Taxing Corporate Capital Gains: Economic Implications and Policy Options
About This Event

Despite the significant revenue it raises, the taxation of corporate capital gains has received far less attention than the taxation of individual capital gains. How does the taxation of corporate capital gains affect investment, sales of business property, and other economic decisions? How do other countries tax corporate capital gains? Listen to Audio


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What reform options merit consideration? Panelists at this AEI conference will examine these and related questions.

Agenda

9:45 a.m.
Registration and Breakfast
10:00
Introduction:
Bill Thomas, AEI
Panelists:
Mihir A. Desai, Harvard University
Jonathan Hare, PricewaterhouseCoopers LLP
Alan D. Viard, AEI
Moderator:
Alex Brill, AEI
11:30
Adjournment

Event Summary

March 2007

Taxing Corporate Capital Gains: Economic Implications and Policy Options

Despite the significant revenue it raises, the taxation of corporate capital gains has received far less attention than the taxation of individual capital gains. How does the taxation of corporate capital gains affect investment, sales of business property, and other economic decisions? How do other countries tax corporate capital gains? What reform options merit consideration? Panelists at this AEI conference examined these and related questions on March 23, 2007.

Mihir A. Desai
Harvard Business School

Corporate capital gains taxes are substantial, relative to the corporate income tax. It is important to consider reform because there are efficiency consequences resulting from the tax. A corporate capital gain can arise from a subsidiary that a company wishes to sell, from one firm holding stock in another, or from a venture capital investment. The consequences of a tax are the "lock-in effect"--the desire to avoid a tax by holding on to a stock--timing issues, and tax planning issues.

Corporate ownership matters for productivity. If companies are locked in to the investment, assets are not held by the most productive owner. The tax also influences the level of cross-holding (one corporation owning another). Unrealized gains with respect to public corporations, because of cross-holding, amount to $900 billion and have risen substantially over time.

In 1996, Germany had a considerable level of cross-holding. Reform on capital gains taxes allowed companies to disgorge their holdings and freed the web of corporate ownership. Eight years later, corporate ownership patterns are much simpler. The corporate capital gains tax reform played a significant role in changing ownership patterns so that the company who should own the asset now can.

Our options are to get rid of the tax, reduce it to 15 percent, or declare a one-year holiday. The latter is not a good idea. Reform can remedy the distinctive distortionary aspect stemming from productivity disparities with different owners. Germany offers evidence that changing the tax will have efficiency benefits.

Jonathan Hare
Pricewaterhouse Coopers

In Europe, sixteen out of twenty-seven countries have a full or partial capital gains exemption on the disposal of shares, and fourteen of these exempt the sale of both foreign and domestic share holdings. The member states that do not exempt gains are those with smaller, less-developed economies.

In April 2002, the United Kingdom, introduced a capital gains exemption to make it a more competitive, attractive investment location. In order to qualify for the exemption, a company must hold 10 percent of the subsidiary being disposed of for twelve months and must be an operating company. The low amount of lost tax revenue is a reflection that corporations avoided paying tax gains prior to reform through tax planning.

There is evidence that the exemption has freed up the mergers and acquisition market by allowing companies to dispose of subsidiaries tax-free, thus facilitating transactions. There are a few consequences to reform: freeing up internal organizations--especially in bringing cash back as capital from aboard--allowing companies to more easily hold their foreign investments directly from the UK, and bringing proceeds from disposal directly back into the UK tax net rather than sending them offshore.

Ireland implemented a similar exemption in 2004. The Irish say that the revenue loss is small, another reflection that groups had previously planned around paying tax on gains. In 2007, France implemented a 5 percent exemption for those with a 5 percent stake and ownership for at least twenty-four months. The reforms implemented in the UK, Germany, Ireland, and France have allowed for increased efficiency.

Alan D. Viard
AEI

In addition to the lock-in effect, the capital gains tax discourages investment. The current law penalizes the sale of used capital and therefore reduces investment up-front. There are three reforms that will remedy this in a simple model: zero gains tax with depreciation recapture, zero capital gains with tax carryover basis, or reduced capital gains tax.

One reform is the zero capital gains tax rate with recapture for depreciation. The idea is to recapture the disproportionate amount of depreciation allocated to earlier years, but the capital gains rate must be zero. The second reform option in the simple model requires the buyer of used capital to carry over depreciation. The recapture payment is effectively made by the buyer by giving up depreciation allowances. The third option is simply to reduce the capital gains tax rate in a way that is mathematically equivalent to the recapture amount.

AEI intern Jenna Lally prepared this summary.

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