Risk-Based Rules and the Taxation of Capital Income

This article makes four main points. First, the widely recognized crisis in the taxation of financial assets, resulting from the development of the innovative new financial products commonly called derivatives, results from the tax system's reliance on what I call "risk-based rules." These are rules that give the presence or absence of elements of economic risk a tax significance that is distinct from any effect that such risk has on fair market value or the accrual of economic gain or loss. My point should be a familiar one, since variants of it have previously been made by many others. However, by using the broader terminology of "risk-based rules" -- rather than, say, "debt versus equity" or "fixed versus contingent return" financial instruments -- I hope to suggest that the problem is more general, extending beyond the taxation of financial instruments. Second, the tax system's reliance on risk-based rules does in fact cause problems for the taxation of income from capital generally. I show this by examining the taxation of tangible assets other than human capital. Such assets, along with financial assets and human capital, constitute most of the domain of productive capital. The regime for taxing tangible assets uses risk-based rules in a number of respects, including to determine who owns an asset for tax purposes and thus is entitled to deduct depreciation, whether there has been a taxable sale or exchange, which members of a partnership are entitled to certain deductions and to higher outside basis for their partnership interests, and whether deductions are limited by the at-risk rules. While taxpayers cannot exploit the tax system's reliance on risk quite as aggressively with respect to tangible assets as they can with respect to financial assets, given the former assets' lesser flexibility and generally higher transaction costs, the difference may not be as great as one would think. Prior to the enactment of the tax reform act of 1986, which blocked tax sheltering by individuals through legal changes other than to risk-based rules, taxpayers were already making substantial progress in defeating these rules. The derivatives revolution points the way to further tax planning innovations with respect to tangible assets. Such innovations will very likely prompt a new era of tax sheltering by individuals if certain post-1986 legislative trends -- higher and more progressive tax rates, increased tax preferences for income from capital assets, a greater capital gains differential, and the increasing enactment of exceptions to non-risk-based anti-tax-shelter rules -- continue. Moreover, even if the last of these post-1986 legislative trends does not go very far, in that provisions such as the passive loss rules, capital loss limitation, and investment interest limitation continue to prevent taxpayers from deducting substantial tax shelter losses against their labor income, the tax system's "success" may increasingly be limited to ensuring that capital income is taxed at a zero rate, rather than at a negative rate. Third, these current and prospective future developments suggest a need to rethink the various risk-based rules that affect the taxation of tangible assets. Efforts to expand these rules greatly -- as by broadening the tax definition of a realization event (at least in the case of gain), more aggressively testing sale-leaseback transactions for "economic substance," or fully applying the at-risk rules to real estate -- would appear to hold little promise. Even retaining many of these rules -- rather than moving in the direction of a regime where tax realization was determined purely formalistically, and where explicit deduction-trading between taxpayers were permitted, but where an expanded version of the passive loss rules was used to protect the earned income tax base against the deduction of tax shelter losses -- may be unwise on balance. I make no definite argument that such a change in tax regime would be desirable, given its range of unpredictable effects, such as on the volume of tax-motivated transactions. I do argue, however, that the question of whether we should shift to such a regime presents a difficult empirical question, the resolution of which should depend on assessing the likely transactional and revenue effects. Fourth, the problems with relying on risk-based rules raise serious questions about the entire enterprise of taxing income from capital. As I have noted elsewhere, if a zero tax rate on capital income is sufficiently often the best we can do, then the longstanding debate concerning the relative merits of income taxation and consumption taxation may eventually resolve itself. Why even attempt to tax income from capital -- the component that distinguishes income taxation from taxing merely labor income or consumed income -- if the revenue yield, even if it remains more than trivial, is sufficiently limited relative to the tax planning, compliance and administration costs?