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D. Particular Forms of Income Taxation
(1) Taxes on Wages
A tax on wages is an income tax that cannot be shifted away from the wage earner. There is no one to shift it to, especially not the employer, who always tends to earn a uniform interest rate. In fact, there are indirect taxes on wages that are shifted to the wage earner in the form of lower wage incomes. An example is that part of social security, or of unemployment compensation premiums, levied on the employer. Most employees believe that they completely escape this part of the tax, which the employer pays. They are wholly mistaken. The employer, as we have seen, cannot shift the tax forward to the consumer. In fact, since the tax is levied in proportion to wages paid, the tax is shifted backward wholly on the wage earners themselves. The employer's part is simply a collected tax levied at the expense of a reduction of the net wages of the employees.
(2) Corporate Income Taxation
Taxation of corporate net income imposes a “double” tax on the owners of corporations: once on the official “corporate” income and once on the remaining distributed net income of the owners themselves. The extra tax cannot be shifted forward onto the consumer. Since it is levied on net income itself, it can hardly be shifted backward. It has the effect of penalizing corporate income as opposed to income from other market forms (single ownership, partnerships, etc.), thereby penalizing efficient forms of enterprise and encouraging the inefficient. Resources shift from the former to the latter until the expected rate of net return is equalized throughout the economy—at a lower level than originally. Since interest return is forcibly lower than before, the tax penalizes savings and investment as well as an efficient market form.24
The penalty, or “double-taxation,” feature of corporate income taxes could be eliminated only by abolishing the tax and treating any net incomes accruing to a corporation as pro rata income to its stockholder-owners. In other words, a corporation would be treated as a partnership, and not according to the absurd fiction that it is some sort of separate real entity functioning apart from the actions of its actual owners. Income accruing to the corporation obviously accrues pro rata to the owners. Some writers have objected that the stockholders do not really receive the income on which they would be taxed. Thus, suppose that the Star Corporation earns a net income of $100,000 in a certain period, and that it has three stockholders—Jones, with 40 percent of the stock; Smith, holding 35 percent of the stock; and Robinson, owning 25 percent. The majority stockholders, or their management representatives, decide to retain $60,000 as “undistributed” earnings “in the firm,” while paying only $40,000 as dividends. Under present law, Jones’ net income from the Star Corporation is considered as $16,000, Smith's as $14,000, and Robinson's as $10,000; the “corporation's” is listed at $100,000. Each of these entities is then taxed on these amounts. Yet, since there is no real corporate entity separate from its owners, the incomes would be more properly recorded as follows: Jones, $40,000; Smith, $35,000; Robinson, $25,000. The fact that these stockholders do not actually receive the money is no objection; for what happens is the equivalent of someone's earning money yet keeping it on account without bothering to draw it out and use it. Interest that piles up in someone's savings bank account is considered as income and taxed accordingly, and there is no reason why “undistributed” earnings should not be considered individual income as well.
The fact that total corporate income is first taxed and then “distributed” as dividend income to be taxed again, encourages a further distortion of market investment and organization. For this practice encourages stockholders to leave a greater proportion of their earnings undistributed than they would have done in a free market. Earnings are “frozen in” and either held or invested in an uneconomic fashion in relation to the satisfaction of consumer wants. To the reply that this at least fosters investment, there are two rejoinders: (1) that a distortion in favor of investment is as much a distortion of optimum market allocations as anything else; and (2) that not “investment” is encouraged, but rather frozen investment by owners back into their original firms at the expense of mobile investment. This distorts and renders inefficient the pattern and allocation of investment funds and tends to freeze them in the original firms, discouraging the diffusion of funds to different concerns. Dividends, after all, are not necessarily consumed: they may be reinvested in other firms and other investment opportunities. The corporate income tax greatly hampers the adjustment of the economy to dynamic changes in conditions.
(3) “Excess” Profit Taxation
This tax is generally levied on that part of business net income, dubbed “excess,” which is greater than a base income in a previous period of time. A penalty tax on “excess” business income directly penalizes efficient adjustment of the economy. The profit drive by entrepreneurs is the motive power that adjusts, estimates, and coordinates the economic system so as to maximize producer income in the service of maximizing consumer satisfactions. It is the process by which malinvestments are kept to a minimum, and good forecasts encouraged, so as to arrange advance production to be in close harmony with consumer desires at the date when the final product appears on the market. Attacking profits “doubly” disrupts and hampers the whole market-adjustment process. Such a tax penalizes efficient entrepreneurship. Furthermore, it helps to freeze market patterns and entrepreneurial positions as they were in some previous time period, thus distorting the economy more and more as time passes. No economic justification can be found for attempting to freeze market patterns in the mould of some previous period. The greater the changes in economic data that have occurred, the more important it is not to tax “excess” profits, or any form of “excess” revenue for that matter; otherwise, adaptation to the new conditions will be blocked just when rapid adjustment is particularly required. It is difficult to find a tax more indefensible from more points of view than this one.
(4) The Capital Gains Problem
Much discussion has raged over the question: Are capital gains income? It seems evident that they are; indeed, capital gain is one of the leading forms of income. In fact, capital gain is the same as profit. Those who desire uniformity of income-pattern taxation would therefore have to include capital gains if all forms of monetary profit are to be brought into the category of taxable income.25 Using as an example the Star Corporation described above, let us consider Time1 to be the period just after the corporation has earned $100,000 net income and just before it decides where to allocate this income. In short, it is at a decision point in time. It has earned a profit of $100,000.26 At Time1, its capital value has therefore increased by $100,000. The stockholders have, in the aggregate, earned a capital gain of $100,000, but this is the same as their aggregate profit. Now the Star Corporation keeps $60,000 and distributes $40,000 in dividends, and for the sake of simplicity we shall assume that the stockholders consume this amount. What is the situation at Time2, after this allocation has taken place? In comparison with the situation prevailing originally, say at Time0, we find that the capital value of the Star Corporation has increased by $60,000. This is unquestionably part of the income of the stockholders; yet, if uniform income taxation is desired, there is no need to levy a tax on it, for it was already included in the $100,000 income of the stockholders subject to tax.
The stock market always tends toward an accurate reflection of the capital value of a firm; one might think, therefore, that the quoted value of the firm's shares would increase, in the aggregate, by $60,000. In the dynamic world, however, the stock market reflects anticipations of future profit, and therefore its values will diverge from the relatively ex post accounting of the firm's balance sheet. Furthermore, entrepreneurship, in addition to profits and losses, will be reflected in the valuations of the stock market as well as in business enterprises directly. A firm may be making slim profits now, but a farseeing entrepreneur will purchase stock from more shortsighted ones. A rise in price will net him a capital gain, and this is a reflection of his entrepreneurial wisdom in directing capital. Since it would be impossible administratively to identify the profits of the firm, it would be better from the point of view of uniform income taxation not to tax the business income of corporate stockholders at all, but to tax a stockholder's capital gains instead. Whatever gains the owners reap will be reflected in capital gains on their stock anyway, so that taxation of the business income itself becomes unnecessary. On the other hand, taxation of business income while exempting capital gains would exclude from “income” the entrepreneurial gains reaped on the stock market. In the case of partnerships and single enterprises that are not owned in shares of stock, the business income of the owners would, of course, be taxed directly. Taxation of both business income (i.e., profits accruing to stockholders) and capital gains on stock would impose a double tax on efficient entrepreneurs. A genuinely uniform income tax, then, would not tax a stockholder's pro rata business income at all, but rather the capital gain from his shares of stock.
If business profits (or capital gains) are income subject to tax, then, of course, business losses or capital losses are a negative income, deductible from other income earned by any particular individual.
What of the problem of land and housing? Here, the same situation obtains. Landlords earn income annually, and this may be included in their net income as business profits. However, real estate, while not given to stock ownership, also has a flourishing capital market. Land is capitalized, and capital values increase or dwindle on the capital market. It is clear that, once again, the government has an alternative if it desires to impose uniform personal income taxes: either it can impose the tax on net profits from real estate, or it can forgo this and impose a tax on increases in the capital values of real estate. If it does the former, it will omit the entrepreneurial gains and losses made on the capital market, the regulator and anticipator of investment and demand; if it does both, it imposes a double tax on this form of business. The best solution (once again within the context of a uniform income tax) is to impose a tax on the capital gain minus the capital loss on the land values.
It must be emphasized that a capital gains tax is truly an income tax only when it is levied on accrued, rather than on realized, capital gains or losses. In other words, if a man's capital assets have increased during a certain period, from 300 ounces of gold to 400 ounces, his income is 100 ounces, whether or not he has sold the asset to “take” the profit. In any period, his earnings consist not simply in what he may use for spending. The situation is analogous to that of a corporation's undistributed profits, which as we have seen, must be included in each stockholder's accumulation of income. Taxing realized gains and losses introduces great distortions into the economy; it then becomes highly advantageous to investors never to sell their stock, but to hand it down to future generations. Any sale would require the old owner to pay the capital gains levy accumulated for an entire period. The effect is to “freeze” an investment in the hands of one person, and particularly of one family, for generations. The result is rigidity in the economy and failure of the hampered market to meet flexibly the continual changes in data that always take place. As time goes on, the distortive effects of the economic rigidity grow worse and worse.
Another serious hampering of the capital market results from the fact that, once the capital gain is “taken” or realized, the income tax on this particular gain is actually far higher and not uniform. For the capital gains accrue over a long stretch of time, and not simply at the point of sale. But the income tax is based only on each year's realized income. In other words, a man who realizes his gain in a certain year must pay a far bigger tax in that year than would be “justified” by a tax on his actually acquired income during the year. Suppose, for example, that a man buys a capital asset at 50 and its market value increases by 10 each year, until he finally sells it for 90 in four years’ time. For three years, his income of 10 goes untaxed, while in the fourth year he is taxed on an income of 40 when his income was only 10. The final tax, therefore, largely becomes one on accumulated capital rather than on income.27 The incentive for keeping investment rigid, therefore, becomes even greater.28
There are, of course, grave difficulties in any such tax on accrued capital gains, but, as we shall see, there are many insuperable obstacles to any attempt to impose uniform income taxes. Estimates of market value would pose the greatest problem. Appraisals are always simply conjectures, and there would be no way of knowing that the assessed value was the correct one.
Another insuperable difficulty arises from changes in the purchasing power of the monetary unit. If the purchasing power has fallen in half, then a change in capital value of an asset from 50 to 100 does not represent a real capital gain; it simply reflects the maintenance of real capital as nominal values double. Clearly, a constant nominal value of capital when other prices and values double would reflect a high capital loss—a halving of real capital value. To reflect gains or losses in income, then, a person's capital gain or loss would have to be corrected for changes in the purchasing power of money. Thus, a fall in purchasing power tends to result in the overstatement of business income and hence leads to a consumption of capital. But if a man's capital gains or losses must be corrected for changes in the purchasing power of money in order to state his true income for a certain period, what standards can be used for such a correction? For changes in purchasing power cannot be measured. Any “index” used would be purely arbitrary. Whichever method is adopted, therefore, uniformity in income taxation cannot be achieved, because an accurate measurement of income cannot be attained.29
Thus, to the controversial question, “Are capital gains income?” the answer is emphatically yes, provided that (1) a correction is made for changes in the purchasing power of the monetary unit, and (2) the accrued rather than the realized capital gain is considered. In fact, whenever businesses are owned by stockholders (and bondholders), the gains on these stocks and bonds will provide a fuller guide to income earned than the actual net income of the firm. If it is desired to tax incomes uniformly, then taxes would have to be levied on the former only; to tax both would be to level a “double” tax on the same income.
Professor Groves, while agreeing that capital gains are income, lists several reasons for giving capital gains preferential treatment.30 Almost all of them apply, however, to taxation on realized, rather than on accrued, capital gains. The only relevant case is the familiar one that “capital gains and losses are not regularly recurrent, as are most other incomes.” But no income is “regularly recurrent.” Profits and losses, of course, are volatile, being based on speculative entrepreneurship and adjustments to changing conditions. Yet no one contends that profits are not income. All other income is flexible as well. No one has a guaranteed income on the free market. Everyone's resources are subject to change as conditions and the data of the market change. That the division between income and capital gains is illusory is demonstrated by the confusion over the classification of authors’ incomes. Is the income in one year resulting from five years’ writing of a book “income” or an increase in the “capital worth” of the author? It should be evident that this entire distinction is valueless.31
Capital gains are profits. And the real value of aggregate capital gains in society will equal total aggregate profits. A profit increases the capital worth of the owner, whereas a loss decreases it. Moreover, there are no other sources from which real capital gains can come. What of the savings of individuals? Individual savings, to the extent that they do not add to cash balances, go into investments. These purchases of capital lead to capital gains for stockholders. Aggregate savings lead to aggregate capital gains. But it is also true that profits can exist in the aggregate only when there is aggregate net saving in the economy. Thus, aggregate pure profits, aggregate capital gains, and aggregate net savings all go hand in hand in the economy. Net dissavings lead to aggregate pure losses and aggregate capital losses.
To sum up, if it is desired to tax uniformly (this goal will be analyzed critically below), the correct procedure would be to consider capital gains as equivalent to income when corrected for changes in the purchasing power of the monetary unit, and to consider capital losses as negative income. Some critics charge that it would be discriminatory to correct capital for changes in prices without doing the same for income, but this objection misses the point. If the desire is to tax income rather than accumulated capital, it is necessary to correct for changes in the purchasing power of money. For example, capital rather than pure income is being taxed during an inflation.
(5) Is a Tax on Consumption Possible?
We have seen that attempts to tax consumption via sales and excise taxes are vain and that they inexorably result in a tax on incomes. Irving Fisher has suggested an ingenious plan for a consumption tax—a direct tax on the individual akin to the income tax, requiring annual returns, etc. The base for the individual's tax, however, would be his income, minus net additions to his capital or cash balance, plus net subtractions from that capital for the period—i.e., his consumption spending. The individual's consumption spending would then be taxed in the same way as his income is now.32 We have seen the fallacy in the Fisher argument that only a tax on consumption would be a true income tax and that the ordinary income tax constitutes a double tax on savings. This argument places greater weight on savings than the market does, since the market knows all about the fructifying power of saving and allocates its expenditures accordingly. The problem we have to face here is this: Would such a tax as Fisher proposes actually have the intended effect—would it tax consumption only?
Let us consider a Mr. Jones, with a yearly income of 100 gold ounces. During the year, he spends 90 percent, or 90 ounces, on consumption and saves 10 percent, or 10 ounces. If the government imposes a 20-percent income tax upon him, he must pay 20 ounces at the end of the year. Assuming that his time-preference schedule remains the same (and setting aside the fact that there will be an increased proportion spent on consumption because an individual with fewer money assets has a higher time-preference rate), the ratio of his consumption to investment will still be 90:10. Jones will now spend 72 ounces on consumption and eight on investment.
Now, suppose that instead of an income tax, the government levies a 20-percent annual tax on consumption. Fisher maintained that such a tax would be levied only on consumption. But this is incorrect, since savings-investment is based solely on the possibility of future consumption. Since future consumption will also be taxed, in equilibrium, at the same rate as present consumption, it is evident that saving does not receive any special encouragement.33 Even if it were desirable for the government to encourage saving at the expense of consumption, taxing consumption would not do so. Since future and present consumption will be taxed equally, there will be no shift in favor of savings. In fact, there will be a shift in favor of consumption to the extent that a diminished amount of money causes an increase in the rate of preference for present goods. Setting aside this shift, his loss of funds will cause him to reallocate and reduce his savings as well as his consumption. Any payment of funds to the government necessarily reduces the net income remaining to him, and, since his time preference remains the same, he reduces his savings and his consumption proportionately.
It will help to see how this works arithmetically. We may use the following simple equation to sum up Jones’ position:
(1) Net Income = Gross Income – Tax
(2) Consumption = .90 Net Income
(3) Tax = .20 Consumption
With Gross Income equal to 100, and solving for these three equations, we get this result: Net Income = 85, Tax = 15, Consumption = 76.
We may now sum up in the following tabulation what happened to Jones under an income tax and under a consumption tax:
We thus see this important truth: A consumption tax is always shifted so as to become an income tax, though at a lower rate. In fact, the 20-percent consumption tax becomes equivalent to a 15-percent income tax. This is a very important argument against the plan. Fisher's attempt to tax consumption alone must fail; the tax is shifted by the individual until it becomes an income tax, albeit at a lower rate than the equivalent income tax.
Thus, the rather startling conclusion is reached in our analysis that there can be no tax on consumption alone; all consumption taxes resolve themselves in one way or another into taxes on incomes. Of course, as is true of the direct consumption tax, the effect of the rate is discounted. And here perhaps lies a clue to the relative predilection that free-market economists have shown toward consumption taxes. Their charm, in the final analysis, consists in the discounting—in the fact that the same rate in a consumption tax has the effect of a lower rate of income tax. The tax burden on society and the market is lower.34 This reduction of the tax burden may be a very commendable objective, but it should be stated as such, and it should be realized that the problem lies not so much in the type of tax levied as in the over-all burden of taxes on individuals in the society.
We must now modify our conclusions by admitting the case of dishoarding or dissaving, which we had ruled out of the discussion. To the extent that dishoarding occurs, consumption is tapped rather than income, for the dissaver consumes out of previously accumulated wealth, and not out of current income. The Fisher tax would thus tap spending out of accumulated wealth, which would remain untaxed by ordinary income taxation.
- 24. Some writers have pointed out that the penalty lowers future consumption from what it would have been, reducing the supply of goods and raising prices to consumers. This can hardly be called “shifting,” however, but is rather a manifestation of the ultimate effect of the tax in reducing consumer standards of living from the free-market level.
- 25. It must not be inferred that the present author is an advocate of uniform taxation. Uniformity, in fact, will be sharply criticized below as an ideal impossible of attainment. (An ethical goal absolutely impossible of attainment is an absurd goal; to this extent we may engage, not in ethical exhortation, but in praxeological criticism of the possibility of realizing certain ethical goals.) However, it is analytically more convenient to treat various types of income taxation in relation to uniform treatment of all income.
- 26. For the sake of convenience, we are assuming that this income is pure profit, and that interest income has already been disposed of. Only pure profit increases capital value, for in the evenly rotating economy there will be no net savings, and the interest income will just pay for maintaining the capital income structure intact.
- 27. For a discussion of taxation on accumulated capital, see below.
- 28. See Due, Government Finance, p. 146.
- 29. Another problem in levying a tax on accrued capital gains is that the income is not realized in money directly. Uniform taxation of income in kind, as well as of psychic income, faces insuperable problems, as will be seen below. Just as there may be taxes on the imputed monetary equivalents of income in kind, however, there may also be taxes on accrued capital gains.
- 30. Harold M. Groves, Financing Government (New York: Henry Holt, 1939), p. 181.
- 31. Irregular income poses the same problem as irregular realized capital gain. The difficulty can be met in both cases by the suggested solution of averaging income over several years and paying taxes annually on the average.
- 32. Fisher and Fisher, Constructive Income Taxation, passim.
- 33. Neither does hoarding receive any special encouragement, since hoarding must finally eventuate in consumption. It is true that keeping cash balances itself yields a benefit, but the basis for such balances is always the prospect of future consumption.
- 34. In the same way, the charm of the sales tax lies in the fact that it cannot be progressive, thus reducing the burden of income taxation on the upper groups.