Dear Dr. Poterba,

\>

\>

\>

\>Congratulations on being selected as a member of the Presidents Tax

\>Reform

\>panel. The charge the panel has been given presents an opportunity to

\>affect significant changes, and will also require the consideration of
new

\>ideas and approaches. I\'d also like to thank you for offering to
forward

\>the attached proposal to the other members of the panel.

\>

\>

\>

\>Several years ago I had an idea for streamlining the approach to the

\>reporting and collection of taxes on capital transactions. I shared it

\>with several investors, investment advisors, several CPA\'s, the CFO
of

\>a

\>major corporation, and my Congressman, the Honorable Benjamin Cardin,

\>Chairman of the House Ways and Means Committee who called me
personally to

\>discuss it. And while I was particularly encouraged by the CFO\'s
comment,

\>\"This makes so much sense it\'ll never see the light of day in
Washington\",

\>I did not pursue it further.

\>

\>

\>

\>After the announcement of the establishment of this panel, however,

\>several of those that I shared it with initially, contacted me and

\>encouraged me to submit it. Over the past few weeks I have updated it

\>and now offer it to your panel for consideration.

\>

\>

\>

\>I hope the panel will take the time to consider it, and that you will

\>find

\>it useful for your recommendations in response to your charge. At the

\>very least, I would hope it would generate discussion that might lead
to

\>an even better approach. If there are any questions regarding this

\>proposal, I would be available to the panel at their request.

\>

\>

\>

\>I wish you, and all members of the panel, the best of luck in your

\>efforts, and I look forward to your recommendations. Please confirm

\>that you have received the attachment. Thank you.

\>

\>

\>

\>Sincerely,

\>

\>

\>

\>

\>

\>William N. Zeiger, Ph.D.

\>

\>3920 Log Trail Way

\>

\>Reisterstown, MD 21136

\>

\>410.526.7422

\>

\>Email: wnzeiger@comcast.net

\<\<RevCapGain2003.doc\>\>

**Don't Tax the Gain, Tax the Transaction**

**[Introduction]{.underline}**

Ever since the Income Tax was instituted in 1913, no single aspect of
the tax has received more interest than the tax on capital gains. Over
the years, congress has raised and lowered the rates it has applied to
capital gains, and like the rest of the Tax Code, it has become more
complicated.

With regard to the taxation of capital gains, congressional lawmakers
generally fall into two groups. The first believes that the capital
gains tax rate should be eliminated or greatly reduced, while the second
believes that the tax rate should be raised, or at least not lowered.
The issue of how to tax capital gains in a manner that is satisfactory
to all continues to elude politicians, lobbyists and economists on both
sides of the argument, and these seemingly irreconcilable differences of
opinion may never be resolved.

It should be clear to anyone familiar with the economic situation over
the past three to four years following the market collapse, that the
loss of trillions of dollars of shareholder wealth does not generate
much in the form of either capital gains or the subsequent tax revenues
derived from those gains. The same is true for other capital asset
classes as well; businesses fail or are sold at a loss, and properties
held for investment purposes often lose their value.

Over the years, various alternatives for dealing with capital gains have
been suggested. Several of the most important ones are listed below:

1.  Indexing Capital Gains

2.  Accrual Taxation

3.  Fixed Exclusion

4.  Variable Exclusion

5.  Lifetime Exclusion

6.  Rollover of gain

7.  Taxing Capital Gains at death

8.  Progressive rates

All of these proposals continue to focus entirely on taxing gains, and
merely represent modifications of the existing system as opposed to a
fundamental shift in thinking and approach. In his book, "The Labyrinth
of Capital Gains Tax Policy", Leonard E. Burman points out that "Taxing
gains only upon realization is the source of most of the problems in
taxing capital gains." The inability to formulate an acceptable Tax
policy for capital transactions is due to this continued focus on the
"gain" aspect of these transactions.

I would offer the following suggestion for consideration as an approach
to solving many of the difficulties and complexity of the present
system: **TAX THE TRANSACTION, NOT THE GAIN.** In essence, tax all
capital transactions, both when entered into and when closed.

To illustrate, consider how a typical stock transaction is handled
presently, and how the tax revenues are derived from the transaction.
This example was chosen since it was the one most commonly encountered
by the typical investor, although the exercise would be equally valid
using any other item falling under the terms of capital gains taxation,
such as bonds, options, futures contracts, commercial properties, and
small businesses. It will be followed by the proposed Transaction tax
approach to compare how the tax revenues would be derived.

# **Present Tax Approach**

Assume I have purchased 1000 Shares of XYZ stock at \$20/share. A year
or so later the stock has risen to \$30/share and I decide to sell. I
have a profit of \$10,000 (1000 shares x \$10/share profit). Since this
is a long-term gain, my tax rate on this gain will be 15%, for a total
tax of \$1500. If this had been a short-term gain, the tax rate could
have been as high as 35.0%, representing a tax of \$3,500 for those
residing in the highest tax bracket.

## **Proposed Transaction Tax Approach** 

This time we will apply a 1.0% Transaction tax on both the purchase and
sale. The 1.0% rate was arbitrarily chosen, although it will be shown
that this rate will generate annual tax revenues **greater** than those
collected under the present system of taxing only realized capital
gains. In fact, it will be shown that the "revenue neutral" Transaction
tax rate, that is, the rate that would generate the same revenues as
under the present system, would be under 0.3%. Thus, the original
purchase of 1000 Shares at \$20/Share costs \$20,000. A 1.0% Transaction
tax would be levied of \$200. Later, when this stock is sold for
\$30/share, the 1.0% Transaction tax would again be applied resulting in
a tax of \$300. Under this Transaction tax approach, the total tax
collected would be \$500.

If, on the other hand, the stock trade decreased in value from the
original \$20/share to \$10/share, the initial acquisition of the stock
would again generate a tax of \$200, but the closing transaction would
only be \$100 (1.0% of \$10,000) for a total tax of \$300. Since there
is no longer a tax on any potential gain, there is, likewise, no
provision in the Transaction Tax approach for deduction of any losses,
only a decrease in the amount of the Transaction Tax on the closing
trade.

It is anticipated that the brokerage house would be responsible for
collecting the tax and forwarding it to the government, similar to the
way that payroll taxes are collected today on individual salaries and
forwarded by the employer. This would result in a high level of
**compliance** and **enforceability**. For other capital investments not
falling in the realm of financial instruments, such as investment
properties, the purchase and sale of small businesses, etc, the agents
for the transaction would be responsible for collection and forwarding
of the tax from both parties upon transfer of ownership or title.

The increase in annual tax revenues under this proposed Transaction tax
approach is due to two, related factors:

1.  The base on which the tax is imposed is different, in that it is
    levied on the total value of the transaction, and

2.  It is applied on both the **opening** and **closing** transactions,
    not just on those closing transactions that result in a gain. While
    expansion of the base certainly is important, this second point is
    equally important since the continued reliance on taxation of the
    gain derived in a closing transaction results in a far smaller
    amount of revenue than one might expect**.** Table 1 shows the tax
    consequences of eight different situations that could occur. Again,
    a stock transaction has been used in the example, although it would
    apply to the other capital investment types mentioned previously.

**Table 1.**

  ----------------------------------- --------------- -------------------
  **Capital Investment Event**        **Capital Gains **Comments**
                                      collected?**    

  1\. Stock sold at a profit.         Yes             

  2\. Stock sold at a profit but with No              
  an off-setting loss.                                

  3\. Stock sold at a loss.           No              Deduction allowed

  4\. Stock transferred to a          No              Deduction allowed
  non-profit organization or charity.                 

  5\. Stock transferred at death to   No              Stepped-up basis to
  heirs.                                              heirs

  6\. Stock "Locked-In".              No              Likely future
                                                      event: 1,2,4 or 5

  7\. Stock sold by a Non-Profit      No              Tax exempt status
  organization.                                       

  8\. Stock held by Non-U.S. entity   No              
  not subject to our tax system.                      
  ----------------------------------- --------------- -------------------

> Faced with decreasing revenues from capital transactions, tax policy
> writers have relied upon the primary "tool" available in their
> toolbox, which is to raise the rates on capital gains. However, this
> might not be the best way to increase tax revenues given the
> observations in Table 1, above. The Transaction Tax, however, would
> tax every capital investment, albeit at a low level. The key question
> is whether the Transaction Tax, when applied to all capital investment
> transactions, both when entered into and closed, would generate as
> much annual tax revenue as the present system of taxing capital gains
> as they are realized?
>
> Table 2 compares the tax revenues generated under the current system
> of taxing realized capital gains to the potential revenues that would
> be generated under the proposed Transaction Tax approach. Column A
> indicates the total net capital gains reported by individuals in the
> tax year indicated. The subsequent tax realized on those gains is
> shown in Column B. The information in Columns A and B was obtained
> from the U.S. Treasury\'s Office of Tax Analysis. Column C shows the
> total value of all stock transactions reported on the combined
> NYSE-NASDAQ-ASE for the years indicated, and was obtained from the
> Economic Research Department of the NASDAQ. Column D represents the
> tax revenues that could be realized by adoption of a 1.0% Transaction
> Tax.

**Table 2**

+-----+----------+--------------+----------------------+--------------+
| Y   | A        | B            | C                    | D            |
| ear |          |              |                      |              |
|     | Total    | Tax Revenues | Total value of all   | 1%           |
|     | Realized | Derived      | stock transactions   | Transaction  |
|     |          |              |                      |              |
|     | Capital  | from Capital | on NYSE/NASDAQ/ASE   | Tax Revenues |
|     | Gains    | Gains        |                      |              |
|     |          |              | (Billions)           | (Billions)   |
|     | (B       | (Billions)   |                      |              |
|     | illions) |              |                      |              |
+-----+----------+--------------+----------------------+--------------+
| 1   | 455.2    | 89.0         | 13,329.4             | 133.2        |
| 998 |          |              |                      |              |
+-----+----------+--------------+----------------------+--------------+
| 1   | 552.6    | 111.8        | 18,762.4             | 187.6        |
| 999 |          |              |                      |              |
+-----+----------+--------------+----------------------+--------------+
| 2   | 644.2    | 127.2        | 32,399.8             | 323.9        |
| 000 |          |              |                      |              |
+-----+----------+--------------+----------------------+--------------+
| 2   | 349.4    | 65.6         | 22,240.8             | 222.4        |
| 001 |          |              |                      |              |
+-----+----------+--------------+----------------------+--------------+
| 2   | 268.6    | 49.1         | 15,663.4\*\*         | 156.6\*\*    |
| 002 |          |              |                      |              |
+-----+----------+--------------+----------------------+--------------+

\*\* represents only 10 months, Jan-Oct, 2002

Again, the amounts reported in Columns A and B are derived from the sale
of all types of capital investments subject to Schedule D reporting
mentioned previously. The amounts reported in Column D, however, only
represent stock transactions reported on the three exchanges noted. It
does not include those amounts that would be derived from collecting a
Transaction fee from all these other sources. Thus, the amounts in
Column D significantly underestimate the potential revenues that could
be generated, in spite of the fact that it represents a Transaction Tax
rate of 1.0%.

Since this panel was charged with developing recommendations that are
"revenue neutral", one can easily calculate the revenue-neutral rate
that would need to be applied to the amounts in Column C in order to
equal the tax revenues reported in Column B:

**[Tax Year Revenue-neutral Rate]{.underline}**

1998. 0.66%

1999. 0.59%

2000. 0.39%

2001. 0.29%

2002. 0.31% / 0.26%\*\*

\*\*Estimated by extrapolation of the 10-month data to 12 months

Although both tax revenues and the value of the total stock transactions
on the NYSE/AME/NASDAQ decreased substantially between 2000 and 2002 as
the stock market collapsed, the Transaction Tax approach continued to
provide satisfactory levels of tax revenues due, primarily, to the
increased share volume activity on these exchanges. It is expected that
this revenue-neutral rate will continue to decline in future periods as
share volume activity continues to increase.

It's important to remember that these revenue-neutral rates would likely
be even lower than the rates shown above since it was achieved using
only the data from the three exchanges noted. It is anticipated that the
rates applied may need to be varied depending upon which markets are
being considered, since their potential returns differ substantially The
Bond market, for example, might have a Transaction tax rate of only
0.05% applied. Regardless of the eventual rates decided upon, the
important point is that the Transaction rate does not need to be the
same for all capital asset classes.

**[How does this affect the typical investor?]{.underline}**

If we assume for the moment that the Transaction Tax rate is set at
0.30%, then compared to a similar long-term gain under the existing tax
system, the investment will become profitable, after tax, when it shows
a gain of 0.60%, although not as profitable as under the present system
until the investment reaches a 4.10% increase at which time it is
equivalent to the existing system. At any increase above 4.10%, the
investment is more profitable compared to the existing system.

Thus, a stock investment at \$40.00/share will be profitable, after tax,
at \$40.24/share. It will have the identical tax liability at
\$41.64/share, and will be more profitable at any price above
\$41.64/share, when compared to a similar investment under the existing
long-term tax rate of 15% of the gain. In addition, short and long term
transactions will be treated identically, and no longer reported on any
tax schedule.

From the government's point of view, it would receive a constant revenue
stream throughout the year, and since Schedule D would be eliminated, it
would no longer be necessary to receive, file, track, check, or handle
the millions, if not billions, of individual transaction reports filed
each year from the brokerage houses on these transactions. This would
result in a tremendous savings in both time and expense for the
government, the brokerage houses, and the investor. The brokerage houses
would set the appropriate Transaction Tax rate in the computer
corresponding to the different asset classes and then collect and
transmit those funds to the government.

###### Issues to be Resolved

> While this approach results in advantages for both the government and
> the taxpayer, it is not without some issues and concerns which would
> need to be addressed, including:
>
> **Initial Market Response** -- The opportunity for investors to
> "unlock" capital could result in a market sell-off, though several
> approaches could be instituted to temper this response. If the new
> rules were not made retroactive, then the rate for previously held
> stocks could be decreased from 15% to 5% over 5 years, for example.
> This would provide some incentive not to have everyone cash in at
> once, but the ever-increasing tax advantage would require the
> continued lockup of capital which may not be as profitable as bringing
> one's financial assets under the new tax program. Perhaps a
> combination of both systems could be used to transition all taxpayers
> immediately the first year. For example, one might tax 50% of the gain
> under the old system and 50% of the value of the closing transaction
> under the new system. In any event, it would be advantageous to affect
> the transition in as short a time as possible to enable the
> elimination of Schedule D as soon as possible.
>
> **Bonds** -- For those individuals who hold bonds for their interest
> returns alone, a 1% Transaction Tax would be too high and thus bonds
> may need to have a different tax rate applied. Also, due to the volume
> of bonds traded, a smaller tax rate would still generate a tremendous
> amount of revenues for the government. For example, Treasury
> securities (Bills, Notes and Bonds) trade over \$350 Billion a DAY.
> Even at a Transaction Tax rate of 0.1% for Bonds, this would generate
> \$350 Million/day or around \$87 Billion/year.
>
> **State Tax Forms** -- States that base their forms on the Federal
> forms would either loose this as a source of revenue or require the
> reporting of all financial transactions on a similar "State Schedule
> D". Unfortunately, this would defeat one of the major objectives of
> this proposal, namely, the simplification of the tax collection and
> reporting process for capital transactions.
>
> **Charitable Deductions** -- Some suggest that charitable deductions
> could be adversely affected, although there is nothing in this
> proposal that would remove the ability to deduct charitable
> contributions or prevent the donation of a financial asset to a
> charitable organization. The advantages for a taxpayer to donate a
> highly appreciated asset to receive a substantial deduction for
> something that may have cost considerably less in the past has not
> changed under this proposal. While the original purchaser of the asset
> would have paid the Transaction Tax upon acquiring the asset, and may
> also receive a tax deduction for their contribution, the charitable
> organization would maintain it's tax exempt status and not be subject
> to the transaction tax upon liquidation of the asset.

#### RECOMMENDATION

1.  That the House Ways and Means Committee adopt legislation
    instituting a Transaction Tax on all capital investment transactions
    which would **replace** the present system of taxing capital gains.
    Those items subject to the tax would be identical to those presently
    subject to capital gains taxation.

2.  That Schedule D be eliminated entirely from the Income Tax forms
    since it would no longer be applicable.

### [BENEFITS TO BE REALIZED]{.underline}

1.  A potential increase in annual tax revenues over that which is
    presently collected.

2.  Simplification of the tax-filing process due to elimination of
    Schedule D from the Income Tax forms, resulting in tremendous cost
    savings for the brokerage houses, investors, and the government as a
    result of decreased record-keeping and/or filing requirements.

3.  Extremely high level of Compliance and Enforceability.

4.  Ends the discussion of how to tax capital gains since it is no
    longer based on realized gains.

5.  Would encourage increases in capital investment and savings.

6.  Would release "locked-in" gains which would then be freed up to be
    reinvested in more profitable investments, returned to circulation
    in the economy through the purchase of goods or services, or saved
    for future consumption.

7\. Eliminates the need for the consideration of indexing since
transactions are taxed when they occur.

8\. Would eliminate the need for the creation of economically
inefficient tax shelters.

##### Summary

Adoption of the Transaction Tax as a **replacement** for the present
system of taxing capital gains would satisfy all of the requirements
desired in a tax system, i.e. Simplicity, Fairness, Compliance,
Enforceability, and the Promotion of economic prosperity, while
simultaneously generating more tax revenues.

**References:**

Burman, Leonard E. 1999. The Labyrinth of Capital Gains Tax Policy: A
Guide for the Perplexed.

Washington, D.C.: The Brookings Institution Press.

Graetz, Michael J. 1999. The U.S. Income Tax: What It Is, How It Got
That Way, and Where We Go from Here. New York: W.W. Norton & Company.

Slemrod, Joel and Jon Bakija. 2004. Taxing Ourselves: A Citizen's Guide
to the Debate over Taxes.

Cambridge, Mass.: The MIT Press.

William N. Zeiger

February 2005