Leonid A. Levin

Taxation and Valuation.

I tried to use some insights from computer theory to analyze the failure of persistent efforts at the US tax reform despite the strong and sustained public interest. I think I identified a fundamental difficulty that is not well understood yet in the economic literature. I also suggested somewhat unusual ways around. Of course, convincing the very conservative fiscal community of anything new is an uphill battle. So, I was overjoyed to see my article, The Equity Tax and Shelter , published in Tax Notes 93(9):1203-1208, 11/26/2001: http://www.cs.bu.edu/fac/lnd/civic/eqtx.htm.

Taxes have major costs beyond the collected revenue: deadweight from distorted incentives, compliance and enforcement costs, etc. Many proposals have aimed to alleviate these effects but invariably introduced greater distortions than those they claimed to remove.

Here is my observation. Modern Economics is based on classical game theory. The agents act rationally, maximizing some consistent (and legally definable) values, such as their assets or income. This approach, however, fails to recognize the intractability of consistent valuation and of other types of rational behavior in many games (much more so in real life). For instance, in playing chess the first idea that comes to mind is to understand how to compute the positions' value, and to choose each move to maximize it. The value must be consistent across a move, i.e., agree with the best value of the next position one move can achieve. Indeed, each position has such a consistent value: one side has a winning strategy or both have a draw. One only needs to keep moving to positions of the same value: what a silly way to pass time!

It is the well known exponential intractability of this strategy that saves the fun! I argue that any legal definition of the tax base value will be inconsistent with taxpayers' motives and thus distortive. (Taxing a gain in chess positions would change the game completely.) I discuss unusual but, I think, neat, sound, and practical ways around. I see the culprit not as the taxation itself, but as the official valuation of resources, income, etc. that taxation usually involves. If taxes can be expressed in natural units (e.g., corporate shares), not in national currency, the distortion could be avoided. Here is the appendix from the above link:

Appendix

Suppose some form of consumption taxes is adopted: qualified publicly traded corporations pay no income tax; investment in them is deducted from investors' taxed income. The tax is deferred until divestment and applies to dividends and proceeds from sold shares. Then the entire stock market value would be untaxed income and the deferred tax on it an enormous interest-free loan from the IRS: a major hole from the income tax perspective.

Plugging it, however, does not require paying the missing tax, only the interest on it. This removes the need to monitor business to decide which part of firms' value is untaxed income: all of it is. Still, these values cannot be gauged by share prices. This would lead to manipulation of the stock market, seriously challenging its integrity. A simple way out is to express the liability not in dollars but in corporate shares the IRS would collect and promptly auction. If t, i are the income tax and interest rates, a fraction t · i of all shares held outside the corporate sector is regularly paid as tax interest.

A further, tax-neutral but enhancing liquidity, simplification is to drop the tax deduction at the investment time along with taxes on dividends and gains from sold shares. Going public makes the shares' prior cost basis tax-deductible but invokes "conversion" tax -- a fraction t of all shares. Publicly traded shareholders shield their investees (direct or held through income-taxed intermediaries), too: The IRS returns the respective part of the investee's equity or income tax to the shareholder.

This approach is as gap-free as ideal income taxation, but preserves the grace of consumption taxes: undistorted incentives, minimal compliance and enforcement costs, etc. It requires no complicated rulings or regulations, except tax-unrelated, such as those protecting minority shareholders. With no risks or chances to hide or delay liability, the rates t, i should be low. Firms averse to diluting shares or paying interest can buy back shares or debt. A regular trickle of auctioned shares may even have a stabilizing effect on the stock market.

Bonds, tradable in fractions, can be treated similarly. Yet, as bonds carry no voting powers, a simpler equivalent is taxing their proceeds with interest t · i, compounded from the bond's issue. Other corporate obligations to income-taxed customers can stipulate a buy-back price, its growth treated as income to the holder.