THEORETICAL PERSPECTIVES ON THE TAXATION OF CAPITAL INCOME AND FINANCIAL SERVICES: A SURVEY

Transcription

1 Chaper 2 THEORETICAL PERSPECTIVES ON THE TAXATION OF CAPITAL INCOME AND FINANCIAL SERVICES: A SURVEY Robin Boadway and Michael Keen* *We are graeful o Alan Auerbach, Parick Honohan and conference paricipans for many helpful commens. Views expressed here are hose of he auhors, and should no be aribued o he Inernaional Moneary Fund.

2 - 2 - I. INTRODUCTION The financial secor is he proximae source of mos capial income, and makes is living by providing financial services of various kinds. Thus he ax reamen of capial income and financial services shape he environmen wihin which financial inermediaion occurs. The level and manner in which capial income is axed is clearly likely o affec, for insance, he exen and form of financial inermediaion; and he reamen of financial services will impac direcly he provision of such services. The purpose of his chaper is herefore o provide a broad background for he wider discussion of financial inermediaion in his book by reviewing wha is known abou a leas some cenral aspecs of he opimal axaion of capial income and financial services. While he axaion of capial income and (perhaps o a lesser, bu neverheless increasing, exen) of financial services are recurren policy concerns in many counries, formal heoreical analyses have ofen focused more on he posiive effecs of axaion han on he design of opimal policy. Thus he erriory of his chaper is a once dauningly large and largely unexplored. For boh reasons, he reamen is selecive and, perhaps, eclecic. If here is a heme running hrough he selecion of opics here, i is ha of addressing wo srands of hough o be found in he opimal ax lieraure which, if acceped, would have profound implicaions for he ax reamen of financial aciviies: hese are he views ha capial income should no be axed, and nor should financial services. The chaper hus sars by reviewing he lessons of heory for he opimal axaion of capial income (Secion II), he cenral issue being wheher capial income should be axed a all. This is clearly a pivoal quesion in hinking abou he axaion of financial aciviies: if i is no opimal o ax (or subsidize) capial income, hen he main raionale for axing he income associaed wih financial ransacions becomes he pracical one of bolsering he axaion of labor income (or consumpion). Secion III addresses he issues raised for he opimal design of axes on capial income assuming ha such axes are indeed desired ha have been highlighed by financial innovaion in recen years. Finally, Secion IV addresses he more paricular, bu policy relevan, quesion of wheher, and if so a wha rae and (more briefly) how, he services of financial inermediaries should be subjec o commodiy axaion. Secion V concludes wih a discussion of some of he caveas and limiaions of he discussion here, some of which are addressed elsewhere in his volume. II. THE OPTIMAL TAXATION OF CAPITAL INCOME Whaever is underlying source, capial income generally arises as he reurn on a financial asse as ineres paid on a bank deposi, for example, or as capial gains on share in a company. The ax reamen of capial income a cenral feaure of any ax sysem hus plays a poenially key role in shaping he fiscal environmen wihin which he financial sysem operaions. This secion ses ou some of he key issues, and coninuing conroversies, relaed o he axaion of capial income. We sar by considering he axaion of capial income a household level, and hen urn o is axaion a business level. Two caveas common o all he models discussed should be sressed a he ouse. Firs, all assume ha he governmen can commi o he fuure pah of ax raes ignore he fundamenal

3 - 3 - ime inconsisency problem ha arises in he axaion of capial income, and so ignore a ime consisen problem ha is inheren o ax design in he presence of capial accumulaion. This poin is aken up below. Second, i is also assumed hroughou ha he governmen is unresriced oher han by is ineremporal budge consrain in is abiliy o issue deb. This effecively uncouples he pah of capial accumulaion from privae savings decisions: if he laer would oherwise imply oo rapid an addiion o he capial sock, he governmen can soak up he excess by selling deb; if i implies excessively slow accumulaion, he governmen iself supply funds o finance invesmen. The cenral concern in axing capial income is hen o bring abou he minimum disorion of lifeime consumpion and labor supply decisions consisen wih he governmen s ineremporal revenue needs. A. The Opimal Taxaion of Household Capial Income There is a large lieraure on he opimaliy of axing capial income or of no axing i. Resuls depend on he ype of model being used, and he assumpions underlying he insrumens and informaion ha is available o he governmen. The analysis is necessarily dynamic in naure, since capial income is generaed from asses ha by definiion las for more han one period. This in iself no only makes he analysis more complicaed, bu also raises fundamenal issues abou how o model dynamic economies. Especially imporan in his regard is he reamen of bequess. The exreme cases of relevance are he infinie-lived dynasic model in which bequess are fully operaive and agens are perfecly farsighed and he overlapping-generaions (OLG) model in which here are no bequess. An imporan disincion beween hese wo cases lies in he ease wih which hey can accommodae heerogeneous households. In he dynasic model, each cohor is generally and naurally (hough no inescapably) formulaed as being a single represenaive agen, so he opimal ax problem adops he classical Ramsey formulaion. The OLG model is beer able o handle heerogeneiy of he sor ha mos relevan for inroducing redisribuive concerns. To address hese issues, his secion sars by considering he proper role of capial income axaion in he hree main cases considered in he lieraure: an economy comprising only one ype of individual, who lives for only wo periods; he Ramsey growh model of a single infiniely lived individual or dynasy; and an OLG model. A large par of he purpose here is o clarify he links beween, and common inuiion behind, he resuls from hese differen models. The discussion hen urns o he case in which agens differ in heir earnings capaciy (so ha capial income axaion may have a redisribuional role across income groups), o he effecs of resricions on he insrumens and informaion available o governmen and, finally, o he ime consisency issue. Homogeneous households We summarize he resuls for he wo exreme ypes of models wih heerogeneous households he infinie-lived represenaive agen model of Ramsey, and he OLG model wih a represenaive agen in each cohor. Our discussion draws on he recen review by Erosa and Gervais (2001, 2002).

4 - 4 - Benchmark wo-period case To fix ideas, i is useful o sar wih he simple case of opimal ax design in he conex of a single individual (or a number of idenical individuals) who lives for only wo periods, consuming and supplying labor in each. Though arificial he governmen could in his case employ a nondisoring poll ax his proves useful in undersanding he resuls from (somewha) more realisic conexs below. Suppose hen ha our consumer seeks o maximize lifeime uiliy U ( C1, C2, L1, L2 ), where C and L denoe respecively consumpion and labor in period. Allowing for a full range of ax raes, his opimizaion is subjec o a lifeime budge consrain: (1 + τ c2 ) p2c2 (1 τ w2 ) w2l2 (1 + τ c1) p1c1 + = (1 τ ) w 1 1L w 1 + (2.1) (1 + (1 τ ) R) (1 + (1 τ ) R) r where R is he pre-ax ineres rae, he p and w are pre-ax commodiy prices and wage raes, and, imporanly, boh consumpion ax raes τ C and labor ax raes τ w may vary over ime. The governmen chooses hese ax raes o maximize he consumer s uiliy subjec o raising some fixed presen value of ax revenue (so ha we implicily assume deb policy o be unconsrained oher han by long-erm solvency). A number of observaions follow from his simple srucure. Firs, alhough (2.1) allows for five ax insrumens wo on consumpion, wo on labor and he capial income ax here is no loss of generaliy in resricing aenion o any hree of hese, seing he oher o zero. This is because here is no loss of generaliy in ax models of his kind in aking some good o be unaxed numéraire; and, moreover, since he effec of he capial income ax is o disor ineremporal prices, his can be achieved by insead inducing appropriae ime variaion in he oher axes. Inuiively, wih only four commodiies here is no gain in deploying any more han hree axes. Thus here is no loss of generaliy is supposing, for example, ha he governmen can deploy only he wo labor axes and he capial income ax, so ha he consumer s budge consrain is simply: 1 p C + p2c2 (1 τ w2 ) w2l2 = (1 τ ) w1 L1 + w (1 + (1 τ ) R) (1 + (1 τ ) ) (2.2) r r R Clearly he disincive role of he capial income ax is in is effec on prices across periods, having no effec on relaive wihin-period prices. r 1 This can be seen by noing ha (2.1) is equivalen o (2.2) wih τ r, τ w1 and τ w2 in he laer replaced by * r ( 1+ (1 τ ) r)( 1+ τ ) 1 r c1 = 1 1 τ r 1+ τ c2 τ, * w1 1 τ τ = 1 τ w1 * w2 = 1 and w τ c1 1 + τ c2

5 - 5 - Second, having chosen insrumens in his way, he quesion of wheher or no capial income should be axed reduces o he quesion of wheher or no a paricular pair of commodiies should be axed a he same rae. In (2.2), for insance, i can be seen ha he key effec of he capial income ax is o disor he relaive price of consumpion in he wo periods. If, herefore, i is opimal o ax consumpion in he wo periods a he same rae, hen i is opimal no o ax capial income. The usefulness of his is ha i enables one o invoke esablished resuls on he desirabiliy of uniform axaion wihin subses of groups. Wriing he expendiure funcion for he consumer s opimizaion as * * * * E( p1, p2, w1, w2, u), where he aserisks indicae ax-inclusive presen value prices, i is opimal o ax boh consumpion goods a he same rae and hence no o ax capial income given opimal axaion of labor income in boh periods, if he expendiure funcion akes he implicily separable form 2 * * * * E( A( p1, p2, u), w1, w2, u) for some funcion A(.). 3 A sufficien condiion for his is ha he direc uiliy funcion ake he form U φ( C, C ), L, ), wih φ(.) homogeneous of degree one. ( L2 Third, an implicaion of he preceding observaion is ha he answer o he quesion of wheher or no i is opimal o ax capial income or, more generally, he opimal value of r depends on he assumpion made as o which oher axes may be levied. If, for insance, one insead allows for axes on consumpion in each period as well as on capial income, he opimal rae of capial income axaion will be zero if i is opimal o ax labor in he wo periods a he same rae. And for his i is sufficien whaever he paern of pre-ax prices (meaning, in paricular, whaever he pre-ax ineres rae) ha he expendiure funcion * * * * akes he form E ( p1, p2, B( w1, w2, u), u). I may seem surprising ha wheher or no one wishes o ax capial income urns on wha is in effec merely a normalizaion, since clearly he allocaion of resource brough abou by he opimal ax sysem does no depends on wha is an essenially arbirary choice of insrumens. The poin is, however, ha he reamen of capial income required o bring abou ha allocaion depends on he range of insrumen s deployed. Suppose, for insance, ha preferences are such ha uniform axaion of consumpion in he wo periods is opimal, bu ha he only insrumens available are he wo axes on consumpion and he capial income ax. If he capial income ax rae is hen se o zero, uniform axaion of C1 and C2 hen effecively leaves he relaive prices of labor in he wo periods undisored; which is no in general opimal. Fourh, he opimal ax problem has a paricularly simple soluion if preferences are addiively separable over ime, so ha U ( C1, C2, L1, L2 ) = U ( C1, L1 ) + βu ( C2, L2 ), (wih β > 0 being a discoun facor) a form of separabiliy quie disinc from he implici 2 This is essenially a generalizaion of ha of King (1980) and Akinson and Sandmo (1980) for he special case of a wo period life cycle wih labor supply only in he firs period (which is in urn essenially an applicaion of Corle and Hague (1953): if leisure is equally subsiuable for firs and second period consumpion, and if he governmen is free o issue deb as well as ax labor and capial income, here is no role for capial income axaion. 3 See Deaon (1979). Besley and Jewi (1995) derive a more general sufficien condiion on preferences for uniform axaion o be opimal.

6 - 6 - separabiliy of he second observaion above and, moreover, he discoun facor happens o equal he pre-ax ineres rae (so ha β = 1/(1 + R) ). In his case, i is opimal whaever he choice of insrumen se no o ax capial income. Moreover, boh consumpion and labor supply are consan over ime a he opimum, and hose axes which are deployed (on firs and second period consumpion, for insance) are opimally ime invarian. 4 A converse observaion is also useful: if preference are of his ineremporally separable form and he opimum is a seady sae in consumpion and labor, hen ha opimal ax sysem has capial income unaxed and oher ax raes ime-invarian. (All his is proved in an Appendix ). The inuiion is simply ha, as is well known, hese preferences combined, criically, wih an equaliy beween he discoun and ineres raes imply ha in he absence of ax he consumer would keep boh consumpion and labor consan over he life-cycle. In effec, consumpion and labor are essenially idenical commodiies in absence of axaion, and here is hen no gain, when i comes o designing an inherenly disoring ax sysem, from reaing hem differenly wihin periods or o disor decisions beween hem over ime. I should be noed ha he sufficien condiions for i be opimal no o ax capial jus described are more resricive han he implici separabiliy condiion above in he sense ha i also requires a foruious coincidence beween pre-ax prices (he ineres rae) and preferences (he consumer s discoun rae). Neverheless, his case has a paricular imporance in his lieraure: once one moves ou of he wo-period case ino he realm of growh heory, aenion naurally focuses on opimal axaion in seady saes. The Ramsey growh model A naural exension of he wo period case jus addressed is o ha of he infiniely lived individual, In he simples version of his case, he represenaive agen s ineremporal uiliy funcion is of he addiively separable form: ( C L ) β U,. (2.3) =0 Suppose, as in he classic paper by Chamley (1986), ha he governmen uses wage and capial income axaion only. Noe ha, since here are in effec infiniely many goods, his does involve some loss of generaliy; he usefulness of adding consumpion axaion o he policy menu is reaed below. The household faces a per-period budge consrain: C + A + 1+ ( r ) A 1 = w L + (2.4) where w and r are he afer-ax wage and ineres rae, and a is he level of household asses. The represenaive household maximizes (2.3) subjec o (2.4), aking he fuure pah of prices o be given. This yields he sream of household choices C ( w, r ), L ( w, r ) (and A w, r ).Per period aggregae producion is given by a consan reurns o scale hus ( ) producion funcion Y F( K, L ) =, where K is he capial sock in period, which 4 More precisely, he firs-order condiions characerizing an opimal ax sysem are saisfied along a growh pah of he ype jus described. The claims in his paragraph are proved in an Appendix.

7 - 7 - depreciaes a rae δ. Denoing he (exogenous) sream of governmen expendiures by he economy s resource consrain is: ( 1 ) K + G Y C + K + 1 δ = (2.5) Before-ax facor prices are deermined compeiively by he relevan marginal produciviy condiions: F k δ = r, Fl = w. Leing B be he public deb a ime, he per period governmen budge consrain is given by: r A + τ w L = 1 ( + R ) B G B τ + (2.6) where τ r = r r and τ w = w w are he per uni capial and labor income ax raes. 5 By Walras Law, one of (2.3) and (2.4) is redundan. Deleing he former, he planner s problem is hen o: G, w Max τ, τ, b r = 0 β U ( C ( w, r ), L ( w, r )) s.. (2.4) (2.7) Chamley (1986) shows ha he soluion o his problem has a sriking propery, and one ha has become exremely influenial: 6 if he Ramsey soluion converges o he seady sae wih consan consumpion and labor supplies, hen he opimal ax on capial income will go o zero. Inuiively, his can be seen as a generalizaion of he resul for he wo-period case noed above: if consumpion and labor do no change over ime, here is no gain from disoring he ineremporal dimension of choice beween hem. Even sronger resuls are obained by resricing he form of he uiliy funcion. If he per period uiliy funcion is addiively separable wih a consan ineremporal elasiciy of consumpion, so ha U ( C L ) = C σ V ( L ),, σ (0,1) (2.8) hen capial income axaion is zero no merely in he limi bu from he firs period on. In period zero, capial is effecively fixed so is axed a a confiscaory rae. Afer ha, however, here is no need o ax capial income. The reason why i is no opimal o ax capial income afer he firs period can again be seen from he wo-period case. For hese preferences can be shown o imply ha he expendiure funcion (over any finie number of periods) has he 5 There is a sligh abuse of noaion here, in ha hese ax raes were specified in ad valorem form above raher han, as here, specific. The wo are equivalen from he perspecive of he consumer, so ha which one uses is essenially a maer of modeling convenience. 6 See also Akeson, Chari and Kehoe, 1999 and Erosa and Gervais, 2001 and 2002.

8 - 8 - implici separabiliy of he form 7 * * * E( A( p1, p2,...), w1, w2,... u), so ha given opimal axaion of wage income in each period here is no gain from axing capial income. Though remarkable, i should be sressed ha even par from he assumpion ha he governmen is able o commi o he fuure pah of axes, and unconsrained in is deb policy he general resul of capial income axaion being zero in he long run only applies in he seady sae. If here are ongoing changes in he srucure of he economy ha preclude i from converging o a seady sae, he resul does no apply. This analysis also assumes ha only wage and capial income axaion are used as governmen policy insrumens, which is a real resricion, since here are here more han ow consumpion goods. As Coleman (2000) has recenly poined ou, adding consumpion axaion can have fairly dramaic effecs in erms of reinforcing he argumen for zero capial axaion. Adding more insrumens o he governmen s policy se can only make i less likely ha i will be opimal o ax capial income, since here is hen less poenial need o deploy capial income axaion as a surrogae for missing insrumens. 8 The overlapping generaions model Erosa and Gervais (2001, 2002) ake he alernaive approach of analyzing labor and capial income axaion in an OLG model of idenical represenaive agens each of whom lives for J+1 periods. In obvious noaion, he lifeime uiliy funcion for a cohor born in period is now: ( C L ) J j β U j, j (2.9) j= 0 Labor produciviy may vary over he life cycle. Leing z j be he produciviy (measured in unis of effecive labor supply) a age j, assumed o be he same for all cohors, he per period budge consrain is now: C + A + 1+ j ( r j ) A j j 1 = w j z j L j + (2.10) 7 This can be seen by noing ha lifeime preferences are in his case of he form 2 1 σ 1/ σ U (.) = u( φ( C1, C2 ), L1, L2 ), where φ(.) = ( = C ) is homogenous of degree one. and so saisfy he sufficien condiion for implici separabiliy menioned in he ex above. 8 Coleman also noes ha if he governmen is unresriced in is choice of ax insrumens, and assuming ha he represenaive household has posiive iniial asses, a ax scheme ha axes consumpion proporionaely and subsidizes labor proporionaely a he same ax rae in all periods is effecively a ax on iniial wealh, and so is lump-sum. (This can be seen by adding a erm represening iniial asses o he lef of (2.1)). Assuming iniial asse wealh is large enough o pay for fuure ax requiremens, a firs-bes is achieved and he opimal ax on capial income would be zero, which would be disorionary. This is essenially he ime consisency poin in anoher guise.

9 - 9 - where, noe, ax raes are allowed o be boh ime- and cohor-specific. As before, he represenaive household of cohor maximizes (2.7) subjec o (2.8) o deermine Cj ( w, r ), Lj ( w, r ), and hus A j ( w, r ). Wih a consan populaion growh rae, he share of households of age j in he populaion, µ j, will be consan over ime. The per period budge consrain of he governmen can hen be wrien: J J rj µ j Aj + τ j µ j Lj = 1 j= 0 j= 0 ( + r ) B G B τ l + (2.11) The objecive funcion of he governmen is assumed o be he discouned sum of lifeime uiliies, where he discoun rae is denoed γ. Denoing by W ( w, r ) be he lifeime uiliy of cohor, he problem of he governmen is hen o: w Max τ, τ, b r = 0 γ W ( w, r ) s.. (2.9) (2.12) The soluion o his problem is given in Erosa and Gervais (2001, 2002). In his seing and in sharp conras o he Ramsey growh seing of Chamley (1986) he zero capial income ax resul in he long run does no apply excep in special circumsances. The reason is ha now consumpion and leisure generally vary over he individual s life cycle even in he seady sae. There are, however, wo cases in which he opimal rae of capial income axaion is zero echoing again he wo cases idenified in he wo-period case above. One is ha in which consumpion and leisure are consan over he life cycle. This will be he case if he planner s discoun rae is he same as he households ( γ = β ) and produciviy is consan over he life cycle ( z j = z j) (his laer feaure ensuring ha no simply hours worked bu effecive labor supply a disincion ha did no exis in our wo-period model is consan over he life cycle). The second case is ha in which he uiliy funcion akes he form of (6) above. In his case as one would now expec he opimal ax on capial income will again be zero for all periods beyond he firs (ha is, even if he consumer is no in a seady sae). 9 Noe oo ha hese resuls presume ha he governmen is able o deploy cohor-specific ax raes. If i canno do so, hen some ax on capial income will generally be desirable even in he circumsances jus described. (See also Alvarez e al, 1992). More precisely, Erosa and Gervais (2001) are able o show ha in his case capial income axaion will be posiive if 9 For he case in which preferences are no separable over ime, Erosa and Gervais (2002) show ha i will be opimal no o ax capial income from period 1 onwards if preferences are of he form U ( G( C1, C2 ), L1, L2 ), wih G homoheic. This of course is he sufficien condiion for implici separabily of he expendiure funcion menioned in he hird observaion of he wo-period case.

10 and only labor supply is decreasing over he life cycle. Of course, if consumpion axaion were allowed, no capial income axes would be required if he opimal consumpion ax is consan over ime, which is he case under uiliy funcions of he ype given in (6). Heerogeneous households Once households differ, he analysis becomes even more complicaed. The exising analyses focus on he case in which households differ by income-earning abiliy, or produciviy, and rely on a celebraed resul of Akinson and Sigliz (1976). Consider an aemporal economy in which all households have idenical uiliy funcions defined on labor and a vecor of n consumpion goods, U ( C, L 1, Cn, L). Households differ, however, in heir wage raes w i, where w i+1 > wi, reflecing heir differen abiliies or produciviies. Following Mirrlees (1971), he governmen is unable o observe wage raes, bu can observe incomes yi wi Li and so can apply a nonlinear income ax. Also, he governmen canno observe individual commodiy demands bu can observe ransacions anonymously; so i can also apply linear (only) excise axes. The governmen is assumed o maximize a quasi-concave objecive funcion, which ensures ha redisribuion goes from higher o lower wage households. Is problem is o choose a se of ax policies o maximize is objecive funcion subjec o a resource consrain, and a se of incenive compaibiliy ( self-selecion ) consrains. These require ha higher-wage households prefer heir own incomes (boh earned and disposable) o ha of lower-wage households; require, ha is, ha he greaer amoun of leisure ha he high abiliy ypes could ake if hey were o earn he same gross income as he low abiliy ypes would be less valuable o hem han he consumpion hey would forego. The Akinson-Sigliz Theorem says ha if he uiliy funcion is weakly separable in goods and labor, so ha U ( C1, L, Cn, L) = U ( g( C1, L, Cn ), L), hen differeniaed commodiy axes should no be used. The inuiion for his is sraighforward. 10 The nonlinear income ax is deployed o achieve he opimal amoun of redisribuion. A he opimum, incenive consrains will be binding on all bu he lowes-wage households oherwise more redisribuion could be accomplished. Differenial commodiy axaion will hus be useful only o he exen ha i weakens he incenive consrains. Under weak separabiliy, he preference ordering over goods is independen of labor supply. Therefore, higher-wage mimickers would choose he same goods bundle as he lower-wage households hey are emped o mimic. Bu hen differenial commodiy axaion canno make i less aracive o hem o mimic, and so has no effec oher han he adverse one of disoring consumer choice. By he same oken, if he Akinson-Sigliz separabiliy condiion does no apply, he self-selecion consrain will be weakened by imposing higher commodiy axes on goods ha are more complemenary wih leisure, which are he ones ha will be more heavily demanded by he mimickers. 10 See Edwards, Keen and Toumala (1994) and Nava, Schroyen and Marchand (1996).

11 The Akinson-Sigliz resul can be applied o he problem of capial income axaion by reinerpreing he disinc goods as consumpion a differen daes. Differenial commodiy axaion of he aemporal inerpreaion hen ranslaes ino a disorion of ineremporal prices, and so corresponds o he axaion of capial income. Noing his analogy, Sigliz (1987) shows ha if household uiliies are weakly separable beween goods and labor, hen all ha is needed is an opimal nonlinear ax wihin each period, wih no ax or subsidy applied o ineres income. The reasoning is essenially he same as in he aemporal case: being a differenial ax on fuure consumpion, an ineres ax would only be used if fuure consumpion were more complemenary wih leisure han is curren period consumpion, and an ineres subsidy in he case of relaive subsiuabiliy. 11 If leisure and fuure consumpion are complemens, a indirec ax on fuure consumpion weakens he selfselecion consrain: higher-wage mimickers will enjoy more leisure, and heir consumpion bundle will include a higher proporion of fuure consumpion han low-abiliy persons. A ax on fuure consumpion will make i relaively more difficul for he former o mimic he laer. Though his analysis is suggesive, here are a number of caveas and resricions ha should be noed. Firs, if he labor supplies of households of differen produciviies are no perfec subsiues, ineres income axaion or subsidizaion is called for depending on he subsiuabiliy-complemenariy relaionships among he differen ypes of labor and capial, as Sigliz (1987) shows. Second, and more profoundly, he rick of reinerpreing commodiies as consumpion a differen daes is more problemaic han i may a firs appear, and really only works in he wo-period case. Once one goes o he more realisic world of muliple periods wih labor supplied in several of hem, he Akinson-Sigliz logic no longer applies. For one hing, as we have seen in he earlier discussion of axaion wih homogeneous households, allowing labor supply o vary for more han one period makes he case for axing or subsidizing ineres income more likely. Even more fundamenally, once households are subjec o nonlinear income axaion in successive periods, he naure of heir opimizaion problem and of he governmen s informaion consrain becomes much more complicaed. For insance, he governmen may use consumers firs-period decisions on earnings o make inferences abou underlying abiliy, for insance; and consumers awareness of his may hen affec hose earning decisions. To dae, here is no fully saisfacory analysis of iner-emporal nonlinear income axaion, making i difficul o say anyhing even vaguely definiive abou he case for axing or subsidizing capial income in a world of heerogeneous households. Resricions on ax insrumens and informaion The above models of opimal axaion assume ha he governmen is boh well (hough no quie fully) informed and unresriced in is policy insrumens. Bu he policy environmen may be more resricive han ha. 11 This discussion presumes ha ineres income is axed a a consan rae, which would be appropriae if individual capial income could no be observed. If i can be, presumably one migh wan ineres income in he second period o be axed in a nonlinear fashion.

12 Take, for insance, he Ramsey growh conex and suppose ha while he governmen can levy consumpion, labor income and capial income axes, he labor income ax rae is consrained o be nonnegaive. Coleman (2000) demonsraes wo remarkable resuls. Firs, suppose ha a leas some of he governmen revenue raised hrough axes is ransferred lump sum o he household, who hen consume i. Since his lump-sum income is spen on axable consumpion goods, a consumpion ax is somewha more general han a labor income ax. If one now consrains labor axaion o be nonnegaive as above, labor income should never be axed, while capial income should be subsidized in he long run. In effec, he consumpion ax is used o raise revenue and canno be replicaed by labor income axaion. On he oher hand, if all ax raes mus be nonnegaive, in he long run i is opimal o ax only consumpion, while in he inermediae run, all hree ax sources migh be used. Second, suppose ha all governmen revenue is used o purchase public goods or services and none is ransferred o households as cash. If labor income axaion is precluded from being negaive, so a firs bes canno be achieved, hen a consumpion ax is no longer needed beyond he firs period: is effecs can be replicaed by combinaions of he oher wo axes. We are back in he world of Chamley (1986) discussed above, and all his resuls. In paricular, capial income axes converge o zero as he economy converges o a seady sae. Resricions on insrumens may also be imporan in he conex of axing heerogeneous households. One possibiliy, for insance, is ha he governmen can use only linear income axes, perhaps because of resriced adminisraive capaciy. Deaon and Sern (1986) shows ha in his case differenial commodiy axes can be dispensed wih if he uiliy funcion is no only weakly separable bu, moreover, if he sub-uiliy funcion of goods is quasihomoheic so ha all Engel curves are linear. In his case which is clearly more resricive han ha of he Akinson-Sigliz resul above commodiy axes do no add anyhing o he abiliy of he governmen o differeniae among households of differen income levels. Applying he same ineremporal inerpreaion as above, he implicaion is ha he circumsances under which capial income axaion can be dispensed wih are even more resricive han hose which apply when nonlinear axes can be used. Again, he resuls are agnosic wih respec o wheher axaion or subsidizaion of capial income is opimal in he even ha he required resricions do no apply Anoher line of inquiry, and one ha is poenially especially relevan for financial markes, assumes ha while he governmen can observe household labor income (as above) i canno observe capial income; a bes i can ax capial income anonymously and indirecly using a consan ax rae. According o he above analysis, no such capial income ax would be needed if he condiions of he Akinson-Sigliz Theorem or is exensions were saisfied. Two ses of circumsances have been idenified in which capial income migh neverheless be axed even if he required separabiliy condiions were o hold. The firs arises because of he possibiliy of unobserved bequess. As argued by Boadway, Marchand and Pesieau (2000) and Cremer, Pesieau and Roche (2002), if for some reason he size of bequess is no saisically independen of wage raes, he axaion or subsidizaion of ineres income can be a useful supplemen o an opimal nonlinear labor income ax. In paricular, a ax should be used if bequess are correlaed are posiively correlaed wih wage raes, and vice versa.

13 Gordon (2001) has idenified a second circumsance. He consrucs a model in which households choose a porfolio of asses as well as an amoun of savings. The porfolio combines a risky asse (equiy) and a risk-free asse (deb). He argues ha if risk aversion falls wih wealh, higher income households will hold relaively more equiy in heir porfolios and lower income households more deb. In hese circumsances, disribuional consideraion mean ha a subsidy on deb will be opimal. The ime consisency issue As noed a he ouse, all he analyses reviewed above assume ha he governmen can coslessly commi o he fuure pah of ax raes. When i canno so commi, however, here is an inheren empaion o renege on previously announced plans. The poin here is ha a any given ime, he sock of previously accumulaed capial is large relaive o he annual flow of new invesmen. In hese circumsances, raional governmens will be unable o avoid imposing high axes on ha capial and he income i generaes, despie he fac ha in he long run hese axes decrease capial accumulaion and lead o inefficiencies (Fischer, 1980). Tha is, even hough governmens would wish o commi, if hey canno do so hen hey will wish o impose heavier axes on capial once savings decisions have been made han hey promise ex ane. This may be one reason why raes of capial income axaion observed in he real world end o be much higher han opimal ax analysis of he kind above would advocae (hough he fac ha effecive raes of capial income ax are ofen lower han sauory raes, and someimes even negaive reflecing he availabiliy of deducions raher dulls he poin 12 ). This ime consisency problem has poenially profound implicaions for capial income axaion. In poliically sable counries, governmens may carry sufficien credibiliy for he problem o be of only limied significance. In ohers, however especially, i would seem, many developing counries he problem may be more profound. Faced wih his problem, governmens, recognizing ha hey are unable o avoid excessive axes on capial income and ha he privae secor will also recognize his, and amend is behavior accordingly can ake measures o undo he wors effecs of excessive axaion. They may find i desirable, for insance, o allow capial o move o lower ax jurisdicions (Kehoe, 1989) or even o olerae some degree of evasion of capial income axes (Boadway and Keen, 1998). Oher measures o overcome he ime consisency problem involve up-fron subsidies o invesmen, such as ax holidays and invesmen ax credis. Such subsidies may also be based on poliical economy argumens, such as common agency argumens for poliical paries providing favors in reurn for financial suppor (Marceau and Smar, 2002). Designing policies o overcome inefficiencies arising from he poliical process is, of course, problemaic since i is no clear how governmens could be persuaded o underake hem. B. Opimal Taxaion of Corporae Income There are wo main ypes of argumens for axing corporae income as par of an opimal ax sysem. The firs which is ha ypically sressed in policy discussion sees he corporae 12 This has long been he case in Sweden, for insance; on he US, see Gordon and Slemrod (1988).

14 ax as a wihholding device agains capial income a source. The second sees he corporae ax as a ax on economic rens earned by corporaions. This secion considers hese in urn. The wihholding role of he corporaion ax Corporaions are legal eniies, disinc from heir owners, in which incomes earned on behalf of shareholders are pooled. If shareholders could be axed direcly on he income hey earn hrough corporae ownership, he wihholding role would disappear. Disinc consideraions arise, however, in relaion o domesic and foreign shareholders. Wihholding agains he income of domesic shareholders The case for using he corporae ax as a wihholding device agains domesic shareholders is based on wo presumpions: ha i is desirable o ax capial income from all sources a he personal level, and ha i is difficul o aribue all income earned hrough corporaions o individual shareholders as i accrues. The key issue here is he difficuly of axing capial gains on an accruals basis a he personal level (an issue o which we reurn in Secion III): if, as is almos invariably he case in pracice, capial gains are axed on a realizaion basis, hen income ha is reained and reinvesed in he corporae secor can be shelered from personal ax unil i is aken ou as eiher sales of shares or fuure dividends. Taxing corporae income as i is earned is a way of bringing his income ino he ax sysem a he appropriae ime. Designing a corporae ax sysem for his purpose involves a number of consideraions, some of which are difficul o implemen perfecly. The base for he corporae ax should be only reained earnings, excluding boh ineres paymens and dividends (since hese can readily be axed a he personal level). All accrued curren and capial coss should be deducible, including rue depreciaion of depreciable asses and he impued cos of invenory use, naural resources and inangible asses and here are well-known difficulies in properly accouning for hese. However, as discussed shorly, here are reasons o include all equiy income earned by he corporaion o saisfy he oher wihholding role ha wih respec o he income of foreign shareholders, whose dividends escape domesic axaion. To he exen ha he corporae ax is inended o be a wihholding device, credi for his wihheld ax should be given o shareholders when hey evenually ake heir income ou of he corporaion. This requires some form of inegraion applied a he personal level: for example, a ax credi could be given agains dividends and capial gains earned in corporaions ha had paid he corporae ax. This is concepually sraighforward for dividends, bu problemaic for capial gains, since i would require idenifying ha par of gains ha is due o axed reenions, a dauning ask 13 Special provisions would need o be applied o deal wih some ypes of ownership. Firs, corporaions migh hemselves hold shares in ohers, eiher subsidiaries or as minoriy 13 Neverheless, he ask is no hopeless: Norway aemps o do exacly his.

15 owners. To avoid double axaion of corporae source income, he iner-corporae flows of capial income should be excluded from ax. Thus, if he corporae ax applies o corporae reained earnings, capial gains earned by domesic corporaions on heir shares in oher corporaions should be ax-exemp. 14 If he ax applies o all corporae equiy income, boh capial gains and dividends earned by domesic corporaions should be exemp. This has obvious implicaions for financial corporaions. Second, careful aenion should be paid o he axaion of small corporaions. The aim should be o ensure ha hey are reaed on a par wih unincorporaed businesses so ha here are no pure ax incenives for incorporaion. Noe ha domesic households migh sill be able o sheler heir capial income in foreign corporaions, and he domesic corporae ax canno do anyhing o miigae ha. If he foreign counry has very low corporae ax raes, or if households are able o avoid paying domesic ax by simply failing o repor heir incomes, households will be able o earn ax shelered income abroad and here is lile he corporae ax sysem can do o avoid ha. Wihholding agains he income of foreign shareholders Furher consideraions arise in an open economy. Since he personal income ax is generally levied on a residence basis, and so does no apply o foreign shareholders, he wihholding role applies only, in general, o a subse of shareholders. 15 More fundamenally, if invesors in a corporaion are able o earn some more or less fixed afer-ax rae of reurn on he world marke, any ax levied on heir capial income will ulimaely end up being shifed back o domesic residens hrough induced capial ouflows, and hence a reduced rae of reurn o immobile domesic facors. In hese circumsances, one migh no wan o ax corporaions a all (alhough ime-consisency problems may noneheless lead o axaion, as menioned earlier). Bu oher wihholding argumens can be made for axing foreign-owned corporaions. If he counry has some power in world capial markes, so ha i need no ake he afer-ax reurn on world markes as given, hen a ax on foreigners will indeed o some exen be borne by hem. Mos counries, however and especially developing counries are no in his posiion, excep perhaps in relaion o some naural resources. More imporan in pracice is he observaion ha, o he exen ha foreign-owned corporaions can credi ax paid in he hos counry agains corporae income ax in heir home counry, such a ax will serve mainly o ransfer ax revenues from foreign reasuries o he domesic one. This argumen seems o have some weigh in debor counries, such as Canada, and is a major consideraion in ax-seing many developing counries. Why credior counries migh allow crediing for axes paid abroad by heir domesic corporaions is a maer of coninuing 14 This has no been sandard pracice bu, following he German ax reform of 2000, appears o be becoming more common. 15 One could conceive of inernaional cooperaion o his effec each counry uses is corporaion ax as a wihholding device agains oher s personal income ax sysem bu his is no observed in pracice.

16 research ineres. 16 Bu, given ha major invesing counries like he USA have such a sysem, he case for capial-imporing counries using a corporae ax is srenghened. The design of a ax o exploi he ax crediing pracices of credior naions is somewha differen from ha whose role is o wihhold agains domesic shareholders. There is some incenive o mimic he ax srucure and rae of he main credior naions o exploi mos effecively he ax revenue ransfer. Since ax crediing migh be jeopardized by discriminaory reamen of foreign versus domesic corporaions, ha implies ha he ax reamen of corporaions of all ypes will parly be driven by a desire o exploi he ransfer of revenues from foreign reasuries. The need o rea foreign and domesic corporaions on a par has a furher imporan implicaion. Provisions for inegraing he corporae and personal axes mus be implemened a he personal level raher han he corporae in order o arge hem o domesic shareholders alone. Tha is, credi mus be made o residen households agains corporae axes paid by domesic corporaions in which hey have shares raher han, say, credi being paid o corporaions ha pay ou dividends o domesic residens. However, in his case, he raionale for inegraion is no longer obvious, as Boadway and Bruce (1992) argue. If he marginal invesor in a corporaion is a nonresiden, he degree of inegraion will affec domesic residen s incepive o save, while he firm s incenive o inves will be deermined by he corporaion ax. Thus inegraing via he personal ax undoes any ax ha migh apply a he personal level, raher han undoing he corporae ax; and he corporae ax will effecively be borne by he firms hemselves, causing a disorion in invesmen. Reflecing in par increased awareness of he relaive ineffeciveness of inegraion in open economies, a number of economies have in recen years moved away from inegraion schemes owards a classical form of corporaion ax, under which dividends are axed wihou allowance for underlying corporaion ax paid. 17 Thus, he case for corporae ax iself comes ino quesion in an open economy, excep o he exen ha i is effecive a ransferring income from foreign reasuries. Even so, he benefis of ha ax-ransfer mus be offse agains he invesmen disorions are imposed, and he case for inegraion is considerably weakened. The corporaion ax as a ren collecor The second possible role of he income ax, and one ha has radiionally been sressed in he academic lieraure, is ha of a ax on economic rens (or pure profis), meaning he excess of revenues over he full opporuniy coss of earning hem. The argumen is ha mos economic rens earned in he economy will be earned in he corporae secor, and so are convenienly idenified and axed here. An appropriaely designed corporae ax a one ha is neural, in he sense of no disoring corporae decisions will diver some of he 16 Gordon (1992), for insance, argues ha a capial exporing counry acing as a Sackleberg leader may find i desirable o offer a credi in order o induce a higher ax abroad and hereby sem capial fligh. 17 See Fues and Huber (2000) for an argumen ha such a sysem is indeed opimal in an open economy seing.

17 rens from he privae secor o he public secor. Such a ax will be fully efficien, and hus economically ideal, in ha i does no disor producion decisions by he axed firm. Wheher i is equiable o ax rens a he level of he firm is anoher maer. The ax can be viewed as a confiscaory ax on he curren owners of asses ha give rise o fuure rens, which may be regarded as horizonally inequiable o he exen ha oher sources of asse wealh are no so axed. Rens can come from a variey of sources. One imporan source migh be he ownership of fixed facors, such as naural resources, ha have no alernaive use. Ohers are locaional or informaional advanages. Ye anoher migh be he monopoly profis ha come wih marke influence. The economic modeling of neural corporae axes has ended o focus on he fixed facor sory, using a dynamic model of he firm (see King, 1977; Akinson and Sigliz, 1980; Auerbach, 1983). The firm is viewed as having a sricly concave producion funcion wih possibly boh curren and capial inpus. The sric concaviy gives rise o economic rens a he profi maximizing (as well as he social) opimum. I is sraighforward o exend he analysis o ake accoun of oher sources of rens, like monopoly and renewable or nonrenewable naural resources. As well, he focus of he lieraure has ended o be on firms ha earn business incomes from he sales of goods and services raher han hose ha earn financial income. Inernaional consideraions again maer, however. To he exen ha he source of he rens is no specific o a paricular locaion access o a paricular mineral deposi, for insance, or o a proeced local marke a ax on rens may drive invesmens o oher jurisdicions offering a lower rae of ax. There are various ways, in principle, o design a corporae ax so ha i is neural. Two benchmarks are an economic-profis ax and a cash-flow ax (Boadway, 1980). An economic profis ax has as is base he impued curren-period economic profi of he firm. This requires accouning for all revenues less coss on an accruals basis. Revenues include hose from all sales of goods and services in he accouning period, all measured on an accrual (raher han cash-flow) basis. Coss are more complex. The coss of using curren inpus wihin he accouning period are deduced on an accruals basis. The coss of using capial inpus mus be appropriaely impued o each accouning period. For depreciable capial, his involves boh rue economic depreciaion and he full cos of financing he depreciable asse holdings. For depleable asses, i involves he value of resources depleed in he period as well as he financing coss. For invenory, i is he value of goods aken ou of invenory plus he cos of financing. For inangible asses, i includes he depreciaion of hose asses, and so on. Needless o say, here are difficul measuremen coss involved in measuring economic profis: appropriae marke prices such as for inangibles ofen do no exis; he rue values of economic depreciaion and depleion of asses are difficul o measure; he coss of financing asses mus ake accoun boh deb and equiy financing; coss of depreciaion and finance mus be adjused for inflaion; and a cos of risk-aking mus be impued o reflec uncerainy abou fuure inpu and oupu prices. These difficulies make he implemenaion of an economic-profis ax virually infeasible. I is much easier o apply he cash-flow alernaive, which akes advanage of he fac ha he presen value of economic profis is also he presen value of cash flows of he firm. A cash

18 flow ax on business income akes as is base he cash flow of revenues from he sale of oupu less he cash flow cos of inpus as hey accrue. There are wo main varians of such a ax. Under an R-base cash flow ax (in he erminology of he Meade Commiee (1978)), ne financial inflows relaed o deb (ineres paymens and repaymens of ineres and principal) are excluded from he base. Under an R+F -base, hey are included; such a ax is equivalen (as a consequence of he ideniy beween he firm s sources and uses of funds) o an S-based ax levied direcly on ne disribuions o shareholders (dividends less new equiy issues). Under a cash flow ax, he difficulies of accrual accouning no longer apply. Capial purchases are simply expensed in he accouning year in which hey are made, and no allowance need be made for he coss of financing. A cash-flow ax avoids he need o ake measure rue depreciaion and depleion, rue coss of equiy financing, and he coss of risk. Moreover, no inflaion accouning is required. This simpliciy does come wih a cos, a leas from he policy-maker s perspecive. Firs, neuraliy of he cash flow ax requires ha he ax rae be consan over ime, whereas a pure income ax reains neuraliy even if he ax rae changes year by year. 18 Second, i will ypically be he case ha cash flows are negaive for some firms, especially young, growing ones ha are engaged in large invesmens. For he ax o be fully neural, ax losses mus be refundable in he year is which hey occur (or carried forward a an appropriae rae of ineres), somehing ha policy-makers are nooriously averse o allowing (perhaps reasonably enough, given he poenial danger of firms disappearing once hey have claimed ax rebaes on losses). This problem can be overcome, and he advanages of cash-flow accouning mainained, under a modified cash-flow ax (Boadway and Bruce, 1984). Under his alernaive, no all invesmens are fully expensed in he year in which hey occur. Insead, any arbirary amoun of hem can be added o an accoun he undepreciaed capial sock for ax purposes. The firm is allowed o draw down he undepreciaed capial sock a some rae each year, and a deducion is given o he firm for he financial coss associaed wih holding ha undepreciaed capial sock. This scheme reains he virues of a cash-flow ax, especially he use of cash raher han accrual accouning and he avoidance of inflaion indexing. I can also avoid he main problem of he cash-flow ax, he need for refundabiliy of losses. The abiliy o draw down he undepreciaed capial sock can be resriced o ensure ha negaive axable income is no generaed. The main difficuly wih implemening he ax is o choose an appropriae cos of finance o apply o he undepreciaed capial sock. 19 One form of modified cash flow ax ha has araced paricular ineres is he Allowance for Corporae Equiy (ACE) scheme, under which companies are allowed o deduc agains ax an amoun equal o some noional rae of reurn on is invesed equiy (calculaed reenions plus new equiy issues in he curren period). Such a scheme whose properies 18 Wih a falling rae of cash flow axaion, for insance, here is an incenive o bring forward invesmen in order o ake he up-fron deducion a a higher rae han he laer reurns will be axed. The poin is nealy made by Sandmo (1979). 19 Bond and Devereux (1999) argue for he use of he risk-free rae of reurn.

19 are developed in deail by Devereux and Freeman (1991) was implemened by Croaia in he laer 1990s; 20 similar schemes bu wih he impued equiy axed a a reduced rae raher han fully exemped have been adoped in Ausria, Brazil and (unil 2001) Ialy. These are perhaps he mos deliberae aemps ha have ye been made o craf he general corporaion ax as, in effec, a ax on rens. The case for a ax on economic rens depends on heir quaniaive imporance. One would expec ha some secors are more likely o generae economic rens han ohers. Thus renype axes are mos ofen found in relaion o he resource exracion. 21 Wheher i is useful o apply a ren ax o he enire corporae secor is an open quesion. Treamen of financial insiuions I migh be argued ha here is a possibiliy of economic profis being a feaure of he financial secor, given he usual dominance of a few large firms. In principle, a cash-flowype ax can also be designed o apply o financial income. Two alernaives are possible. One approach would be o rea financial asses accumulaed by he firm for he purposes of earning income analogously o he reamen of real capial in he nonfinancial firm: he coss of holding hem would be deducible and he revenues hey generae axable. In a pure cash flow sysem, he ax base applying o he financial earning of he firm would include financial income less he ne acquisiion of asses less he real coss associaed wih inermediaion. More formally, denoing by A he income-earning financial asses of he firm, and by Ȧ is rae of change, by r be he ineres rae on hese asses, he base is ra A & C, where C includes all he nonfinancial coss incurred on a cash-flow basis. (Modified cash flow axaion would creae an accoun ino which financial asses could be pu, similar o he undepreciaed sock of capial under he modified cash-flow sysem.) The oher alernaive, which is analogous o he S base described above, would also include ne financial ransacion wih nonshareholders on he liabiliy side. These would include deb ransacions as well as liabiliies in he form of deposis ino he inermediary. For hese ransacions, he firm would add o is ax base he cash flow ransacions arising from he acquisiion of hese liabiliies: ne changes in he sock of such liabiliies less he paymen of ineres on hem. Denoing he sock of deb by B, he base is in his case ra A& + B& ρb C. 22 The case for including hese elemens of financing arises because of he possibiliy of he financial insiuion earning pure profis because of he services i provides and he marke power i migh have. In he end, he case for imposing a cash flow 20 Keen and King (2002) assess he Croaian experience. 21 In fac, in he case of naural resources, here are alernaives o ren axes as a means of ensuring ha some share of resource rens accrue o he public secor, including royaly sysems, he sale of leases, and join public-privae venures: see Boadway and Flaers (1993). 22 In principle, hese ne liabiliy ransacions could also be included in he cash-flow ax base of nonfinancial corporaions as well. As shown by Boadway, Bruce and Minz (1983) show, he neuraliy properies of alernaive cash flow ax bases varies depending on wha one assumes abou he deerminans of he financial srucure of he firm.

20 ax on financial corporaions, and he form ha ax should ake, depend on a judgmen as o wheher he rens ha are earned are significan enough o warran he adminisraive coss of imposing he ax. C. Summary The lieraure on he opimal axaion of capial income is large, disparae, and someimes difficul. I has focused, o a very large degree, on he quesion of wheher capial income should be axed a all. The answer o his depends on wha oher insrumens are available o he governmen: if i is unresriced in is abiliy o ax consumpion and labor income, for insance, hen he capial income ax is a redundan insrumen, since is effecs can be replicaed by inroducing appropriae ime variaion in hese oher axes. Even when he choice of insrumens is such ha he capial income ax is no redundan, however, here are imporan benchmark cases in which i should no be used. This is he case if he opimum happens o have he feaure ha each individuals consumpion and labor supply remain consan over ime as in he seady sae of a Ramsey growh model or in which ineremporal preferences have he feaure ha here is no gain from disoring ineremporal prices. Clearly hough hese are boh resricive ses of circumsances. I is a grea weakness of he lieraure reflecing in par he analyical complexiy of he issue ha i gives relaively lile firm guidance on he raes a which capial income should be axed (or even wheher he ax should be posiive) ouside hese special cases. All hese resuls are subjec, moreover, o he fundamenal ime consisency problem: even if he governmen would wish no o ax capial income, i may be forced o do so by he expecaion of he privae secor ha, ex pos, some such ax will be opimal. Aenion hen focuses on he devices ha governmen migh use o miigae his problems, a line of enquiry ha is proving fruiful in undersanding why i is, for insance, ha many developing counries coninue o find i aracive o offer ax holidays and oher up-from incenives o foreign invesors. Taxing income a corporae level should be seen as a means o he end of axing households, and o ha exen is ulimaely moivaed by adminisraive raher han heoreical concerns, There is poenially an imporan role for he corporae ax as a means of wihholding agains personal capial income, and a corporae level ax may be a paricularly convenien way of levying a nondisoring ax on rens. In his are a leas, heory has provided quie clear guidelines as o proper ax design. III. NEW FINANCIAL INSTRUMENT AND THE CAPITAL GAINS PROBLEM The proliferaion of new financial insrumens over he las wo decades or so has raised profound concepual and pracical problems for ax design. These issues which remain largely unresolved are no jus ones for he mos advanced economies o grapple wih. They affec emerging marke economies wih sophisicaed financial secors, and even many relaively low-income counries mus address he difficulies hey may consequenly face from he financial aciviies of some of heir larges (and ofen foreign-owned) axpayers.