/or under an associated business income tax system such as the familiar company income tax. These taxes must, however, be appropriately integrated. We have argued also that most of the technical difficulties in imposing capital income taxation can be overcome. Some

M Benge, “Capital Gains and Reform of the Tax Base” in JG Head and R Krever (eds), Taxation Towards 2000 (Sydney: ATRF, 1997), 351-392. 35 See, for example, MJ McIntyre, “Tracing Rules and the Deduction for Interest Payments: A Justification for Tracing and a Critique of Recent US Rules” in JG Head and R Krever (eds), Taxation Towards 2000 (Sydney: ATRF, 1997), 437-478. 36 With precious few exceptions, European experience with the taxation of imputed rent is, however, hardly encouraging. 37 See, for example, J Head, “Super Cuts to Cost Dearly”, Australian Financial Review, 29 May 2006, 22.

90


appropriate trade-off between the basic objectives of efficiency, equity and revenue adequacy should be achievable. Fundamental reform of capital income taxation can, however, be approached in different ways, and a variety of off-the-shelf alternatives have been suggested. Some of these approaches may well be easier than others in the tax circumstances of a particular country. These alternatives also vary widely with the nature of the personal tax system in which they are embedded. Where the personal tax is based on comprehensive income, capital income would ideally be taxed under an integrated personal and company income tax system. Where, however, personal tax is imposed on a consumption or wage income base, capital income taxation is necessarily confined to the business tax supplement and will ideally be imposed on cash flow rather than on economic income.

A.

The Comprehensive Income Tax Approach

If Australia was to attempt a fundamental reform of the personal income tax system within the comprehensive income tax framework, far-reaching changes would clearly be required in the capital income area. Under the present structure the tax treatment of the various components of capital income (and saving) is widely divergent with serious distorting effects, inequities and revenue losses. Much more consistent treatment is essential if a sustainable hybrid – let alone a comprehensive income tax – is to be achieved. Three alternative tax reform strategies need to be distinguished. At the near-ideal end, a comprehensive real income base would require full inflation adjustment of capital gains, interest payments and receipts, trading stock, and depreciation, but this may well be unattainable in practice despite the obvious benefits in terms of efficiency and equity. The second alternative of a consistent nominal income base would also be very demanding, requiring as it does some form of retrospective accrual taxation of capital gains – while leaving obvious problems of inefficiency and inequity due to the lack of inflation adjustment. The third alternative is a sustainable hybrid which would still require a substantial shift in the direction of comprehensiveness. Some of the major changes required for this latter strategy would include: full taxation of realised capital gains (with inflation adjustment); quarantining of tax losses on geared share and rental property investment; comprehensive accrual taxation of financial derivatives; an end to concessional taxation of share repurchases; and the restoration of coherence in the tax treatment of superannuation savings. We have argued above that a satisfactory approximation to comprehensive and consistent taxation of capital income and savings under the personal income tax is achievable, given the necessary political resolve and appropriate packaging. Some departures from the ideal must nevertheless be expected in practice – notably in such areas as capital gains, owner-occupied housing and superannuation. The pressures imposed at these weak points by interest deductibility and tax arbitrage could well prove difficult to contain, especially at high-income levels under the progressive rate structure required by vertical equity. It is, however, a basic observation that the more comprehensive the base


91

broadening, the larger the rate reductions that can be achieved at the top of the income scale without reducing effective progressivity. In this way the distortions, inequities and tax avoidance pressures can all simultaneously be much reduced. In the associated company tax area, the Business Tax Review of 1999 restored a considerable measure of integrity to the business income base. Although inflation adjustment has not been attempted, the current depreciation arrangements offer a reasonable approximation to the ideal of economic depreciation, and many of the more egregious sectoral and industry concessions have been removed. The most serious remaining problems are arguably those which stem from the lack of co-ordination between the personal and company income tax systems, notably the scope for income shifting and tax avoidance through the use of interposed and service entities to avoid the higher rates of personal income tax on labour income. These and related distortions and inequities could, however, be eliminated under one or other of two off-the-shelf models of full personal and corporate tax integration. Under the compulsory partnership approach, recommended for Australia by the Campbell Committee38 and for the United States by the US Treasury,39 pre-tax corporate net profit would be notionally “allocated” to resident shareholders and taxed under the progressive rate structure of the personal income tax, with full refundable credit for corporate tax paid. In this way domestic tax policy objectives of equity and efficiency would be fully achieved. The corporate tax rate would be set to optimise the trade-off between international tax policy objectives of securing an adequate return from the taxation of inward investment by Australia as the country of source, whilst ensuring that such investment is not unduly deterred with the possible loss of external benefits such as technology transfer. The possible difficulties of the partnership approach have been carefully explored in the literature, notably by Goode40 and McLure41 – and more positively, by Swan42 and Officer43 for the Campbell Committee. Swan and Officer argue that a good approximation to the partnership ideal is achievable in practice, but this remains very much a minority view. The US Treasury, which recommended this approach in their 1977 study, had abandoned it by 1984,44 a position confirmed in a subsequent 1992 38 Committee of Inquiry into the Australian Financial System (Keith Campbell, chair), Australian Financial System: Final Report (Canberra: AGPS, September 1981). 39 US Treasury Department, Blueprints for Basic Tax Reform (Washington, DC: Government Printing Office, 1977). 40 RB Goode, The Post War Corporation Tax Structure (Washington DC: US Treasury Department, Division of Tax Research, 1948). 41 CE McLure, Jr, Must Corporate Income Be Taxed Twice? (Washington: Brookings Institution, 1979). 42 P Swan, (1982), “Is There a Case for Complete Integration of Corporate and Personal Income Taxes?” in Australian Financial System Inquiry, Commissioned Studies and Selected Papers, Vol 3 (Canberra: AGPS, 1982). 43 RR Officer, “Company Tax and Company Finance” in Australian Financial System Inquiry, Commissioned Studies and Selected Papers, above n 42. 44 US Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department’s Report to the President (Washington, DC: Government Printing

92


study.45 As corporate structures have become increasingly complex, the problems of the compulsory partnership approach have become insurmountable. This solution having, therefore, by common consent been ruled out, policy attention has been focused instead on a voluntaristic rate-alignment alternative. The inherent difficulties of the compulsory partnership approach cannot, however, be overcome in this way. Indeed further problems arise. The model proposed by the Carter Royal Commission46 sought to achieve full partnership treatment of corporate profits by aligning the top rate of the personal income tax with the company tax rate at 50 per cent. This was indeed almost precisely what was done under the Keating income tax reform package following the National Taxation Summit in the mid-1980s. With the two rates aligned at 49 per cent and with a full imputation system, a full voluntary allocation of profits to domestic shareholders could be approximated, and the distortions, inequities and tax avoidance problems under the previous classical system would very largely disappear. For domestic shareholders the company income tax would serve therefore as a withholding tax on corporate profits. At the same time the tax would continue to serve as a source tax on foreign ownership of Australian companies. The gross-up and credit arrangement applying in the case of domestic shareholders would not extend to foreign shareholders. There is, however, a possible conflict between domestic and international tax policy objectives under the Carter-Keating rate alignment model, which serves to explain why the new Australian system lasted only one full year (1987-88). With company tax rates declining in a number of major developed countries overseas, Australia’s 49 per cent rate was fast becoming uncompetitive and was accordingly reduced to 36 per cent. No comparable reduction could at that time be contemplated in the personal tax top rate which had only just been substantially reduced from 60 per cent to 49 per cent. The top personal and company tax rates were therefore forced apart under pressure from international tax competition, and they have since diverged further as the company rate was reduced to 33 per cent and now stands at 30 per cent as compared with the top personal tax rate of 45 per cent (or 46.5 with the Medicare levy). Business groups have since been pressing vigorously for rate realignment with a reduction in the top personal tax rate to the present corporate tax rate at 30 per cent. Such a reduction in the top personal tax rates would, however, be enormously expensive in revenue terms. In the context of widening wealth and earnings inequality,47 it would also be totally unacceptable in vertical equity terms. Any possible benefits in increased work effort or savings would also arguably be very small. The conflict Office, 1984). 45 US Treasury, Report on Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once (Washington, DC: Government Printing Office, 1992). 46 Canada, Royal Commission on Taxation (K Carter, chair), Report of the Royal Commission on Taxation (Ottawa: Government Printer, 1966). 47 See AB Atkinson and A Leigh, “The Distribution of Top Incomes in Australia”, (Discussion Paper No 514, ANU Centre for Economic Policy Research, 2005).


93

between domestic and international tax policy objectives in the present Australian economic situation cannot therefore easily be resolved or avoided in this way. It might be argued that extensive base-broadening in the coverage of capital income under personal income tax could help justify the rate-alignment strategy by increasing the weight of tax at high income levels. Whether or not such a package might be acceptable would depend heavily on how close we could come to the comprehensive tax ideal in this area. This brings us back therefore to the political and administrative challenge of achieving consistent treatment of most, if not all, components of capital income under the personal income tax.

B.

Dual Income Tax (DIT)

In view of the political and administrative challenge posed by interest deductibility and tax arbitrage in taxing capital income at high income levels under the progressive rate structure of a comprehensive income tax, it is tempting to consider whether the traditional “global” framework might be abandoned and a low flat-rate schedular tax applied to capital income. Under such an approach it could well be easier politically to achieve comprehensive and consistent treatment of the more sensitive capital income components such as capital gains, negatively geared share and rental property investment, financial derivatives, superannuation, etc. Such an approach has indeed been applied under the so-called dual income tax (DIT) pioneered in the Nordic countries in the early 1990s.48 Under the DIT, capital income is taxed separately from labour income at a low flat rate, and the global framework of the comprehensive income tax is abandoned.49 In a secondbest world, optimal tax analysis would suggest that higher rates of tax should be applied to inelastic income sources and lower rates to elastic sources. In the open economy setting facing Australia, the high and increasing international mobility of capital would strongly suggest that capital income components should be taxed at relatively low rates. Applied comprehensively at a flat uniform rate, the separate tax on capital income could eliminate, or at least greatly reduce, the distorting effects on the allocation of savings and investment which are such a prominent feature of the present personal income tax. Unlike the flat tax proposals, the DIT would allow the pursuit of vertical equity objectives through a separate progressive-rate tax on labour income. As applied in Norway, Sweden and Finland, the flat-rate tax on capital income was imposed at the bottom rate of the labour income tax, at 25-30 per cent, while the progressive rate structure of the labour income tax ranged up to 50 per cent or more.

48 See PB Sorensen, above n 30. 49 The social security contributions of OECD countries apply exclusively to labour income and could be said to create a substantial de facto DIT. This is so at least to the extent benefits are not actuarially linked to contributions.

94


Integration of the corporate tax with the personal tax is easily achieved under the DIT by setting the corporate rate equal to the flat rate applying to capital income. A simple exemption for dividends under the personal tax ensures full neutrality. It would not therefore be necessary to sacrifice vertical equity by reducing the top personal tax rate to the current corporate rate of 30 per cent, as proposed by business groups in Australia. Under either approach some tension clearly remains between domestic and international tax policy objectives. More than almost any other OECD country, Australia relies heavily on the corporate tax as a source of revenue.50 Under the DIT the company tax rate could in principle be held at or near the present level of 30 per cent. Given the disincentive effects on elastic female labour supply, however, it would be impossible to justify a rise in the bottom rate of the personal tax – currently 15 per cent – to 30 per cent, or even 25 per cent, as under the separate labour income tax in dual rate countries. Difficulties arise under DIT in distinguishing capital and labour income components in the case of small private companies and unincorporated businesses. With the capital income tax rate set equal to the bottom rate of the labour income tax, there is an obvious incentive to shift labour income into the low-taxed capital income category. This problem was largely resolved in the Nordic countries by imputing a normal rate of return on business capital to determine the capital income component with the balance of profit being treated as labour income. In order to control remaining tax avoidance problems and to ensure full neutrality, some further adjustments have since been made.51 These do not, it seems, too greatly complicate the system, though it remains far from simple. It is difficult to believe that such a comprehensive valuation of business assets and associated imputations would be acceptable to business groups in Australia. Although considerable broadening of the capital income base was achieved under the switch to a flat rate tax on capital income in the Nordic countries, significant distortions and tax arbitrage problems still exist in areas such as capital gains, superannuation and owner-occupied housing.52 Although the DIT has obvious attractions, administrative difficulties and non-neutralities therefore remain. It is clearly no panacea for the problems of capital income taxation.

50 However, the OECD figures may exaggerate this reliance as they fail to take account of the Australian imputation system, which effectively returns a not insignificant proportion of that tax to shareholders. Significantly, they also treat income taxes on contributions to superannuation funds and on fund earnings as “company” taxes. 51 PB Sorensen, above n 12. 52 It should, however, be noted that similar non-neutralities arise under the CFBT and ACE systems.


C.

95

The Comprehensive Business Income Tax (CBIT)

Although, under DIT, interest receipts (like capital gains and other forms of capital income) are in principle fully taxable at the separate uniform flat rate, full nominal interest deductibility encourages tax arbitrage operations which exploit the inevitable non-uniformities remaining in the capital income base. The comprehensive business income tax (CBIT) proposed by the US Treasury53 offers an alternative application of the separate flat-rate tax approach which could overcome these problems. Under the CBIT the interest deduction at the corporate level would be denied. Both interest and profits would thus be taxed at the corporate level – while interest, like dividends and capital gains on equity interests, would be exempt from tax at the personal tax level. The CBIT would operate therefore as a comprehensive withholding tax on the major categories of business and investment income. On the DIT analogy, personal tax would apply at progressive rates to other income sources – primarily therefore to labour income but also to some types of capital income. It is therefore a central feature of the CBIT that debt is taxed the same as equity – a matter of no small importance with the growth of financial innovation and the emergence of debt derivatives with significant equity characteristics. Concerns regarding the incentive to finance with foreign debt are also removed under CBIT as the denial of the interest deduction would extend to interest on foreign debt. Under the US Treasury proposal the CBIT rate would be aligned with the top personal tax rate at 31 per cent, and the difficult problem under DIT of distinguishing labour income from capital income in the case of small private companies and unincorporated businesses cannot arise. Like the corresponding rate-alignment proposal for the top personal tax rate and the company income tax rate at 30 per cent in Australia, this does however presuppose that a relatively low top personal tax rate and associated progressive rate structure can satisfy vertical equity objectives. Although much additional interest income would become taxable under the CBIT, and a lower statutory rate could be applied, it does appear that this proposal, attractive as it is, could not simultaneously satisfy both domestic and international tax policy objectives under current Australian conditions. Clearly the CBIT, with its sweeping denial of the interest deduction, would represent a major departure from international tax practice and would pose obvious problems under prevailing tax treaty norms. Difficult negotiations with other countries must clearly be expected, and it could well be years before such a system could be introduced. Serious transitional problems also arise domestically, as denial of the interest deduction could impact heavily on highly geared companies. Another significant problem of the CBIT, as compared with the DIT, relates to its less-than-comprehensive coverage of capital income components. Whereas the DIT in its ideal form applies a separate but fully comprehensive tax on capital income, the US Treasury CBIT proposal is restricted to the major business income components, that is, interest and the return on corporate and non-corporate equity. Although 53 See above, n 45.

96


current problems of distinguishing debt from equity could in this way be eliminated, corresponding problems arise, for example, in the taxation of rental payments and royalties.

D.

Cash Flow Business Taxes (CFBT)

In spite of their very considerable attractions, neither the comprehensive income tax, nor even the DIT or the CBIT, can guarantee uniform and consistent taxation of capital income. Distortions in the allocation of savings and investment seem certain to remain, under any realistic application of even the more sophisticated DIT and CBIT alternatives. We have already noted that source-based corporate taxes have survived the increasing pressures of international tax competition largely because of the existence of location-specific rents stemming from natural resource endowments, quality infrastructure, a skilled workforce and agglomeration effects. Since, under increasing capital mobility, the tax on the normal return to capital must be shifted onto less mobile factors, it is hardly surprising that attention has increasingly been focused on the possibility of imposing the source-based corporate tax on economic rents. The rent tax is in fact the natural business tax complement to the personal consumption tax. Discussion of such taxes was accordingly pioneered by the US Treasury54 and the Meade Committee55 and has been taken up in other contributions to this literature by Bradford,56 Hall-Rabushka,57 and others. The CFBT would involve immediate expensing of investment. Since the present value of the cash flows from a marginal investment project just equals the initial investment outlay, the CFBT leaves marginal investments tax-free and falls on economic rents and risk. In a closed economy a tax on economic rents is ideally neutral and non-distorting. In the open economy, however, multinational companies commonly earn rents from firm-specific as well as location-specific assets. A CFBT on such internationally mobile rents can therefore distort the location decisions of multinationals. Under the CFBT substantial amounts of revenue will also be raised from the taxation of risk – which will involve some distortion if loss-offsets are imperfect. On the Domar-Musgrave income tax analogy, the government becomes in effect a partner in the business, sharing more or less symmetrically in positive and negative cash flows. In addition to the economic rents it will therefore share in the return to risk on these investments.58 Despite some unavoidable distortions, the efficiency and simplicity advantages of the CFBT nevertheless remain substantial. The complications of inflation adjustment and the need to determine economic depreciation simply do not arise. What the Meade Committee call the “R-base” has been widely favoured and offers the enormous 54 55 56 57 58

See above n 3. See above n 4. See above n 5. R Hall and A Rabushka, The Flat Tax (Stanford, CA: Hoover Institution Press, 1995). For a contrary view, see Hubbard, above n 11, and Kaplow, above n 28.


97

advantage that it is confined to real transactions – thus avoiding the complexities involved in keeping track of financial transactions. As we have already noted above, the CFBT is the natural business complement to the personal consumption tax. In the tax reform context such taxes are therefore normally considered together. The natural complement of the personal cash flow tax on consumption (in the Fisher-Kaldor-Meade tradition) is what the Meade Committee calls the “R+F” base business tax. Both at the personal level and at the business level it would accordingly be necessary to keep track both of real and financial flows. This would clearly involve great complexity – beyond, in some respects, what is required for the comprehensive income tax system. As a consequence, in recent years the major focus in the consumption tax debate has switched from the personal expenditure tax (F-K-M style) to the pre-paid consumption tax or wages tax. In the case of the wages tax, financial transactions are simply ignored.

E.

The Bradford X Tax Solution

The well known X-tax package proposed by David Bradford combines a progressiverate personal tax on labour income with a flat-rate R-base business tax on cash flow imposed at the top rate of the wages tax.59 To replace the revenue from the current US income tax, Bradford estimates that a CFBT rate aligned with the top personal tax rate at 30 per cent would be sufficient. The CFBT base would be calculated (following Hall-Rabushka)60 like a VAT, but using the subtraction method rather than the usual credit invoice method – with a further deduction to remove labour income from the business tax base. Wages would be taxed at graduated rates under the separate personal tax in accordance with standard vertical equity objectives. The X tax offers obvious advantages in terms of efficiency and simplicity. The complications and inefficiencies caused by the discriminatory taxation of the different components of capital income are automatically eliminated. Business investment is taxed uniformly and consistently without the familiar distortions and difficulties associated with such matters as depreciation calculations, inflation adjustment and business form. Since financial transactions are completely excluded from the X tax base, the complexity and tax arbitrage problems stemming from inconsistent taxation of interest payments and receipts would seem to be removed. It appears, however, that a separate tax on financial institutions would be required.61 As a form of consumption tax, the X tax would seem to offer important intertemporal efficiency and horizontal equity advantages as compared, say, with comprehensive income tax and DIT or CBIT. In the simple life-cycle model these latter taxes discriminate against saving, and such discrimination is removed under the consumption tax. The magnitude of any likely boost to saving is, however, much disputed – even among supporters of the consumption tax – and depends on fiercely contested assumptions regarding the intertemporal substitution elasticity. Engen and 59 Bradford, 2005, above n 5. 60 See above n 57. 61 A Auerbach, “The Future of Capital Income Taxation” (2006) 27(4) Fiscal Studies 399-420.

98


Gale62 have argued convincingly that the boost to saving might not exceed 0.5 per cent of GDP.63 The X tax package is, however, well supported in life-cycle modelling by Altig et al.64 As we have argued previously, moreover, the purest feasible consumption tax is not generally ideal. Once the simple life-cycle model is modified to take account of variable labour supply, age-related labour supply elasticities and non-deductible costs of human capital investment, some measure of discrimination against saving would seem to be required. These arguments are greatly strengthened when the range of savings motives is extended to include a pure accumulation motive in recognition of the substantial utility derived from saving and wealth holding by the rich. It is true that the significant rent and risk components of capital income will be taxed under the supplementary cash flow business tax; but the normal return on capital is exempt. It seems clear therefore that some measure of wealth or wealth-transfer taxation could well be required to supplement the wages tax under the Bradford proposal. The simplicity of the X-tax package could as a result be largely lost. Although the transition problems caused by large wealth accumulations are avoided under the wages tax, other difficulties must be faced. Thus, for example, problems arise for the X tax if rates of the personal or business tax are likely to change over time. Rising rates of the personal tax on wages would have similar disincentive effects on savings to those of the comprehensive income tax or the DIT, though as we have argued above some measure of discrimination against saving could well be justified in the generalised life-cycle model. Changes in the business tax rate would likewise have distorting effects on investment decisions. Complex transitional provisions will also be required to minimise the distortions and inequities that will otherwise occur when the business tax is first introduced. For this purpose the complications of income accounting would need to be retained for some period. A final major dilemma in the open economy setting has to be the very serious doubt surrounding creditability of this unfamiliar type of source tax under the foreign tax credit regimes of the US, UK and Japan. Difficult negotiations would obviously be required.

F.

The ACE Alternative

Unless and until one of the major residence (FTC) countries – preferably the US – adopts the cash flow tax, this important option for taxing capital income seems destined to remain on the shelf. It is therefore of particular interest to consider an alternative approach to cash flow taxation, the ACE tax, which could successfully avoid the international complications. 62 EM Engen, and WG Gale, “The Effects of Fundamental Tax Reform on Saving” in HJ Aaron and WG Gale (eds), The Economic Effects of Fundamental Tax Reform (Washington, DC: Brookings Institution, 1996). 63 The most important empirical studies are carefully reviewed by Ballard, above n 23. 64 D Altig, AJ Auerbach, LJ Kotlikoff, KA Smetters and J Walliser, “Simulating Fundamental Tax Reform in the United States” (2001) 91 American Economic Review 574-95.


99

Instead of immediate expensing for investment, as under the standard approach to the CFBT, the ACE proposal of the IFS Capital Taxes Group would allow a deduction for an imputed normal rate of return on corporate equity.65 Just as the expensing of investment serves to exempt the present value of expected cash flows from marginal investments, a deduction for the nominal risk-adjusted rate of return would remove expected returns from the tax base, leaving marginal investments exempt and taxing economic rents. In order to implement this approach, however, it would be necessary to apply the relevant firm-specific risk premium, and this information is simply not available. Any practical approximation that might be attempted would clearly fall well short of ensuring full neutrality in the manner of the standard CFBT. It has, however, been demonstrated by Bond and Devereux that a deduction for the normal risk-free rate of return is a perfectly satisfactory alternative – provided that comprehensive loss-offset provisions prevail, including an unlimited carry-forward of losses with interest.66 Under the ACE scheme the deductibility of interest would therefore be matched with a deduction for the imputed cost of corporate equity. Neutrality between debt and equity – which is achieved under CBIT by denying the deduction for interest at the corporate level – is achieved under ACE through a matching deduction for corporate equity. Analogous to the Domar-Musgrave findings on income tax, under ACE the government becomes a partner in the enterprise sharing symmetrically in the positive and negative cash flows of the business. In addition to sharing in any economic rents generated, the government will clearly share in the risk premium on these investments. Significant amounts of revenue will therefore be raised from the taxation of risk under ACE (as under CFBT).67 Since a nominal risk-free rate is applied, the inflation premium remains exempt as under CFBT. Unquestionably the most important advantage of ACE, as compared with CFBT, is that it fits comfortably into the prevailing structure of international tax relationships and tax treaty norms. By operating formally within the accepted income tax framework, it provides a practical approach to the implementation of the cash flow principle in the international setting. There are, however, other important advantages. Thus, for example, the symmetric treatment of debt and equity under ACE eliminates the need for thin capitalisation rules to protect the domestic tax base. Since firms receive a deduction for the imputed return on equity as well as for interest on debt, a multinational can have no incentive to undercapitalise a subsidiary operating in a country with an ACE system.

65 IFS Capital Taxes Group, Equity for Companies: A Corporation Tax for the 1990s, (IFS Commentary No 26 (CO26), 1991; MP Devereux and H Freeman, “A General Neutral Profits Tax” (1991) 12 Fiscal Studies 1-15. 66 SR Bond and MP Devereux, “On the Design of a Neutral Business Tax and Uncertainty” (1995) 58 Journal of Public Economics 57-71. 67 Once again, for a contrary view, see Hubbard, above n 11, and Kaplow, above n 28.

100 (2007) 22 AUSTRALIAN TAX FORUM

The ACE approach would likewise avoid the distortions in the timing of investment due to anticipated tax rate changes which are a serious problem under CFBT. The transition problems under ACE are also likely to be less significant. An additional feature of ACE is that the taxation of capital income (such as dividends, interest and capital gains) under the personal income tax could be continued if desired. The government is not therefore necessarily committed to a personal tax on wages as under the Bradford X tax. This extra dimension of flexibility could well be regarded as an advantage in the pursuit of the vertical equity objective. The personal tax on capital income must, however, apply comprehensively and uniformly if the important neutrality characteristics of ACE are to be preserved. Other advantages and disadvantages of ACE are common to cash flow or rent taxes in general, such as CFBT. Both types of tax eliminate the distortions due to deviations of tax depreciation from economic depreciation. Both taxes are also neutral in relation to financing decisions. On the negative side, by exempting the normal return, both types of cash flow tax require higher statutory rates than income tax to raise the required revenue.68 This would tend to deter inward investment by the more profitable multinationals and would also encourage profit shifting through transfer pricing. Particularly in view of the obvious advantages of the ACE alternative in the international setting, it could well be the preferred option for a country wishing to pursue the cash flow approach to capital income taxation. ACE-type taxes have been applied in a few European countries, notably in Croatia and most recently in Belgium (from 2006). The experience to date has in fact been rather mixed.69

V.

Conclusions

Although many leading tax economists have come to favour some form of progressive personal consumption tax with an appropriate cash flow business tax supplement, we have seen that the arguments for this approach are by no means completely straight forward. In the generalised life-cycle model we have found that there is a reasonably strong case for some measure of taxation on saving and capital income, though the precise degree of discrimination is difficult to specify. At the practical level, capital income taxation poses an immense challenge, technically and politically, under the comprehensive income tax. Unless a much closer approach to comprehensive and consistent taxation of the major capital income components can be achieved, the personal income tax will remain an awkward and possibly unsustainable hybrid, and the familiar distortions, inequities and revenue losses will continue. The source-based company income tax provides the cornerstone 68 Furthermore, such revenues would be subject to much greater variability under changing macroeconomic conditions. Depending on the treatment of losses (especially if there is any carryback) this variability may be offset by some automatic counter-cyclical properties. 69 See the review of this experience by A Klemm, “Allowances for Corporate Equity in Practice” (Working Paper WP/06/259, IMF, 2006).

Taxing capital income 101

of the capital income tax system, though distortions and inequities still result from a continuing lack of co-ordination with the personal income tax. Conflict between domestic and international tax policy objectives would appear to rule out the obvious Carter-style rate-alignment solution to company and personal tax integration, at least under current Australian circumstances. Given the technical and political problems of ensuring approximate uniformity of tax treatment for capital income components under the progressive rate structure of the personal income tax, it could be well worth considering the alternative option of flat-rate capital income taxation under the dual income tax or DIT. Under this Nordic approach, progressive rate taxation applies to earned income at rates rising to 50 per cent, while a lower flat rate would apply to capital income at the bottom rate of the personal tax. This would seem to accord with optimal tax principles in a world where capital is highly mobile. Administrative problems arise, however, in distinguishing labour and capital income in the case of small private companies and proprietorships. Since some capital income components inevitably enjoy concessional treatment in the practical political setting under DIT, full nominal interest deductibility and tax arbitrage must remain a problem. From this viewpoint the US Treasury CBIT proposal offers considerable attractions in taxing interest, like profits, at a flat rate under the corporate tax. Difficult distinctions between debt and equity could therefore be done away with. Alignment of the top rate of the personal tax with the corporate tax rate would ensure integration, but could pose problems of conflict between domestic and international tax policy objectives. Coverage of capital income components is moreover incomplete and problems of international acceptance could be severe. There is in brief no simple panacea for the inconsistencies of capital income taxation either under DIT or CBIT, though their attractions remain considerable. The simplest solution to problems of nonuniformity and lack of co-ordination under capital income taxation would be to exempt the normal return from capital and confine the tax to rental and risk elements or cash flow. For the small open economy, the CFBT has obvious appeal as the source-based corporate income tax will largely be shifted to less mobile labour. Most of the revenue yield is inevitably confined to location-specific rents and risk, and the tax is therefore less distorting. Non-creditability of the CFBT under FTC regime remains, however, a very serious obstacle to implementation. In the area of personal taxation a cash-flow tax on consumption or a wages tax would seem the simplest solution as a method of avoiding the complexities of capital income taxation. In view of obvious transitional problems posed by large wealth accumulations, the progressive wages tax proposed as part of Bradford’s X-tax package would seem the best way to go. It must, however, be remembered that the purest feasible consumption tax or wages tax is arguably far from ideal. The conceptual and practical difficulties of the pre-paid consumption tax and supplementary CFBT therefore remain substantial. As a more practical alternative, the IFS ACE tax proposal could possibly offer an internationally more acceptable method of taxing corporate tax flow. It would also allow the continued taxation of capital income under the personal income tax if that is preferred to the wages tax option.