. IS INCOME FROM CAPITAL SUBJECT TO 

INDIVIDUAL INCOME TAXATION? 

Eugene Steuerle 

U.S. Treasury Department 

OTA Paper 42 October, 1980 

OTA Papers are circulated so that the preliminary findings of tax 

research conducted by staff members and others associated with 

the Office of Tax Analysis may reach a wider audience. The views 

expressed are those of the author, and do not reflect Treasury 

policy. Comments are invited, but OTA Pa.pers should not be 

quoted without permission from the authors. Managing editors are 

Michael Kaufman and Gary Robbins. 

Office of Tax Analysis

U.S. Treasury Department, Room 1116 

Washington, D.C. 20220 

Issued: October, 1980 

3 
TABLE OF CONTENTS 

Page 

ABSTRACT ........................................ I. INTRODUCTION ................................... 11. AMOUNT OF INCOME FROM CAPITAL SUBJECT TO TAX ... 111. INCOME TAX COLLECTIONS ON CAPITAL INCOME ........ I v. ASSETS AND LIABILITIES OF INDIVIDUALS e......... 

‘1. TAX EXPENDITURES FOR INDIVIDUAL SAVING 

AMD INVESTMENT ............................... 

SOME IMPLICATIONS FOR EQUITY AND EFFICIENCY .... VI11 SUMMARY ........................................ 

1 

1 

3 

10 

13 

17 

20 

25 

VI 
ABSTRACT 

Although real capital income from certain sources may be 

subject to tax at very high rates in an inflationary economy, 

this paper suggests that individuals avoid individual income 

taxation on most capital income by saving in tax-preferred 

assets, and by not realizing or not reporting capital income. 

It is found that the average marginal rate of Federal individual income tax on -all capital income is about 10 percent. 

Additiona'lly, the net amount of income from capital reported on 

individual returns is less than one-third of net income from 

capital (excluding inflationary returns) in the economy. 
IS INCOME FROY CAPITAL SUBJECT TO 

INDIVIDUAL INCOME TAXATION?* 

I. INTRODUCTION c 

In an income tax system that taxed all income equally, 

capital income from one source would be treated similarly to 

capital income from another source and to wage income as 

well. In the individual income tax, however, the tax 

treatnent of capital income varies widely according to source 

and differs substantially from the tax treatment of wage 

income. 

Because of the disparate treatment of various types of 

capital income, considerable, debate has arisen over the 

extent to which income from capital is actually taxed under 

the individual income tax. Recent studies have highlighted 

how individuals are taxed on the inflationary component of 

interest income and increases in the value of assets due to 

inflation (see, for instance, Feldstein and Slemrod, 1975). 

On the other hand, other analyses have emphasized that 

various exclusions and deductions allow individuals to avoid 

taxation on income from capital (see, for instance, Pechman 

and Okner, 1974). Additionally, much capital income is not 

recognized immediately and is therefore deferred from 

-*/ I am indebted to George Barsness, Larry Dildine, Yarvey 

Galper, John Gorman, Michael Kaufman and Emil Sunley for 

helpful comments and to Amie Powell and Eunice Taylor for 

their assistance in the preparation of this manuscript. 
-2-

taxation because of the requirement (adopted primarily for 

ease of administration) that taxes be based upon realized 

rather than accrued income. Finally, a recent study by the 

Internal Revenue Service found a much larger rate of 

non-compliance by taxpayers in reporting income from capital 

than in reporting wage income. -1/ 

The purpose of this note is to provide empirical 

estimates of the extent to which income from capital is 

subject to individual income taxation. While some 

individuals do face extraordinarily high rates of tax on real 

income from certain assets (e.g., individuals who save 

through passbook savings accounts in period of high 

inflation), the results of this paper suggest that most 

income from capital, whether nominal or real, is simply not 

subject to individual income taxation. Indeed, about 80 

percent of the assets held by individuals are in forms for 

which there is a tax preference arising from either deferral, 

capital gains tax rates, exclusions, or some other means of 

non-taxation of some or all of the income from the asset. 

These results do not imply that income from capital is 

taxed too lightly or too heavily. Substantial amounts of 

corporate and property taxes are also paid on property or 

-1/ See Estimates of Income IJnreported on Individual Income 

Tax Returns. Amount of income reported on tax returns as a 

percent of amount reportable equaled 97-99 percent for wages 

and salaries , but averaged only 80-88 percent for interest , dividends, capital gains, and rents and royalties. 
-- 

-- 

-3 -

income from property. Moreover, when income from capital -is 

realized for tax purposes, it may face a substantial penalty 

tax on any inflationary component. The incidence of these 

taxes and penalties may be borne by all capital owners, for 

instance, through a lower pre-tax rate of return on 

tax-preferred assets. The results do imply that most capital 

income is not taxed through the one tax the individual 

income tax in which tax rates are related to the ability 

to pay of the taxpayer. In addition, the economy may suffer 

a substantial welfare loss from the misallocation of 

investnent and savings which results when the tax system 

combines substantial incentives for ownership of certain 

types of assets with substantial penalties for recognition of 

income from other assets. 

11. AMCIUNT 3F INCOME FROY CAPITAL SUBJECT TO TAX 

A. Net Income from Capital 

National income data 2/ can be used to provide rough -

estimates of the amount of net income from capital in the 

economy. These estimates are presented in the left-hand side 

of Table 1. Total ,let income from capital for 1979 is 

estimated at $305.5 billion. Sources of income include: 

corporate profits, proprietors' income, rental income, net 

interest income, and income from consumer durables. 

-2/ Source: Survey of Current Business, Yay, 1980, and 

Bureau of Economic Analysis, Department of Commerce (�or

unpublished estimates) . 
,- 

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-5-

The method of estimation used in this paper is to 

measure capital income net of inflationary returns (such as 

inflationary increases in the value of inventories), 

corporate income taxes and property taxes, interest payments 

from individuals to business, and the value of financial 

services (e.g., on checking accounts) furnished by financial 

intermediaries. 

Thus, corporate profits of $85.5 billion are reported 

net of inventory valuation and capital consumption 

adjustments in order to exclude profits resulting from the 

inflationary increase in value of inventories and equipment, 

and the corresponding overstatement of inventory profits and 

understatement of depreciation. For purposes of calculating 

income from capital subject to the individual income tax, 

income from ownership of corporzte stock is measured net of 

$92.5 billion of corporate profits tax liability, leaving 

dividends and retained earnings (adjusted), as the estimate 

of income from cepital arising from corporate stock 

ownership. 

Net rental income of $26.9 billion is also estimsted net 

of capital consumption adjustment. As reported both in Table 1 

4 and in the national income accounts, rental income includes 

imputed rent to owner-occupied housing and is estimated net of 

costs such as real estate taxes and interest. 
-6 -

Subtracted from personal interest income of $192.1 

billion is the value of interest paid by consumers to 

business and the value of services furnished without payment 

by financial intermediaries. Thus, interest income received 

by individuals is measured net of interest payments (other 

interest payments are effectively subtracted in the estimate 

of net rental income) and excludes non-monetary returns to 

deposits in financial institutions. -3/ The estimate of 

interest income is not adjusted downward for inflation. 

Rather, it is assumed that the overstatement of interest 

income by individuals as creditors (and owners of debt 

instruments) is exactly offset by the understatement of their 

income as debtors (and owners of institutions with 

outstanding debt). In estimating national income, the Bureau 

of Economic Analysis uses a similar procedure; for instance, 

real, current-dollar, national income includes net interest 

flowing from the corporate sector, without any inflation 

adjustment . 

Imputations are added in two areas. First, one third of 

proprietors' income is counted as income from capital, while 

two-thirds of proprietcrs' income is treated as wage income. 

Second, a modest estimcte of 4.0 percent real rate of return 

was used to make the $31.7 billion imputation of income from 

consumer durables. 

-3/ These non-monetary returns can be treated as part of 

return to capital; however, this would imply that the return 

to deposits include both the stated interest payments and the 

cost to the financial institutions for handling the deposits. 
-7-

Although the estimated total net income from capital 

figure of $305.5 billion represents real income from capital, 

the tax system is actually based upon nominal rather than 

real income. In an inflationary environment such as 

existed in 1979, nominal income from capital would be 

significantly larger than real income. Adding back the 

inventory and capital consumption adjustments alone would 

increase income from capital by $69.6 billion (see Table 1). 

The largest addition, however, would arise from the nominal 

capital gains on the assets held by individuals. Increases 

in the value of land, residential housing, and other physical 

assets would add several hundred billion dollars annually to 

the nominal amount of income from capital. For instance, 

capital gains on physical farm assets, mainly real estate, 

equaled $102 billion in 1978. -

4/ 

3. Net Income From Capital Reported on Individual Income Tax 

Returns 

Using a sample of 1975 tax returns with da.ta aged to 

1979, -5/ it is estimated that only $96.5 billion in net 

income from capital was reported on individual incone tax 

-4/ Balance Sheet of the Farming Sector, 1979, Supplement, 

P* 40. Data for 1979 are not yet available. 

-

5/ Estimates of income reported on tax returns and taxes o n

incone are estimated using the Treasury Tax Yodel. For a 

discussion of this model, see Wyscarver, 1978. 
-8 -

returns in 1979. A summary of the amount of capital income 

reported on individual income tax returns is presented on the 

right-hand side of Table 1. 

Because the estimates of income from capital in the 

economy are net of interest, real estate taxes and personal 

property taxes, consistency requires that the estimate of 

income from capital subject to individual income taxation 

also be reported net of deductions for such expenses. The 

largest deduction is for interest payments; interest 

deductions reported by itemizers are almost equal in size .to 

interest receipts reported on all returns. 

In apportioning out the amount of capital income 

reported on individual income tax returns, two-thirds of 

proprietorship and partnership income is again assumed to be 

income from wages. Ninety percent of royalty income is 

treated as income from capital, thus allowing a small portion 

of royalty income to be treated as wages of authors and 

similar persons. One-half of reported pension and annuity 

income -G/ is also included as capital income subject to 

-5/ Using the figure "one-half" is only partly arbitrary. 

Consider an employer who contributed a fixed percentage of 

wages to an employee's pension plan for the past 25 years. 

If the employee's wages had grown at 4 percent a year and the 

rate of return on assets had equaled 6 ?ercent, then the 

portion of the capital accumulation after 25 years attributable to the sum of employer contributions would be 51 

percent and the portion attributable to earnings on the 

employer contributions would be 49 percent. 
-- 

-- 

-- 

-3-

individual income tax, although this estimate probably errs 

on the side of overstating the amount of capital income from 

pensions. -7/ 

The $95.6 billion of net income from capital reported on 

individual income tax returns -8/ represents only 32 percent 

of the $305.5 billion of net capital income in the economy. 

If income from capital in the economy had been measured on a 

nominal basis similar to that used to report income on tax 

returns for instance, if capital gains were included in 

the estimate of income from capital in the economy then 

the percentage of capital income reported on individual tax 

returns would have been smaller still. 

-7/ Because many pension plans are inadequatsly funded, many 

pensioners effectively are paid out of current employer

contributions rather than earnings on past contributions. 

More importantly, if one were to attribute the tax subsidy to 

?ension deposits as applying entirely to capital income 

rather than both capital and wage income, then the amount of 

capital income from pensions subject to tax would be listed 

at zero. Further discussion of the amount of subsidy to 

pension income is contained in Section IV. 

-3/ A small amount of income of individuals is also taxed 

as undistributed income on fiduciary tax returns. Estates 

and trusts reported $2.4 billion of taxable income for 1974, 

the last full year for which details are available. Yost of 

this taxable income represented income from capital. See 

Statistics of Income 1974, Fiduciary Income Tax Returns. 
-10-

111. INCOME TAX COLLECTIONS ON CAPITAL INCOVE 

Some revenue and distributional effects of the individual taxation of income from capital are shown in Table 2. 

Breakdowns are provided for 1) income from capital gross of 

deductions for interest, real estate taxes and personal 

property taxes and 2) income from capital net of these 

deductions. 

The change in tax reported for each of these income 

measures is the "average marginal" rate on capital income. 

That is, the tax estimate is the difference between the tax 

that is currently collected and the tax that would be 

collected if the income from capital were excluded from 

taxation. Yeasuring at the margin is a useful means of 

2xamining the economic impact of capital income taxation. 

However, it does not allow a comparison of the taxes on 

capital with the taxes on wages. If capital income had been 

treated as the base, with wage income as marginal income, the 

estiinate of the amount of tax paid by capital would be 

significantly lower. 

Dividing tax revenues of $30.5 billion on net income 

from capital by the amount of net capital income in the 

economy yields an effective "average marginal" rate of 
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-12-

Federal individual income tax of 10.0 percent on all capital 

income. This number should not be interpreted as the 

effective rate of tax for all taxes on income from capital. 

Corporate tax liability of $92.5 billion (see Table 1) on 

corporate income alone is over three times the $30.6 billion 

estimate of individual tax liability on -all capital income.

Adding this corporate tax liability to both the estimate of 

income from capital and to the individual tax liability 

yields an effective Federal tax rate for both corporate and 

individual income taxes of 30.9 percent. -

9/ State and local 

income taxes, as well as property and indirect business taxes 

(to the extent they are considered a tax on capital income), 

would raise the number even higher. 

-9/ Note again that this rate of tax is based upon taxes 

actually paid on all capital income and is not a marginal 

rate of tax on capital income from certain sources alone, 

e.g., income of the corporate sector. Taxes paid are reduced 

by noncompliance and interest deductions, as well as tax 

preferences, and income includes income to housing and 

durables. 
-I3-

IV. ASSETS AND LIABILITIES OF INDIVIDUALS 

An easy means to see why so much income from capital is 

not subject to the individual income tax is to examine the 

portfolio of assets and liabilities held by individuals in 

the United States. 

Individual net worth at the beginning of 1979 is 

estimated by the Board of Governors of the Federal Reserve 

System at $6.5 billion (see Table 3). Of some $8 trillion in 

assets held by individuals, $4.5 trillion are in tangible 

assets such as housing, durables, and land, and $3.5 trillion 

are in financial assets. Very little income from tangible 

assets is reported on individual tax returns. Benefits 

provided by owner-occupied residential housing and durables 

are not subject to tax (although interest payments on 

mortages and installment debt are deductible, as are property 

taxes). Neither is income from investment real estate taxed 

fully, in part because owners of these assets are allowed 

generous depreciation allowances. Very little capital gains 

tax is collected on land, not only because of the capital 

gains exclusion but, more importantly, because increases in 

value of land are deferred from taxation until realized or 
-14-

Table 3 

ASSETS AND LIABILITIES OF INDIVIDUALS IN TXE UKITED STATES -- 1979 

Outstandings at Beginning of Year 

($ billion) 

TANGIBLE ASSETS 

Reproducible Assets 

Owner-Occupied Housing

Other Residential Structures 

Consuner Durables 

Inventories and Non-residential Plant 

& Equipment 

Land 

Residential 

Nonresidential 

Vacant 

TOTAL FINANCIAL ASSETS 

Currency, Savings Accounts 

& Money Market Funds 

Demand Deposits & Currency

Tine and Savings Accounts 

Money Market Fund Shares 

Securities 

U.S. Savings Bonds 

Other U.S. Government Securities 

State & Local Obligations

Corporate & Foreign Bonds 

Open-Market Paper

Corporate Equities 

Pension & Life Insurance Reserves 

Private Life Insurance Reserves 

Private Insured Pension Reserves 

Private Noninsured Pension Reserves 

Government Insurance & Pension Reserves 

Miscellaneous Assets 

TOTAL ASSETS........................................... 

TOTAL LIABILITIES...................................... 

Mortgages, Owner-occupied Nonfarm Homes 

Consuner . Credit __ . .

Non-corporate Business Mortqaqe Debt 

Security Credit & Policy Loans 

Other Debt 

NET WORTH.............................................. 

$4 ,514 

$3,230 

1,448 

395 

793 

594 

$1,283 

517 

567 

200 

$3,491 

$1,349 

242 

1,096 

11 

$1,188 

ai 

123 

75 

65 

36 

809 

$729 

190 

119 

199 

221 

$225 

$8 ,004 

$1,503 . 

$738 

$340 

$213 

$ 53 

$159 

$6 ,501 

Source: Balance Sheets of the U.S. Economy,(Washington: Board of 

Governors of the Federal Reserve System, 1979). 
-15 -

are excluded completely from taxation in the event of death. -10/ 

Compliance data also indicate substantial amount of underreporting of rental income and self-employment income. -11/ 

Of the $3.5 trillion held in financial assets, some 20 

percent of that total, or $729 billion, is in the form of life 

insurance and pension reserves. Earnings on savings in life 

insurance and annuities are usually deferred, often permanently, 

from taxation. The current tax treatment of an individual's 

retirement savings in a qualified plan is equivalent to complete 

exemption of the earnings on that savings if the taxpayer is in 

the same tax bracket when he receives his pension as when his 

employer (or, in the case of an IRA or Keogh plan, the 

individual) deposits money in a pension plan. -12/ If the 

taxpayer is in lower tax bracket, as is usually the case, the 

tax treatment is equivalent %o a subsidy for deferred wages in 

addition to non-taxation of the income from savings. 

-10/ The exclusion applies to heirs as well as decedents and

is achieved by means of an adjustment which increases an 

heir's basis for selling an asset to its value at time of 

death of the decedent. 

-11/ Estimates of Income Unreported on Individual Income-Tax 

Returns, 1979, p.8. Rental income and self-employment income 

reported on tax returns equal less than 65 percent of the 

am0 un t re po r table. 

_.12/ See Sunley, 1977 
-- 

-16-

Another $809 billion of the financial assets of 

individuals are held directly in corporate stock. In the 

individual income tax, corporate stock is given favorable tax 

treatment through the exclusion of 60 percent of long-term 

gains from tax, the dividend exclusion, and, most 

importantly, the combination of deferral of taxation of any 

gains until realized and the exclusion from taxation of all 

gains unrealized at the time of death. 

Individuals also hold $75 billion worth of State and 

' local obligations, the income from which is generally 

non-taxable, and $81 billion worth of U.S. Savings Bonds, the 

income from which can be deferred from taxation until the 

bonds are sold. For calendar years 1981 and 1982 there will 

also be an interest and dividend exclusion for the first $200 

of interest and dividends earned Sy a taxpayer ($400 per 

joint return) or for about 3 percent of total interest and 

dividends. 13/ Of the $8 trillion in individual assets, 

then, about 90 percent is in a form for which some or all 

related income can be excluded or deferred from taxation. 

On the liability side of the ledger, much of the 

interest paid on individual liabilities of $1.5 billion is 

deductible immediately. In fact, it is quite common for 

individuals to borrow and take deductions at the same time 

that they invest in assets (pensions, annuities, land, 

13/ For years before 1980, there is a maximum exclusion of 

ST00 per taxpayer ($200 per joint return) for dividends only. 
-17-

housing, corporate stock) for which income is deferred. The 

tax laws do place some limits on investment deductions in 

excess of investment receipts, but even these limitations can 

be avoided easily by borrowing on equity in housing or assets 

used in business or by increasing consumer debt. 

V. TAX EXPENDITURES FC)R INDIVIDUAL SAVING AND INVESTMENT 

As a final means of examining the extent to which income 

from capital is subject to individual income taxation, Table 

4 presents estimates of tax expenditures -14/ which apply to 

saving and investment by individuals. These figures indicate 

that, disregarding interaction, tax expenditures over $65 

billion in fiscal 1980 are provided for income from capital 

earned by individuals. -15/ The amount of tax expenditures is 

about twice the actual amount of individual tax collections 

on income from capital, The major tax expenditures are for 

capital gains (including non-realization at death) , 

-14/ Tax expenditures are defined by the Congressional Budget

Act of 1974 as "revenue losses attributable to provisions of 

the Federal tax laws which allow a special exclusion, 

exemption or deduction from gross income or which provide a 

special credit, a preferential rate of tax, or a deferral of 

tax liability." See "Tax Expenditures," The Budget of the 

U.S. Government, Fiscal Year, 1981. 

-15/ In the tax expenditure budget, each expenditure is 

estimated independently, that is, without accounting for 

interaction with other expenditures. Tax expenditures are 

published only on a fiscal year basis. Tax expenditures for 

calendar 1979 income would fall between fiscal 1979 and 

fiscal 1980 expenditures. 
-18-

Table 4 

($ millions) 

Amount of - Description :tax expenditures 

Expenditures Related Primarily to Financial 

and Nonbusiness Tanrzible Assets of Individuals 

Exclusion of interest on state and local debt ............................ 3,.090 

Nonrealization of capital gains at death ................................. 4,m 

Capital gains exclusion and tax-free rollover of personal residences ..... 1,545 

Sixty percent exclusion of long-term capital gains ....................... 13,855 

Deductibility of interest on home mortgages and consumer credit .......... 16,100 

Exclusion of pension contributions and earnings .......................... 15,050 

Exclusion of interest on life insurance earnings ......................... 3,365 \ 

Dividend exclusion ....................................................... 490 

Deferral of interest on United States savings bonds ...................... 290 

Expenditures Related Primarily to Noncorporate 

Business Assets Held by Individuals 

Capital gains treatment for agriculture, timber, coal and iron ore ....... 590 

Special provisions for depreciation and rapid amortization ............... 700 

Investment Credit ........................................................ 2,970 

Expensing of capital outlays: agriculture, construction, research, 

exploration and development ............................................ 1,215 

Excess of percentage over cost depletion ................................. 1,150 

Tax incentives for preservation of historic structures ................... 25 

Total, disregarding intaraction .....;................................~ -

65,185 

SOURCE: Special Analysis, Budqet of the United States Government,

Fiscal Year 1981, Appendix G. 

a/ Excludes corporate -tax expenditures. -
-19-

deductibility of interest, and special treatment of pensions 

and life insurance. Caution, however, must be used when 

interpreting these figures. In the tax expenditure budget, 

the expenditure for capital gains results from the exclusion 

from taxation of 60 percent of realized, long-term gains and 

of gains accrued at death, but not from the deferral of tax 

for gains accrued, but not realized, in the current year. 

Also not counted is the tax benefit arising from tax 

exemption of the income from housing and durables, although 

interest deductions are included if they arise from the 

purchase of these assets. On the other hand, tax expenditure 

estimates are based upon nominal rather than real income. 

Finally, the tax expenditure estimates are made by estimating 

the increase in tax that would arise if each item of excluded 

income were added to income subject to the tax on individual 

income tax returns. If all were added together at the same 

time, some of the income would be subject to tax at even 

higher marginal tax rates, and the estimate of total tax 

expenditures for savings and investment would be larger. -l'i/ 

-15/ In cases where several itemized deductions are 

eliminated simultaneously, the total increase in revenue may

be less than the sum of the estimates derived as if each 

deduction were eliminated by itself. Since total deductions 

generally cannot be reduced below the zero bracket amount 

(standard deduction), only deductions above that amount can 

effectively be added to income in estimating the tax 

expenditure. However, the only itemized deduction in Table 4 

is the deduction for interest paid. 
-20-

VI. SOME IMPLICATIONS FOR EQUITY AND EFFICIENCY 

Although the individual income tax is in principle a 

progressive tax on all income, in fact, as discussed above, 

only a small portion of capital income is reported on tax 

returns. Of income that is reported, much reflects nominal 

income due to inflation rather than any real return to 

capital. In particular, interest recipients, who have little 

choice as to the timing of the realization of interest 

income, include substantial amounts of nominal income due to 

inflation in income subject to tax. Conversely, substantial 

deductions are allowed for interest payments and for other 

taxes paid on assets even though income from those assets may 

not be subject to taxation. In the case of interest 

paynents, the deduction of the nominal interest is in excess 

of the real amount of interest paid, resulting in a tax 

subsidy for borrowing which is the opposite of the tax 

penalty for holding interest-bearing assets. 

With respect to capital income, there is little 

adherence to the principle that all income should be equally 

subject to tax. There exist few, if any, assets (or 

liabilities) for which the related real income, and only the 

real income, is subject to individual income taxation. Of 

course, to the extent that owners of capital have equal 

opportunities to make shifts in the asset composition of 

their portfolios , there is a decreased probability that 
-21-

taxpayers with equal ability to pay will bear different tax 

burdens. -17/ However, it is highly improbable that such 

opportunities, and the capability or knowledge to take 

advantage of them, are equal across capital owners. 

Moreover, at least in the individual income tax, the wage 

income of taxpayers is treated quite differently from capital 

income (despite the recent growth in the amount of nontaxable 

fringe benefits received by workers, most employee 

compensation is still subject to taxation). As currently 

designed, therefore, the individual income tax is best 

characterized as a progressive wage tax, accompanied by a 

penalty tax on the realization of a small amount of nominal 

income from capital. 

The efficiency implications are equally serious. Much 

has Seen written about the inefficient allocation of 

investnent in the economy because of the additional taxation 

of corporate sector capital vis-a-vis non-corporate capital 

(Harberger, 1962; McClure, 1975). In an inflationary 

economy, the relative tax on corporate capital income may be 

raised even higher because of the understatement of the real 

3 

value of depreciation (Feldstein and Summers, 1979) or the 

overstatement of real capital gains for assets which are sold 

(Feldstein and Slemrod, 1975). 

-17/ See Feldstein (1976) for the view that "in the long-run 

steady state there are no horizontal equalities if all tastes 

are identical and there is a single type of ability." 
-22-

Inefficiency caused by varying tax rates across assets, 

however, is a two-edged sword. While tax "penalties" are 

placed on the realization of income from some assets or on 

particular uses of capital, tax "subsidies" are granted other 

capital income. Indeed, there are a whole host of tax 

penalties and subsidies, not only in the individual income 

tax, but in corporate and property taxes, as well. To the 

extent that the penalties and the subsidies are placed on the 

same assets, they may partially offset each other, but, to 

the extent that the penalties and subsidies apply to 

different assets, the allocation of investment in the economy 

may become even more inefficient. -

1S/ Additionally, i f

purchases of certain assets receive preferential treatent in 

the loan market, the subsidy arising from the deduction of 

the inflationary component of interest payments may also 

zause inefficient investment by encouraging the purchase of 

assets with economic rates of return lower than alternative 

assets. 

-18/ If subsidy, e.g., for pension savings, is neutral with 

respect to the eventual investment resulting from a dollar of 

savings, then that subsidy may only distort the choice of 

savings medium and not the allocation of investment in the 

economy. 
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As an example of how these varying tax penalties and 

subsidies may combine together in distoring investment 

decisions, assume an economy with a rate of inflation of 10 

percent and a taxpayer with a 50 percent marginal rate of 

tax. Suppose the taxpayer desires to save in order to leave 

some wealth to his children. Consider then his choice 

between investing in a savings account and purchasing some 

vacant land. To produce a 2 percent, real, after-tax rate of 

return, the savings account would have to yield an interest 

rate of 24 percent, while the land would only have to 

increase in value by 12 percent a year. -19/ Let us suppose 

further that the rate of interest for both savings and 

borrowing is 12 percent. The taxpayer could not gain by 

borrowing to invest in a savings account and, after tax, 

would lose 4 percent a year in real terms for direct 

investment of his savings in the account. Flowever, if he 

could borrow 90 percent of the value of the investment in the 

land, then he could achieve at least a 2 percent real rate of 

return on his equity as long as the land did not decrease in 

real value by more than 3.4 percent a year (or increase in 

nominal value by less than 6.6 percent). -20/ Ironically, the 

-

19/ Of course, to the extent there are property taxes on the

land, the nominal rate of return necessary to achieve a 2 

percent real rate of return is increased. 

-20/ One dollar of equity involves ten dollars of investment 

earning a nominal rate, "r," and nine dollars of debt, for 

which tax savings equals half of the interest rate of 12 

percent. Thus $1.12 = $lO(l+r) - ($9x.5x.12), or r = .056. 
-24-

greater the proportion of his own savings invested in the 

land (or the less he borrows), the lower the rate of return 

on his equity. 

The system of myriad tax penalties and subsidies for 

income from various assets not only distorts the overall 

allocation of investment in an economy; it also affects the 

distribution of assets and liabilities among individuals. 

The penalty arising from the taxation of the inflationary 

component of capital income, for instance, increases as the 

marginal rate of tax increases, while the inherent subsidy 

arising from deduction of the inflationary component of 

interest expense also increases with marginal tax rates. 

Similarly, exclusions ancl deferrals are of no value to the 

nontaxable individuals, but increase in value as marginal tax 

rates increase. As individuals with high tax rates shift 

their portfolios to take advantage of the exclusions ancl 

deferrals, they bid up the relative prices of the assets with 

deferred or excluded income. Individuals with lower tax 

rates, being less willing to "pay" for the exclusions and 

deferrals, then shift into alternative assets. At higher 

rates of inflation, the amount of induced shifting is even 

greater. Thus, low-income individuals will tend to hold a 

relatively greater share of interest-bearing assets, and 

high-income individuals will increase their share of both 

borrowing and assets such as farm land, which yields much of 

its return through increases in value. 
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VII. SUMMARY 

Only a small portion of real income from capital is 

subject to individual income taxation. While some persons 

may be taxed at very high rates on certain types of income, 

individuals generally avoid direct taxation by saving in 

tax-preferred assets and by not realizing or not reporting 

capital income. At the same time that much capital income is 

deferred or excluded from taxation, interest expenses are 

often deducted (or realized) immediately as a business 

expense or an itemized deduction. 

The net effect of the different treatment of various 

forms of capital income is an average marginal rate of 

Federal individual income tax on all capital income of about 

10 percent. The net amount of income from capital reported 

on individual income tax returns is less than one-third of 

net income from capital in the economy. 

As a result, the individual income tax can be best 

characterized a progressive wage tax, accompanied by a 

penalty tax on the realization of a small amount of nominal 

income from capital. Since the penalty tax is assessed on 

the realization of nominal income from certain assets rather 

than the accrual of real income on all assets, its 

relationship to a progressive tax on all income is minimal. 
-26-

Moreover, the disparate treatment of various assets results 

in substantial inefficiency in the allocation of resources in 

the economy. The economy not only suffers from too much 

investment in some assets and not enough in others, but there 

is also an inducement toward concentration in higher income 

classes of assets producing income which is excluded from 

taxation and in lower-income classes of assets producing 

income which is taxed most heavily. 

F 
-- 

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