United States 

Department of 

Agriculture Capital Gains Treatment 

Forest Service of Timber Income: 

~~fih~~~t~~~~~~t Experiment Station 

An Economic Assessment 

Research Paper 

N E-556 Donald F. Dennis 

1985 

I 
The Author 

Donald F. Dennis is a research economist for maple marketing and wood 

energy economics research at the George D. Aiken Sugar Maple Laboratory, 

Northeastern Forest Experiment Station, Burlington, Vermont. He received 

a B.B.A. degree in public accounting from the City University of New York, 

an M.S. degree in forestry from the University of New Hampshire, and an 

M.S. degree in forest economics from Yale University. He is currently a Ph.D. 

candidate in forest economics at Yale University. He began his career with the 

Forest Service in 1978. 

Abstract 

Concern over government budget deficits has brought our tax system 

under closer scrutiny. Provisions for capital gains taxation in general, but 

particularly those pertaining to income from the sale of timber, have been 

controversial. This paper outlines criteria used to evaluate tax systems and 

examines how capital gains and the ordinary income tax perform within these 

criteria. Implications for social welfare and impact on timber supply are also 

discussed. 
A Historical Perspective 

Our permanent system of income 

taxation began with enactment of the 

1913 Revenue Act. Soon afterward, 

Congress, recognizing the nation's 

dependence on private investment for 

economic growth, decided to give 

preferential tax treatment to income 

received from the sale of long-term 

capital assets. Since then timber has 

been recognized as one of many capital assets and, as such, eligible for 

capital gains treatment when sold. 

Prior to 1944, capital gains treatment was permitted for income from 

timber sold in a lump-sum transaction, provided the timber was not held 

for sale in the ordinary course of 

business. Capital gains treatment 

was denied if an owner cut timber 

himself for later sale or use in his 

business or (as stated in Bureau of 

Internal Revenue Field Procedure 

Memorandum 249, Feb., 1943) if proceeds received were computed on a 

unit of volume removed basis, as 

opposed to a lump-sum sale (Siegel 

1978). Thus, landowners who disposed 

of timber under a contract where 

marked trees were cut and paid for 

on a unit basis (retained economic 

interest), or who managed the forest 

but cut trees for use in their own 

business, were discriminated against. 

Congress, under political pressure 

stemming from increased timber demand during World War ll and recognizing the negative impacts on timber 

supply this disparity might cause, 

moved to correct this situation. With 

minor modifications over the years, 

today's tax treatment of timber income resulted. 

The relevant sections of the tax 

code are 631(a), 631(b), 1221, and 1231. 

Basically, section 631(a) accords capital gains treatment to taxpayers who 

cut timber for sale or use in their 

trade or business and 631(b) to taxpayers selling timber under a contract 

by virtue of which the owner retains 

an economic interest in the timber. 

Sections 1221 and 1231 outline certain conditions under which the gain 

from timber sold outright (without a 

retained economic interest) can still 

qualify for capital gains treatment. 

These sections deny capital gains 

treatment only when timber considered to be inventory or property held 

for sale in the ordinary course of 

business is sold outright. In most 

situations, capital gains treatment 

is accorded to income from the sale 

of timber. 

Under the current statutes, 60 

percent of long-term (held more than 

1 year) capital gains income is excluded from taxation and the remaining 40 percent is taxed at the ordinary 

tax rate for individuals. For corporations, the long-term capital gains tax 

rate is 28 percent, compared to 46 

percent for ordinary income. Thus, 

capital gains treatment is of considerable benefit to individuals and 

corporations. 

Some perceive these savings as 

a government revenue loss. Over the 

years, capital gains provisions in 

general, and particularly those pertaining to timber, have been controversial. There have been many attacks 

and proposed changes, but Congress 

has continually reaffirmed its 1943 

position. However, it is likely that 

controversy will continue. This paper 

outlines criteria used to evaluate tax 

systems and examines how capital 

gains and the ordinary income tax 

perform within these criteria. 

Criteria for Evaluating 

Tax Systems 

The following criteria may be 

used to evaluate tax systems: 

1. Economic efficiency-A tax should 

interfere as little as possible with 

attainment of optimal resource 

allocation. Whenever possible, it 

should assist in attaining this 

optimum (Gregory 1972). 

2. Equity-fairness of a tax. Both 

vertical and horizontal equity 

should be considered. Vertical 

equity is a comparison of the tax 

burden between different types of 

businesses and incomes; horizontal equity refers to fairness in 

the tax treatment of businesses or 

investments in assets of similar 

nature (Niemi 1978). 

3. Operability-costs of administering the tax, to both government 

and taxpayers, should be kept to 

a minimum. 

4. Revenue adequacy-A tax must 

raise the necessary revenues. 

Economic Efficiency 

Economic efficiency is achieved 

when resources are allocated so that 

no activity can be increased without 

cutting back on some other activity. 

Deciding which efficient solution is 

optimal requires knowledge of the 

social welfare function. Without this 

knowledge, other criteria for judging 

optimality must be used. Neutrality, 

with respect to optimal management 

decisions, is sometimes used to 

measure economic efficiency. Jackson 

(1980) states that "because efficiency 

in production is one necessary condition for the attainment of maximal 

social welfare (Bator 1957), any tax 

which reduces the level of economic 

efficiency by misallocating scarce 

productive factors supersedes the 

attainment of the optimal production 

frontier." 

Pursuing this logic, we will examine the neutrality of various taxes 

in this section. Such an examination 

can be conducted within the framework of a model used to analyze the 

rotation age and management intensity decisions when a perpetual 

series of rotations is considered. The 

basic model, which is an extension 

of the familiar Faustmann (1849) 

formula is: 
where PDV(t,E) = present discounted value of a perpetual series of t-year 

rotations, with management effort E; 

P = stumpage price; 

V(t,E) = volume at age t, with effort E; 

exp = inverse of the natural log function; 

h = discount rate; 

t = age of forest at rotation; 

W = cost per unit of management; 

E = level of management intensity. 

To simplify the analysis all management effort is assumed to occur at the 

time of establishment. The first order conditions (FOC) for maximization of 

equation [I] are: 

where V1(t) and Vf(E) are the first partial derivatives of V with respect to t and E. 

These conditions equate marginal cost with marginal revenue. Equation [2] 

indicates that if E is held constant, the stand should be left to grow until the 

increase in value equals the opportunity cost of delaying the current and 

perpetual series of harvests. Equation [3] shows that, holding rotation age 

constant, management effort should be applied only to the point where the 

present value of the resultant volume increase equals the cost of an additional 

unit of input. The optimal rotation age and management effort to maximize 

present value are determined by solving equations [2] and [3] simultaneously. 

To determine the neutrality characteristics of a capital gains tax equation 

[I] may be modified as follows: 

(I -T) * PV * exp(-ht) + TWE * exp(-ht)-WE PDV(t,E) = I-exp(-ht) 

where T = capital gains tax rate. The FOC simplify to: 

Equation [5] indicates that if management intensity is held constant, the 

capital gains tax is neutral. However, equation [6] indicates that the optimal 

management intensity is influenced by the capital gains tax. This new value of 

E will change the optimal rotation age in equation [5]. Thus, a capital gains tax 

influences the optimal rotation age decision when management costs are 

incurred and are influenced by imposition of the tax. 

The model can also be modified to include an ordinary income tax. 

PDV(t,E) = (I-T)*[PV*exp(-ht) - WE] 

1 -exp(-ht) 

where T = ordinary income tax rate. 

The FOC simplify to: 

and indicate that the ordinary income tax is neutral with respect to both 

rotation age and management intensity. 
However, an important shortcoming of the above model is its failure to 

consider nontimber forest values (Hartman 1976). When these values are introduced, the ordinary income tax is no longer neutral. This is demonstrated bv 

modifying artm man's model to include anordinary income tax and examining 

the FOC 

(1-T) * [PV * exp(-ht) - WE] + IdF(x)exp(-hx)dx PDV(t,E) = 1 -exp(-ht) 

where F(x) = the value of nontimber benefits accruing to the landowner in 

year x. 

The FOC with respect to rotation age is: 

(1-T) * [P* Vf(t) - [h * (PV-WE)]/[1-exp(-ht)]] 

Hartman shows that it may be optimal 

never to harvest the forest. Increased 

taxes reduce timber values relative to 

nontimber values. Because the tax on 

capital gains is lower, the no-harvest 

decision will be optimal less frequently 

than with an ordinary income tax. 

The basic difference between the 

two taxes, with respect to neutrality, 

is the timing of the tax deduction for 

regeneration costs. Tax incentives for 

reforestation improve the economic 

efficiency of the capital gains tax 

(Dennis 1983). Reforestation expenses 

(up to $10,000 annually) now can be 

amortized over the first 7 years, thus 

bringing the timing of the deduction 

closer under the two systems. However, this difference is of little consequence to large landowners for whom 

reforestation costs are far in excess 

of $10,000 or where other capitalized 

management costs (not subject to 

amortization) are substantial. 

Further examination of the FOC 

reveals that a capital gains tax decreases optimal management intensity. The ordinary inkome tax is 

neutral but this distinction breaks 

down if nontimber values are introduced. Also, neutrality differences 

between the capital gain's and ordinary 

income tax are reduced by amortization of reforestation costs. 

The above discussion has considered tax-induced changes in the 

allocation of productive factors. 

Misallocation of resources also can 

result from externalities-interactions 

among economic agents that are not 

adequately reflected in markets. An 

externality exists when the activities 

of one agent directly affect the utility 

of another. If externalities are present, 

profit-maximizing behavior will not 

necessarily lead to an efficient allocation of resources, because the 

producer is not responding to the 

true social price (Varian 1978). A 

traditional remedy, first advanced by 

Pigou (1946), is to alter the tax structure to bring social and private .costs 

into agreement. 

Forests produce benefits that are 

not priced in the market. One justification for preferential tax treatment 

of timber income is to bring the social 

and market prices of timber into 

closer agreement. If the producer 

receives the true social price, then 

socially optimal decisions should 

result. Because capital gains preference, as compared to an ordinary 

income tax, lessens the gap between 

the social and market price of timber, 

it will influence decisions toward the 

social optimum. 

Equity 

Long-term investments in capital assets clearly receive preferential 

treatment. Deleting capital gains 

provisions from the tax code would 

remove this inequity. Income, regardless of source, would be taxed at 

ordinary income rates. However, because income from an entire rotation 

is taxed in the year of harvest, the 

total tax liability is significantly 

greater than if the same income were 

spread over many years. Our progressive income tax is biased against 

forestry or other investments characterized by sporadic income receipts. 

Provisions for income averaging 

relieve this problem somewhat, but 

the bias remains. Some form of vertical inequity exists under each tax 

system but capital gains taxation, 

because of the 60 percent exclusion 

for individuals, reduces the bias 

against sporadic large income receipts in the ordinary income tax. 

Since public agencies do not 

pay taxes, any tax levied on the private sector may be viewed as horizontally inequitable. Capital gains 

treatment, because of the exclusion 

for individuals and low rate for corporations, reduces this inequity for 

timber investment. 

If horizontal equity is to be considered, proposed changes in the tax 

code must affect investments of 

similar nature in the same way. Denying capital gains treatment to timber 

income while retaining it for other 

capital investments clearly introduces 

horizontal inequity. 

Operability 

, Both the ordinary income tax and 

capital gains tax provisions are presently operable. Treating all income as 

ordinary would simplify the tax code 

and make reporting slightly easier. 

Historically, complexities in the tax 

code that strengthen performance 

with respect to other criteria have 

been accepted. 

Revenue Adequacy 

Since determining a measure of 

"necessary" revenue is beyond the 

scope of this study, I will concentrate 

on differences in revenue receipts. 

Capital gains taxation, because of 

the 60 percent exclusion for individuals and low corporate rates, reduces 

Treasury receipts. In some arguments 

against capital gains taxation, figures 

that purport to measure government 

revenue loss or the benefit received 

by taxpayers are quoted. Frequently, 

these figures estimate differences in 

tax revenue that would occur if no 

behavioral changes resulted from the 

proposed changes in the tax system. 

Because behavioral changes do occur, 

these figures generally overestimate 

the impact of tax changes and should 

be used with caution. The change in 

Treasury receipts is dependent upon 

the elasticities of supply and demand 

and, of course, the magnitude of the 

tax rate change. 
Impacts on Timber Supply 

and Social Welfare 

The influence of taxes on timber 

supply is illustrated in Figure 1. Without taxes, supply and demand are in 

equilibrium at price P1 and quantity 

Q1. A tax on timber output shifts the 

supply curve up by the amount of the 

tax to S2. Initially, the price received 

by suppliers is reduced by the amount 

of the tax. However, at this price 

supply and demand are not in equilibrium. The after-tax equilibrium 

becomes (Q2, P2). The price increase 

is less than the amount of the tax 

because the increased price has induced consumers to demand less, and 

the smaller amount can be produced 

at a lower marginal cost (Varian 1978). 

The reduction in output (Q1 less 

Q2) resulting from the tax is caused 

by changes in management intensity 

and rotation age, and by land shifting 

out of timber production into other 

uses. Because the price increase is 

less than the tax, the net price received by the timber grower is reduced. This is reflected in lower soil 

rents for timberland. Forestland 

initially at the margin may shift into 

competing uses. Because rates are 

significantly lower, a capital gains 

tax reduces timber supply less than 

an ordinary income tax. 

Figure 1 also aids in examining 

welfare implications. . . Consumer surplus is the difference between the 

total value consumers receive from 

consumption and the total amount 

they pay for the good. Before the tax, 

consumer surplus is indicated by area 

APIG. Imposition of the tax reduces 

consumer surplus to BP2G. Producer 

surplus is a measure of profit plus 

rent and is expressed as total revenue 

less the area beneath the supply 

curve. The difference between the 

revenue received by the government 

and the loss in consumer and producer surplus is called the deadweight 

loss. Area ABC indicates the deadweight loss of taxation. Its amount 

is determined by the elasticities of 

supply and demand and the magnitude of the tax. Less deadweight loss 

is associated with a capital gains tax 

than with an ordinary income taxthe tax-induced supply shift is less, 

because the tax rate is lower. 

Conclusion 

The present controversy is about 

eliminating capital gains provisions 

in favor of ordinary income tax treatment for timber income. If that is 

done, soil rents for timberland will 

decline, causing some land to shift 

out of timber production. This reduction in soil rent will effectively be a 

lump-sum loss to timberland owners, 

which is particularly inequitable if 

capital gains treatment is retained 

for other long-term investments. 

This inequity alone is a substantial 

argument for retaining capital gains. 

Increased taxes will reduce output 

on much land that remains in timber production, particularly where 

multipleuse management is employed, 

because timber returns decline in 

relation to other values. Taxing timber 

at a higher rate would widen the gap 

between the social and market prices 

of timber, cause significant inequities 

for present timberland owners, and 

have negative impacts on timber 

supply. 

Figure 1.-Implications of a tax-induced supply shift. 

4 
Literature Cited 

Bator, Francis M. The simple analytics 

of welfare maximization. American 

Economic Review; 1957. Reprinted 

in: Breit, William; Hockman, H. M., 

eds. Readings in microeconomics. 

New York: Holt, Reinhart, and 

Winston, Inc.; 1968. 497 p. 

Dennis, Donald F. Tax incentives for 

reforestation in Public Law 96.451. 

Journal of Forestry. 81(May):293- 

295; 1983. 

Faustmann, Martin; 1849. Translated 

and reprinted in: Gane, M., ed. 

Martin Faustmann and the evolution 

of discounted cash flow. Oxford 

lnstitute Paper 42; 1968. 

Gregory, G. Robinson. Forest resource 

economics. New York: The Ronald 

Press; 1972. 283 p. 

Hartman, Richard. The harvesting 

decision when a standing forest 

has value. Economic Inquiry. 14: 

52-58; 1976. 

Jackson, David H. The microeconomics of the timber industry. 

Boulder, CO: Westview Press; 1980. 

136 p. 

Niemi, Kelly C. The landowner through 

a forester's eyes. In: Proceedings, 

Forest Taxation Symposium; 1977 

November 30-December 1; Blacksburg, VA. School of Forestry and 

Wildlife Resources FSW-78-2. 

Blacksburg, VA: Virginia Potytechnic lnstitute and State University; 1978:65-71. 

Pigou, A. C. The economics of wel. 

fare. 4th ed. London, England: 

Macmillan; 1946. 

Siegel, William C. Historical development of federal income tax 

treatment. In: Proceedings, Forest 

Taxation Symposium; 1977 November 30-December 1; Blacksburg, 

VA. School of Forestry and Wildlife 

Resources FSW-78-2. Blacksburg, 

VA: Virginia Polytechnic lnstitute 

and State University; 1978:17-25. 

Varian, Hal R. Microeconomic analysis. New York: W. W. Norton and 

Company; 1978.283 p. 

Dennis, Donald F. Capital gains treatment of timber income: An 

economic assessment. Res. Pap. NE-556. Broomall, PA: U.S. 

Department of Agriculture, Forest Service, Northeastern 

Forest Experiment Station; 1985.5 p. 

Treating timber income as capital gains meets the criteria 

used to evaluate tax systems better than treating it as ordinary 

income. Social we[fare implications and impact on timber supply 

also favor such treatment. 

ODC 950 

Keywords: Taxation; capital gains 

a US. GOVERNMENT PRINTING OFFICE: 1985-505-0281540 
Headquarters of the Northeastern Forest Experiment Station are in 

Broomall, Pa. Field laboratories are maintained at: 

Arnherst, Massachusetts, in cooperation with the University of 

Massachusetts. 

Berea, Kentucky, in cooperation with Berea College. 

Burlington, Vermont, in cooperation with the University of 

Vermont. 

Delaware, Ohio. 

0 Durham, New Hampshire, in cooperation with the University of 

New Hampshire. 

0 Hamden, Connecticut, in cooperation with Yale University. 

0 Morgantown, West Virginia, in cooperation with West Virginia 

University, Morgantown. 

0 Orono, Maine, in cooperation with the University of Maine, 

Orono. 

Parsons, West Virginia. 

0 Princeton, West Virginia. 

0 Syracuse, New York, in cooperation with the State University of 

New York College of Environmental Sciences and Forestry at : 

Syracuse University, Syracuse. 

.O 'Ufiiversity Park, Pennsylvania, in cooperation with the 

Pennsylvania State University; 

:a Warren, Pennsylvania.