Yesterday at the Tax Policy Colloquium, my colleague David Kamin presented his paper (coauthored by Jason Oh of UCLA Law School), The Effects of Capital Gains Rate Uncertaintyon Realization. The piece capably addresses important issues that are known to be there but have been under-explored in prior literature.
The paper’s starting point is that, while one would expect capital gain realizations (and elasticities) to depend, not just on current CG rates but also on expected future CG rates, work in the field, including revenue estimates at different CG rates, has tended to under-appreciate how great the effect might be. It’s well-understood that a capital gains rate change has both short-term and long-term revenue effects, where the former might involve rushing to market before a rate increase, or the initial release of pent-up demand to sell where there’s a rate cut, but the issue merits modeling further out than that, and this is where the paper aims to add insight, such as by offering multiple models of how this might play out.
One core question, of course, is how we might want to get a handle on expected future CG rates, since this is a question of what investors actually anticipate. While this is unlikely to be a function just of the current rate and/or historical rates, two possible benchmarks, before one starts about thinking about, say, which party looks strong in the next election (and what their platforms say about capital gains or tax rates / taxation of investment more generally), would be as follows:
--Random walk from the current CG rate: Under this view, whatever the rate is now, so far as one can tell (leaving aside any particular political information like that noted above), it’s just as likely to go up or down.
--Historically bounded CG rate range: Under this view, we’ve learned from history the basic range within which we (or rather, investors) might expect CG rates to continue fluctuating. Say this runs from about 15% to 30%. So if the current rate is towards the high end or the low end of this range, there’d be some lean towards expecting it to revert towards or even past the middle.
Since the paper presents alternative models rather than advocating one particular approach, it’s open to and potentially consistent with both, but it gives particular attention to the latter.
Anyway, here are some of my main thoughts in response to the current draft:
1) New view with a twist – By reason of its focus on expectations regarding future rates, the paper brought to mind for me the so-called new view of dividend repatriations (and of corporate dividends in the domestic context). This was a positive association for me, as I consider the new view, properly understood – rather than improperly misunderstood, as sometimes it is – as a truly central organizing idea.
Only, the issue discussed by Kamin and Oh is the new view with a twist, as I’ll explain below.
Okay, let’s start with the new view itself, as applied to the international / dividend repatriation context. Suppose that a resident multinational isn’t currently taxable domestically on certain foreign source income (FSI) that is earned through foreign subsidiaries. But let’s further suppose that, as under U.S. international tax law pre-2017 act, dividend or other repatriations of the FSI are taxable to the domestic parent. Then, at least in theory, the FSI is domestically taxable, but benefits from deferral, because the tax awaits the repatriations.
One might think it obvious that deferral lowers the present value of the parent’s domestic liability with regard to the FSI. After all, isn’t that what deferral within an income tax usually does? But the new view (dating from a 1985 paper by David Hartman that drew on earlier work, regarding classical double corporate income taxation, by the likes of David Bradford, Alan Auerbach, Mervyn King, and William Andrews) showed that under certain conditions this is false. More specifically, under those conditions, deferral does NOT lower the present value of the ultimate domestic tax liability.
Suppose we assume the following: taxable repatriation will take place at some point, the repatriation tax rate is fixed and will never change, and the after-tax rate of return that is available domestically equals that which is available abroad. Then deferral does not lower the present value of the ultimate domestic tax liability, with the further consequence that there is no tax lock-out: the system isn’t discouraging companies from repatriating their foreign profits. (Note of course that it is a separate question whether, say, publicly traded companies might be reluctant to repatriate by reason of accounting rules that have built up around the tax rule.)
To show this algebraically, suppose X is the amount of foreign profits that are waiting to be repatriated, r is the globally available after-tax rate of return, and t is the unchanging repatriation tax rate. Given the above assumptions, immediate repatriation, followed by domestic reinvestment of the funds for a period, leaves the taxpayer with X(1 – t)(1 + r). Repatriating at the end of the period leaves the taxpayer with X(1 + r)(1 – t).
One way of explaining the equivalence intuitively is that, while deferral lowers the present value of the tax that would be due if X were repatriated today, the amount to be repatriated, and hence the amount of the tax given t’s fixed character, keeps growing at the same interest rate. So it is crucial to the analysis that this is a one-and-done tax: Once FSI is repatriated, its further domestic growth is not subject to the repatriation tax, only to whatever domestic income tax there might happen to be for all domestic source income.
When I referred above to misuses of the new view based on misunderstanding it, I have in mind treatment of it as a specific empirical claim – i.e., that there is no lockout under a deferral regime, because in fact the assumptions about r and t are actually (or even necessarily) true. But that is simply not the right way to view it or use it. Indeed, that would be on a par with claiming that the Coase Theorem purports to show that it makes no difference who owns a particular legal entitlement, or that the Modigliani-Miller Theorem (MMT) shows that it makes no difference how one uses debt versus equity financing.
It’s become well-recognized that the Coase Theorem, by showing that it makes no difference who owns the entitlement under specified circumstances (i.e., zero transaction costs, and where pertinent to one’s use of it no relevant endowment / distributional effects), doesn’t show that the thing at issue doesn’t matter – rather, it shows where one would have to look in order for it to matter. Likewise, what MMT shows is that, for debt versus equity to matter, it must have something to do with its underlying assumptions – e.g., no bankruptcy or tax implications, and no effect on agency costs under asymmetric information. So once again, what one actually learns is where to look, in assessing whether the thing at issue matters.
In the case of the new view, we learn that, for expected tax burdens under a deferral system to influence repatriation behavior, something about r, or something about t, must be doing the dirty work. Hence, one now knows where to look. So one is applying the new view – not “refuting” it – when one observes that U.S. companies became extra-eager to avoid repatriations in light of (a) the 2004 foreign dividend tax holiday, (b) the clear pre-2017 prospect that the U.S. corporate rate would be lowered from its then 35% level, and (c) the clear pre-2017 prospect that the U.S. would adopt dividend exemption without fully replacing the forgiven future taxes via a deemed repatriation that accompanied its enactment,
Anyway, back to new view with a twist in the Kamin-Oh paper. How do we face a different issue than we did under the international new view? Here’s a short list:
a) The capital gains tax isn’t one-and-done if you sell a capital asset and invest the proceeds in a new capital asset. Instead, it starts accruing all over again. Hence, deferral does offer time value benefits to the taxpayer.
b) Given the step-up in basis at death under Code section 1014, the tax disappears if one is willing to wait long enough, rather than being inevitable at some point.
c) It’s not as clear in CG tax policy as it was in international tax policy that the current rate was likely to go down, rather than up.
d) Suppose the rate is about to change, and you want to beat it to market. In the CG realm, there may be times when this is difficult. E.g., suppose you have a unique business asset that’s hard to value and for which is there a thin market of potential buyers. By contrast, in international, generating a taxable dividend from the foreign sub to the U.S. parent (which need not be funded out of loose cash already on hand) should generally not have been that hard.
2) Uncertainty versus optionality - This last difference brings to central stage an important distinction between two related concepts. One is uncertainty, insofar as taxpayers don’t and even can’t know what future capital gains rates are going to be. The other is optionality, insofar as taxpayers can deliberately plan to realize taxable gains more in low-rate periods and less in high-rate periods, including by selling just before a rate increase or just after a rate cut.
Uncertainty is bad for a risk-averse taxpayer. But optionality can only be good. An option that you possess can’t be worth less than zero. The option to wait for a lower future CG rate is worth more than otherwise if rates are volatile rather than stable. And it’s worth more than otherwise if the rate is more likely to go down than up. Thus, if we believe that future CG rates most likely will stay within the historically observed 15 to 30 percent range, the option is worth more, all else equal, if the current CG rate is in the neighborhood of 30 percent than 15 percent.
Still, because optionality is bound to be an important part of the picture for many or most real world holders of appreciated capital assets, and because an option can’t be worth less than zero, I think of capital gains rate uncertainty as likely, in the main, to put a thumb on the scales in favor of deferral (which, again, is already tax-favored in this setting), not against it).