Do We Collect Any Revenue from Taxing Capital Income?

The wide variation in effective tax rates on income from different types of capital received by different investors creates numerous tax arbitrage opportunities that result in a loss in both government revenue and economic efficiency. The objective of this chapter is to estimate the revenue and distributional effects of tax arbitrage, using tax data from 1983, by examining the effects of two tax changes that would each substantially reduce the opportunities for tax arbitrage. Our principal conclusions are as follows: 1. Taxing real rather than nominal interest income would have raised government revenue in 1983 by 25. 5 billion. 2. This increase in revenue would occur mainly at the expense of those in the highest tax brackets. 3. Taxing the cash flow from real capital and exempting from tax any income from financial assets would have raised government revenue by 17. 4 billion. Since this tax change eliminates all distortions to savings and investment decisions, our revenue forecast suggests that the tax law in 1983 subsidized savings and investment on average. 4. This tax change would benefit those in the highest tax brackets, who have large income from financial assets, at the expense of those in lower tax brackets. 5. Either tax change should improve the efficiency of the allocation of existing capital and improve savings incentives.