1. Taxes on the acquisition and disposal of assets

The acquisition of a financial asset may be the occasion for a tax charge, for a tax relief, or for both.

As shown in Table 1, a few countries allow individuals a deduction from taxable income for amounts used to acquire direct holdings of company shares. With the exception of Canada, these are relatively small countries. In most of these cases, however, the deduction is available only in certain limited circumstances. Such deductions are generally not available for government bonds or bank deposits (see Tables 2 and 3). Table 4, on the other hand, shows that most countries allow a deduction for contributions to personal pension schemes. The only exceptions are Australia, Iceland, and Japan.

Acquisitions of different types of financial assets may also be liable to transactions taxes, such as stamp duties. A majority of countries levy such taxes on acquisitions of company shares (see Table 1). However, most of these taxes are infrequently applied to the acquisitions of government bonds and almost never applied to bank deposits and personal pensions (see Tables 2-4).

The tax treatment of the disposal of financial assets also varies widely among countries. In general, as shown in Table 1, capital gains realized by individuals on their disposals of company shares are subject to tax—either as regular income, or under separate capital gains taxes. A frequent feature of capital gains taxes is that they are levied at lower effective rates (or remitted altogether) when the asset has been held for more than a given period. A smaller number of countries taxes capital gains realized on disposals of government bonds. For personal pensions, Table 4 shows that the whole of the disposal amount (in the form of pensions paid out by the fund) is generally taxable in the hands of the individual. Thus, the general rule for pensions seems to be that some tax relief is given when contributions are made, but that disposals are generally taxed. However, Australia and Japan—two of the three countries in the table that do not provide a general income tax deduction for contributions paid—confine this tax charge to the “income” element of the pension in payment.

2. Taxes on holdings of assets

Around half of all OECD countries levy annual taxes on the net wealth of individuals, above some threshold. ^4/ Tables 1–3 show that these net wealth taxes are applied to financial assets, including bank deposits as well as company shares and government bonds. Accumulated rights in private pension schemes are not, however, included in the bases on which these taxes are levied.

In addition to these explicit wealth taxes, holdings of financial assets may be subject to a number of “implicit taxes” arising from government’s budgetary and regulatory operations. In particular, any asset with a fixed nominal value is exposed to an “inflation tax”. ^5/ Reserve requirements for banks may also impose an implicit tax on bank deposits, when the required reserves must be held in forms that yield low levels of interest. For developing countries in particular, such implicit taxes are typically a far more important source of government revenues than are explicit taxes on financial assets or the financial sector. ^6/

3. Taxes on income from assets

The pre-tax return that is paid on financial assets may be taxed in different ways, according to the nature of the asset and any intermediation between the saver and the ultimate borrower of his surplus funds. Tables 1-3 show that most OECD countries subject company dividends, interest on government bonds, and bank deposit interest to personal income tax in the hands of the saver. But several countries instead levy flat-rate; final withholding taxes on some or all of these sources of income. ^7/ As shown in Table 4, on the other hand, income earned by pension funds is generally exempt.

In the case of corporate source income (dividends), a further dimension of variation is the extent to which that income is taxed in the hands of the company as well as the individual, domestic shareholder. “Classical” corporate tax systems such as those of the US, the Netherlands, Luxembourg and Switzerland impose a tax charge on the company which other countries relieve—in whole or in part—by some form of imputation system or system of relief at the corporate level. In practice, however, different systems may result in a very wide variety of degrees of relief for corporate tax paid on the income, in the case of different types of shareholder. ^8/ When the income is earned in—or paid to residents of—foreign countries, the analysis of the impact of taxation on income from corporate shares becomes even more complex.

4. Statutory tax rates

Tables 5 and 6 provide some information on the tax rates imposed by OECD countries on dividends and interest (Table 5) and on capital gains and net wealth (Table 6). In both cases, the tables refer to individuals rather than institutions. A word of warning is necessary. In most tax systems there are many special treatments of particular circumstances so that the tables would need to be qualified in many ways. The original source from which they are adapted (OECD, 1991) has a great deal of footnotes to try to qualify the information. The reader must be sent to that source for those qualifications.

Table 5.

Tax Rates on Dividends and Interest Received by Individuals

Source: OECD, Taxing Profits in a Global Economy(Paris, 1991). Adapted from Tables 319 and 320, pp. 78-79.

Table 5.

Tax Rates on Dividends and Interest Received by Individuals

	Tax Rate on Dividends		Tax Rate on Interest
	Top rate	Average marginal rate	Top rate	Average marginal rate	Withholding Tax
					Dividends	Interest
Australia	48.3	39	48.3	39	—	—
Austria	25	19.8	50	39.7	25	10
Belgium	25	25	10	10	25	10
Canada	49.1	44.6	49.1	39.5	—	—
Denmark	45	37.6	57.8	51.1	30	—
Finland	60	45.2	10	10	—	10
France	57.9	45	18.1	5.6	—	18.1
Germany	53	39.1	53	39.1	25	—
Greece	50	n. a.	25	—	25	42-50
Iceland	39.8	15.8	—	—	—	—
Ireland	53	50(27)	53	38.4	—	30
Italy	50	39.4	30	12.5	10	12.5-30
Japan	35	35	20	20	20	20
Luxembourg	51.25	24.6	51.25	24.6	15	—
Netherlands	60	49	60	42	25	—
New Zealand	33	28.6	33	25.9	33	24
Norway	19.5	n. a.	40.5	n.a.	25	—
Portugal	25	25	25	25	25	25
Spain	56	28.4	56	31.5	25	25
Sweden	30	30	30	30	30	30
Switzerland	43.8	30.8	43.8	30.8	35	35
Turkey	10	10	10	10	10	10
United Kingdom	40	32	40	24	—	—
United States	36	31	36	28	—	—

Source: OECD, Taxing Profits in a Global Economy(Paris, 1991). Adapted from Tables 319 and 320, pp. 78-79.

View Table

Table 5.

Tax Rates on Dividends and Interest Received by Individuals

	Tax Rate on Dividends		Tax Rate on Interest
	Top rate	Average marginal rate	Top rate	Average marginal rate	Withholding Tax
					Dividends	Interest
Australia	48.3	39	48.3	39	—	—
Austria	25	19.8	50	39.7	25	10
Belgium	25	25	10	10	25	10
Canada	49.1	44.6	49.1	39.5	—	—
Denmark	45	37.6	57.8	51.1	30	—
Finland	60	45.2	10	10	—	10
France	57.9	45	18.1	5.6	—	18.1
Germany	53	39.1	53	39.1	25	—
Greece	50	n. a.	25	—	25	42-50
Iceland	39.8	15.8	—	—	—	—
Ireland	53	50(27)	53	38.4	—	30
Italy	50	39.4	30	12.5	10	12.5-30
Japan	35	35	20	20	20	20
Luxembourg	51.25	24.6	51.25	24.6	15	—
Netherlands	60	49	60	42	25	—
New Zealand	33	28.6	33	25.9	33	24
Norway	19.5	n. a.	40.5	n.a.	25	—
Portugal	25	25	25	25	25	25
Spain	56	28.4	56	31.5	25	25
Sweden	30	30	30	30	30	30
Switzerland	43.8	30.8	43.8	30.8	35	35
Turkey	10	10	10	10	10	10
United Kingdom	40	32	40	24	—	—
United States	36	31	36	28	—	—

Source: OECD, Taxing Profits in a Global Economy(Paris, 1991). Adapted from Tables 319 and 320, pp. 78-79.

Table 6.

Tax Rates on Capital Gains, ^1/ and Nat Wealth ^2/ of Individuals

Source: OECD. Taxing Profits in a Global Economy(Paris, 1991). Adapted from Tables 3.21 and 3.22, pp. 80-81.

^1/Minority shareholders in quoted companies.

^2/The tax base varies substantially across countries.

Table 6.

Tax Rates on Capital Gains, ^1/ and Nat Wealth ^2/ of Individuals

	First Period			Second Period		Base
	Top Rata	Average marginal rate	Length of First Period	Top Rate	Average marginal rate	Indexation of Capital Gains	Tax on Net Wealth of Individuals
Australia	48.3	39	—	—	—	Yes	—
Austria	50	39.7	1	0	0	—	1
Belgium	0	0	—	—	—	—	—
Canada	36.8	10.5	—	—	—	No	—
Denmark	57.8	51.1	3	0	0	No	1
Finland	60	55	5	30	2	No	0.9
France	18.1	0	—	—	—	No	0.5-1.5
Germany	0	0	—	—	—	—	0.5
Greece	0	0	—	—	—	—	—
Iceland	39.8	20	—	—	—	Yes	1.2-2.2
Ireland	50	50	3	35	35	Yes	—
Italy	25	25	—	—	—	—	—
Japan	20	20	—	—	—	—	—
Luxembourg	0	0	—	—	—	—	0.5
Netherlands	0	0	—	—	—	—	0.8
New Zealand	0	0	—	—	—	—	—
Norway	AO	40	3	0	0	No	1-2.3
Portugal	10	10	2	0	0	No	—
Spain	56	31.5	—	—	—	Yes	0.2-2.0
Sweden	30	30	—	—	—	No	1.5-3
Switzerland	0	0	—	—	—	—	0.118-0.711
Turkey	50	27	—	—	—	No	—
United Kingdom	40	33	—	—	—	Yes	—
United States	36	31	—	—	—	No	—

Source: OECD. Taxing Profits in a Global Economy(Paris, 1991). Adapted from Tables 3.21 and 3.22, pp. 80-81.

^1/Minority shareholders in quoted companies.

^2/The tax base varies substantially across countries.

View Table

Table 6.

Tax Rates on Capital Gains, ^1/ and Nat Wealth ^2/ of Individuals

	First Period			Second Period		Base
	Top Rata	Average marginal rate	Length of First Period	Top Rate	Average marginal rate	Indexation of Capital Gains	Tax on Net Wealth of Individuals
Australia	48.3	39	—	—	—	Yes	—
Austria	50	39.7	1	0	0	—	1
Belgium	0	0	—	—	—	—	—
Canada	36.8	10.5	—	—	—	No	—
Denmark	57.8	51.1	3	0	0	No	1
Finland	60	55	5	30	2	No	0.9
France	18.1	0	—	—	—	No	0.5-1.5
Germany	0	0	—	—	—	—	0.5
Greece	0	0	—	—	—	—	—
Iceland	39.8	20	—	—	—	Yes	1.2-2.2
Ireland	50	50	3	35	35	Yes	—
Italy	25	25	—	—	—	—	—
Japan	20	20	—	—	—	—	—
Luxembourg	0	0	—	—	—	—	0.5
Netherlands	0	0	—	—	—	—	0.8
New Zealand	0	0	—	—	—	—	—
Norway	AO	40	3	0	0	No	1-2.3
Portugal	10	10	2	0	0	No	—
Spain	56	31.5	—	—	—	Yes	0.2-2.0
Sweden	30	30	—	—	—	No	1.5-3
Switzerland	0	0	—	—	—	—	0.118-0.711
Turkey	50	27	—	—	—	No	—
United Kingdom	40	33	—	—	—	Yes	—
United States	36	31	—	—	—	No	—

Source: OECD. Taxing Profits in a Global Economy(Paris, 1991). Adapted from Tables 3.21 and 3.22, pp. 80-81.

^1/Minority shareholders in quoted companies.

^2/The tax base varies substantially across countries.

The main message conveyed by these tables is the great diversity (in quantitative terms) in the treatment of incomes from financial assets. In this area the international playing field is far from level. Take the tax on dividends for example. The top rate varies from 10 percent in Turkey to 60 percent in Finland and the Netherlands. For the G-7 countries the range is from 35 percent for Japan to 57.9 percent for France. Interestingly, the tax on corporate income raises much more revenue in Japan than in France. The range is reduced somewhat if instead of looking at the top rate we consider the average marginal rate but it is still very wide.

An even wider-range is found in the top tax rates on interest income which range from zero in Iceland to 60 percent in the Netherlands. For the G-7 countries, the range is from 18.1 percent in France to 53 percent in Germany. If the average marginal tax rate is taken, the range is reduced somewhat but it still remains very wide. As indicated earlier, many countries withhold taxes on interest and dividends at rates that in many cases become final rates. These are also shown in Table 5. Once again, the most striking aspect is the unevenness of the international playing field.

Table 6 gives some information on the statutory treatment of capital gains and of net wealth. The table is largely self-explanatory. Here, in relative terms, the differences among countries are even greater than in the previous table. Some important countries (Germany, Belgium, Netherlands) do not tax capital gains (but Germany and the Netherlands tax net wealth). Some tax capital gains as if they were regular incomes; and some impose preferential rates on these incomes. Furthermore, a few countries make a distinction between short-term and long-term capital gains giving preferential treatment to long-term gains. The distinction between short-and long-term varies from one to five years. Finally, some countries attempt to remove the inflationary component of capital gains by indexing the acquisition cost.

Table 6 shows also that several countries tax the net wealth of individuals with rates that vary from 0.2 percent to 3 percent. These rates, however, are applied to tax bases that diverge significantly either because of different exemption limits or because some wealth is not (or cannot be) taxed.

1. Summary measures of the impact of taxes

A seminal comparison of the structure and level of taxes on capital income in the United States, the United Kingdom, Sweden and Germany was undertaken in the early 1980s by King and Fullerton (1984). The focus of this study was on income originating in the corporate sector. Its measure of the impact of taxes was the overall “tax wedge” between pre- and post-tax returns to the saver (i.e., p - s, using the notation in expression (1) above); or—equivalently—an “effective tax rate” which expresses the tax wedge as a proportion of the pre-tax return:

The King-Fullerton study employed a broad framework, in which this effective tax rate was measured for 81 corporate investment projects. These consisted of investments in three assets (machinery, buildings, and stocks), in three sectors (manufacturing, “other industry”, and commerce), financed in three ways (by new share issues, retained earnings, and debt), with funds supplied by three kinds of “savers” (individuals, pension funds and insurance companies). The same framework has since been used to compare patterns of effective tax rates in a large number of other countries, and to examine how those rates changed in the course of the 1980s. ^9/

Subsequent studies have developed the original framework in several ways. First, they have extended it to cover other forms of capital income, such as income from self-employment, and from investment in housing. Secondly, the King-Fullerton tax wedges and effective tax rates have been disaggregated in some comparative studies into separate components that relate to the corporate and personal tax systems, and effective corporate tax rates have been compared for cross-border as well as domestic investment flows. ^10/ Thirdly, some studies in individual countries have modified the framework in order to make more realistic comparisons of the tax regime for different savings media—by, for example, including transactions taxes such as stamp duties in the analysis, incorporating income from government securities, and treating pension funds and insurance companies as intermediaries rather than as “savers” (as they appeared in the original King-Fullerton study). ^11/

In spite of the refinement mentioned above, the results of the King and Fullerton methodology remain highly fragile with respect to assumptions and information. They are, for example, very sensitive to assumptions about the rate of inflation and about the many exceptions that are common in the tax laws. Those who have tried to apply that method have often remarked on that fragility.

2. Market responses: capitalization and arbitrage

In spite of their limitations, these analytical frameworks can provide useful summaries of the effective tax rates, in a simple numerical form, of the complex tax structures that apply to different types of saving or capital income. There is, however, a potentially serious conception problem with methods such as that typified by King and Fullerton. The problem is that the summaries that are obtained are “ex ante” summaries. Except under very strict and unrealistic assumptions, they do not show how the post-tax rates of return on different assets will vary as a result of the imposition of these taxes. In practice, one should expect that wide differences in effective tax rates for different kinds of asset, as summarized in these studies, are likely to give rise to some offsetting market forces.

For example, suppose that the effective tax rate on an asset such as government debt is increased. In the first instance, this change will make the asset less attractive than others for individuals or companies to hold. As a consequence, they would immediately tend to avoid this asset just as consumers avoid a product that has been subject to a high tax. In equilibrium, however, the outstanding amount of debt must still be held, in aggregate; what will happen is that its pre-tax return must rise to compensate for the higher effective tax rate. ^12/ If the government wants to tax government bonds, it must be willing to adjust the gross yield to induce savers to keep buying those bonds. ^13/ That tax rate increase will, therefore, tend to be capitalized into the price of the debt, resulting in a capital loss for existing holders of the asset—but offsetting at least some part of the decline in their prospective net return.

This capitalization mechanism has sometimes been used to justify tax exemptions for certain types of government securities (or a practice of issuing low-coupon stock whose yield takes the form of lightly-taxed capital gain rather than fully-taxed income): it is sometimes argued that the cost of funds to the government is not affected, since the tax concession will be offset by a higher issue price. This argument, however, might be valid in a world in which all savers were subject to tax at the same rate. However, when taxpayers are subject to different rates of tax, an asset whose yield is tax-favored will be relatively more attractive than other assets to those who are subject to tax at the higher rates. For example, in the United States the fact that municipal bonds are free of federal income tax have made them a favorite habitat for high income taxpayers subject to marginal tax rates higher than the yield difference between taxed and untaxed bonds. Those in different tax rate brackets will then tend to specialize in assets with different tax characteristics, and capitalization will not be complete. ^14/ Some of the benefit of tax concessions will, thus, remain with those individuals and institutions that hold the favored securities. That benefit will be enjoyed at the expense of the government’s revenues.

Variations in tax rates—both between individuals (or organizations), and between different types of asset and between different countries—create opportunities for more complex market responses, in the form of “tax arbitrage”. Such arbitrage is likely to occur, for example, when interest that is paid on borrowing to finance the acquisition of an asset can be deducted at a higher rate than the taxpayer must pay on income from the asset itself. ^15/ This has been especially the case with respect to housing since in some countries (i.e., the United States) interest payments on a mortgage are fully deductible from the regular income of the individual while the return to housing is not taxed unless the house is rented. In addition, markets may find ways to transfer tax deductions from those liable to low tax rates to those liable at higher rates, and to transfer tax liabilities in the opposite direction. The development of the finance leasing industry, particularly in the USA and the UK in the early 1980s, provides a striking illustration of this process.

The general result of these market responses is that tax rates on different forms of capital income, and incomes from different financial assets in particular, do not rest where they are placed by the formal tax structure. There is likely to be a general tendency for returns to different forms of financial asset to be equalized, in net-of-tax terms; and those individuals who are subject to higher formal rates of tax are likely to be able to escape, through tax arbitrage, at least some part of the burden that the tax structure seeks to impose on them.

1. Criteria

The fundamental issue that arises in appraising a tax structure for financial assets is the appropriate standard to apply.

The simplest approach would be to adopt, as a criterion, an “ideal” standard such as the comprehensive taxation of individual incomes, as developed in the late 19th and early 20th centuries by theorists such as Schantz, Haig and Simons. This defines the appropriate object of income taxation during a particular period as:

the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question. In other words, it is merely the result obtained by adding consumption during the period to ‘wealth’ at the end of the period and then subtracting ‘wealth’ at the beginning. ^16/

One major virtue of this approach is that, under simplified circumstances, clear and reasonably straightforward implications can be drawn about particular tax arrangements, and about the appropriate structure of effective tax rates on different sorts of financial assets. ^17/ For example, application of this standard leads directly to the conclusions that accruing capital gains should be subject to tax at the same rate as cash incomes, and that there should be no distinction in tax treatment between debt and equity incomes.

A disadvantage of the approach, however, is the exclusive emphasis of the Schantz-Haig-Simons standard on considerations of horizontal equity, and its neglect of other traditional criteria for appraising tax systems—such as simplicity and transparency, economic efficiency, and administrative feasibility. Attempts to design a tax system for financial assets on the basis of this standard usually founder on the practical impossibility of measuring and taxing all individual capital gains consistently, on an annual accrual basis.

Quite apart from the question of whether values are always known, in order to determine tax liabilities, one would face the problem that the payment of taxes may require the conversion of illiquid into liquid assets. Thus, conversion may (a) involve major transaction costs; and (b) when the operations required are large, may reduce the ex post size of the accrued income compared with the ex ante size.

A further problem with the Schantz-Haig-Simons standard, despite its considerable intuitive appeal, is that its implications do not always accord with popular notions of “fiscal equity”. One important example of the difference arises in the case of capital gains taxation. ^18/ For practical reasons, many gains are subjected to tax only when they are realized in a disposal of the asset. Application of the standard then implies that the taxpayer enjoys a benefit from the “deferral” of his tax liability, from the time that the gain originally accrued. This benefit will usually be greater, the longer is the period since the asset was originally acquired. ^19/ Some schemes that appear reasonably practicable have been proposed to compensate for this deferral advantage. ^20/ In practice, however, no government has yet adopted a scheme of this kind. On the contrary: many countries that tax capital gains apply a lower tax rate, or exempt the gain from tax altogether, when the asset has been held for more than a certain number of years (see Tanzi (1980), especially Chapter 4).

An alternative to an approach based on the Schantz-Haig-Simons standard is to apply results drawn from theories of “optimal” taxation. Such theories seek to combine considerations of economic efficiency with those of distributional equity. At a rather general level, they can often provide useful insights on particular issues. But, while they have proved helpful in clarifying some of the trade-offs that have to be made in designing or modifying tax systems, optimal tax theories do not provide a basis for clear and detailed recommendations about the appropriate provisions of those systems. In addition, these theories suffer—perhaps even more than the Schantz-Haig-Simons standard—from their general neglect of considerations of administrative feasibility.

For the purposes of this paper, therefore, a rather more eclectic approach seems appropriate. A variety of different criteria are applied in the brief discussions that follow, of some of the major issues that arise in the area of financial asset taxation.

2. The appropriate tax rate

Should incomes from capital be taxed at the same rates as labor income? An application of the Schantz-Haig-Simons standard provides an unambiguous “yes” as an answer to this question. For each individual, the tax computation should be based on “global” income from all sources, so that the same marginal rate will apply to every source—though that rate could differ between individuals depending on their income level and their family situation. ^21/ Optimal tax theories, on the other hand, suggest the opposite answer. On certain assumptions about individual preferences between leisure, present consumption, and future consumption, the optimal tax rate on capital income in some simple models is zero ^22/. More generally, different optimal tax rates on the two forms of income emerge from these analyses, according to the parameters of the particular model employed. ^23/

In the theoretical literature of recent years, it has often been concluded that a reduction in the rate of return to saving would reduce the saving rate and thus reduce capital accumulation and, eventually, the rate of growth. The view has been that the taxation of labor has no, or, at least, less negative effects on labor effort and thus on economic efficiency. The theoretical conclusions received a powerful and, at the time, politically important boost from an article by Michael Boskin (1978) that concluded, from empirical analysis, that the elasticity of aggregate personal saving with respect to the net-of-tax rate of return is considerable. Therefore, savings should not be taxed; or, at least, it should be taxed at lower rates than labor.

There are two problems with the Boskin conclusions. First, his results have not been duplicated by others. Second, it ignores a powerful trend now affecting mature economies. This is the fact that financial assets are often disproportionately owned by senior citizens who, according to the life-cycle theory of consumption, have a much higher propensity to consume than younger ones. As a consequence, if the taxes on capital income were reduced, and this reduction resulted in a higher rate of return to financial saving, the rate of saving for a country could fall because the major beneficiaries would be senior citizens who would consume a high proportion of the extra income. ^24/

Even when equity considerations are predominant, some arguments may be presented for taxing capital and labor incomes at different rates. For example, the UK levies its personal income tax on the combined total of labor and capital income, but until 1984 a surcharge was imposed on capital incomes. Two main types of justification were offered for this surcharge. First, it was argued that extra costs—for example, in time and effort—are expended in acquiring labor income, and that it is appropriate on equity grounds that the tax system should recognize these differential costs. Secondly, the surcharge was sometimes defended as a rough form of compensation for the fact that labor income is subject in the United Kingdom—as in most OECD countries—not only to personal income tax, but also to social security contributions. ^25/

The late 1970s and 1980s saw rapidly increasing recognition in most countries of the fact that high inflation rates in that period, in combination with unindexed income tax systems, could result in very high effective tax rates on certain sorts of capital income—but also that particular arrangements (such as those that most countries apply to savings through personal pension funds or savings channeled toward housing) could result in effective tax rates that were zero, or even negative. ^26/ In these circumstances, discussions of the appropriate relative tax rates for capital income on the one hand and labor income on the other began to seem rather far removed from practical realities. A more immediate issue was whether the tax treatments of capital incomes should and could be rationalized, so that these incomes would all be taxed in a transparent manner at the same effective rate for each individual taxpayer. This inevitably called attention to the need to adjust tax bases to remove the effect of inflation.

In discussions of this issue, the main focus of the arguments has been on considerations of economic efficiency and practical feasibility, rather than equity. The operation of financial markets is distorted by tax treatments that differ between primary financial assets (such as debt and equity), or according to the nature of the intermediation between the saver and the ultimate borrower of funds. These distortions typically lack any clear rationale. They may, on the other hand, entail significant economic costs. For example, a tax bias in favor of debt financing of corporations is likely to increase the incidence and risk of bankruptcies. Preferential treatment of savings flowing through intermediaries such as pension funds and insurance companies is likely to increase the power of those institutions in financial markets; this may result in a loss of flexibility, and perhaps—some have argued—in an excessive concern on the part of these markets with “short term” returns, at the expense of longer term investment performance (see Summers and Summers, 1989). ^27/

3. Taxing capital gains

In a similar way, in recent debates over whether capital gains should be subject to tax, considerations of economic efficiency have tended to predominate over more traditional arguments based on considerations of fiscal equity. Financial markets provide many ways in which cash incomes can be converted into increases in the value of an asset. When the two are not subject to tax at the same effective rate, savings flows are distorted, and revenue is lost to the government.

On the other hand, to tax capital gains at the time of realization—which in many cases is the only time at which they can in practice be brought into tax—can damage efficiency by discouraging transactions in assets, tending to “lock in” savers to their existing portfolios. (A similar argument against taxes on asset transfers, such as stamp duties, has been common in the tax literature for almost two centuries. ^28/) Further practical arguments against the taxation of capital gains arise from its administrative complexities, particularly when the tax base is appropriately adjusted for inflation. Outside of the United States, taxes on capital gains yield little revenue directly, and some countries (such as the Netherlands and New Zealand) have concluded that this yield would be insufficient to compensate for the administrative costs and market distortions associated with such a tax.

4. Adjustments for inflation

Inflation distorts the measurement of capital income from both real and financial assets. When rates of inflation accelerated sharply in OECD countries in the 1970s, the nature of these distortions was thoroughly explored in the literature. The appropriate methods of “capital income, or tax base, adjustment” for tax purposes are now widely known—and, in principle at least, reasonably non-controversial. ^29/ For present purposes, the important point is that unadjusted income measures result in distortions to effective tax rates that differ substantially for different financial assets. In many cases, the appropriate adjustment will convert a positive nominal income or capital gain into a negative amount; it will also result in gains being measured on financial liabilities, when those liabilities are fixed in nominal terms.

Studies of effective tax rates on different forms of capital income invariably find that they are highly sensitive to inflation. Changes in those effective tax rates over time, therefore, generally owe as much to changes in the rate of inflation as they do to changes in the formal tax structure. ^30/

1. Integration of corporate and personal income taxes

Over a period of two decades, from the mid-1960s to the mid-1980s, changes were made to the corporate tax systems of many OECD countries with the objective of reducing the greater tax burden on distributed profits than on retained profits, which is inherent in a “classical” corporate tax system. ^32/ Since the mid-1980s several more countries (including Australia, Finland, New Zealand and Turkey) have also moved from classical systems to systems with some form of relief for distributed profits. But other countries (including Japan, Belgium and Denmark) have moved back towards classical systems: these countries now provide a measure of relief for distributed profits by means of a separate, schedular rate for dividend income rather than in the form of a tax credit for corporate tax paid, or a lower tax rate at the corporate level. The general trend in OECD countries away from classical corporate tax systems, and towards greater integration of corporate and personal income tax, thus seems rather less clear than it used to be.

2. Capital gains

On the other hand, the gradual but fairly steady trend in OECD countries for personal income taxes to be extended to capital gains, and for effective tax rates on gains to be raised towards income tax levels, has continued in the last few years—with the introduction of new taxes on capital gains in Australia (1985) and Italy (1991), and significant increases in effective rates in the US (1986) and Canada (1987).

3. Deductions for interest

As Tables 1-4 show, a majority of OECD countries still allow a deduction under their personal income taxes for interest payments on some types of borrowing. However, for several decades there has been a slow but steady tendency for such deductions to be restricted or eliminated, primarily because of the arbitrage opportunities which they create. In the course of the last ten years this trend has continued, with new restrictions on interest deductions being introduced in Denmark, Ireland, New Zealand, Sweden and the US. ^33/

4. Final withholding

A number of countries have recently introduced or extended withholding taxes on income from different sorts of financial assets, with the aim of improving the collection of tax that was theoretically due but often unpaid. In several countries, withholding has led to a sharp increase in revenue. The experience has not always been favorable, however. For example, in 1988 Germany introduced a withholding tax on interest paid to residents, but abandoned it shortly afterwards as a result of the shifting of deposits to neighboring countries. The tax was reintroduced at the beginning of 1993, but appears to be yielding less revenue than had been expected.

Many of these new taxes are final withholding taxes, which remove the source of income from the ambit of progressive personal income tax. Some examples of such taxes on dividend incomes have already been cited; Japan’s 20 percent withholding tax on interest, introduced in 1988, is a further example. The apparent willingness of a number of OECD countries to take certain forms of capital income out of the scope of their progressive personal income tax may represent a significant change of direction. Hitherto, in major income tax reforms undertaken in OECD countries (such as Belgium in 1963, Italy in 1973, Spain in 1978 and Portugal in 1989), it has appeared that changes have been consistently in the direction of converting “schedular” into “global” systems.

5. Savings for retirement

As shown in Section II, the tax treatment of private pension arrangements in most OECD countries can be seen as generous: the provision of income tax relief for contributions paid to pension funds, in combination with the absence of tax on income or gains earned by the funds, has been criticized as “a massive tax deferment mechanism”. ^34/ These arrangements have, however, developed with remarkable consistency in different countries since the early years of this century. It does not appear to offend against popular conceptions of equity, that income tax systems should be designed—in effect—to allow individuals to spread forward an appropriate portion of their taxable earnings, from their years of employment, to their expected years of retirement. Thus, while recent tax reforms in the US and Canada in 1986-87 did introduce tighter restrictions on deductions for retirement savings, the structure of tax arrangements for private pension contributions, pension funds and pensions has generally been left untouched in the process of income tax base-broadening.

6. Inflation adjustment

During the 1970s and early 1980s many OECD countries introduced provisions to index the thresholds and brackets of their income tax schedules—though in some cases the provisions were subsequently dropped, as the tide of inflation receded. The number of countries that tackled the more difficult problem of capital income adjustment was much smaller. Individuals’ capital gains on financial assets are now indexed for tax purposes in Australia, Ireland, Luxembourg, Spain and the United Kingdom. Rather more countries introduced inflation adjustments of an ad hoc kind into their business tax systems, but some of these partial adjustments were swept away in the base-broadening reforms of the later 1980s. Only in Latin America, with its relatively high inflation rates, have there been systematic attempts to adjust capital incomes in a comprehensive manner—including appropriate adjustments for financial assets and liabilities.

7. Future prospects for the taxation of financial assets

The simplest way to predict the future is to extrapolate from the past. On that basis, the prospects for systematic reform that will tackle the many present inconsistencies and complexities in the tax treatment of financial assets do not appear bright. A more likely scenario is that ad hoc changes will continue to be made from time to time in particular areas—sometimes for specific domestic reasons, sometimes in response to developments in other countries or in the slow process of EC harmonization, and very occasionally, perhaps, as a result of the gradual encroachment of the ideas of “academic scribblers”. ^35/ Financial markets will continue to devise new instruments at a faster rate than governments can prescribe appropriate income tax treatments, and the length and complexity of the relevant legislation will inexorably increase.

All of this will be made considerably more complicated by the globalization of the financial market that will provide ample opportunities for arbitrage on an international scale. ^36/ Increasing liberalization of foreign exchange arrangements, and the associated rapid growth in international capital movements, will make the principle of taxing capital incomes on a residence basis increasingly difficult to apply. Although cooperation between national tax authorities in the exchange of information can be expected to increase, the appropriate tax liability on incomes with a foreign source is likely, nevertheless, to become steadily more difficult for national authorities to assess. At the same time, the taxation of those incomes in their source countries will continue to be eroded by rising competition for foreign capital, and also by the practical difficulties of effectively measuring the income of enterprises whose activities span national frontiers. National tax authorities will, increasingly, be tempted to adopt ad hoc approaches that effectively convert taxes on capital income into something different (for instance, applying “formula apportionment” to the worldwide reported incomes of international companies).

There may, perhaps, be attempts to stem the resulting “degradation” of capital income taxation in other ways—for instance, by new international or regional agreements to limit the scale of investment incentives, or to establish minimum levels of withholding taxes or taxes on corporate income. There seems little reason to expect, however, that such attempts will prove more effective in the future than in the past.

And yet one might also detect, in the above sketch of some relevant trends, the outlines of an alternative scenario. In a number of countries, flat-rate taxes are now imposed on capital incomes, or particular sorts of capital incomes. Often, this arrangement is seen as a second-best approach that is defensible only on grounds of practical administrative feasibility; but a case can be made for such flat-rate taxes on grounds of economic efficiency and horizontal equity as well (see Sorensen (1994); and Tanzi (1995)). Where this case is accepted, such taxes could be confined to the original sources of the incomes to which financial assets constitute a claim, such as corporate profits. ^37/ The assets and liabilities themselves could then be removed entirely from the ambit of income taxes. Transparency would be improved, and complexity dramatically reduced.