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Who Pays and When? An Assessment of Generational Accounting November 1995

The accelerated depreciation allowances of the tax code imply that income from existing capital is taxed at a higher rate than income from new capital (investment). Thus, generational accounts must adjust prospective taxes on income from capital in order to assign them to the right generations.
 
 

Tax Law Treats Income from New and Existing Capital Differently

The current annual tax rate on "economic income" from a unit of capital rises as it ages and eventually exceeds the statutory rate. (Economic income is capital income after subtracting economic depreciation--actual depreciation adjusted for inflation.) At first, accelerated tax depreciation allows firms to deduct more than economic depreciation. That shields economic income from tax and reduces the current tax rate. But as accelerated allowances are used (and as inflation erodes their real value), firms must deduct an ever-smaller share of economic depreciation. That exposes an ever-larger share of economic income to tax and raises the current tax rate. The current rate stops rising when tax depreciation allowances are used up, and by then it exceeds the statutory rate.

The same logic also applies for an investment tax credit because it is a special case of accelerated depreciation. That is, given an investment tax credit, the current tax rate on economic income is higher for existing than for new capital. (Investment tax credits do not apply under current law but have applied in the past.)

Firms cannot avoid higher current tax rates by selling existing capital to each other or by selling existing capital and buying new capital. If they did, they could start deducting tax depreciation on the capital they bought as if it were new. But the tax code has recapture and antichurning rules that make such a scheme unprofitable. (And investment tax credits in the past have effectively applied only to newly made capital.) Therefore, the accounts assume that firms never sell existing capital because the law makes the tax come out as if they never do.

But people can buy and sell shares in firms that own existing capital. Because the economic income of existing capital is taxed more heavily than that of new capital, owners and buyers assign a lower value to a firm's existing capital than to otherwise equivalent new capital. The difference in value is the present value of the higher taxes to be paid on the income from existing capital over its life.



Generational Accounts Allow for the Difference in Treatment

In order to sort out the effects of investment incentives among generations, the accounts use the concepts of "normal" and "excess" taxes.⁽¹⁾ (The terms describe what tax law implies; they do not suggest that the normal rate is the "right" rate or that taxes on existing capital are "too high.")

Defining Normal and Excess Taxes

Normal taxes are defined by the taxes to be paid over the life of new capital. That is, the normal tax rate is the present value of taxes on income from new capital as a percentage of the present value of its economic income. Normal taxes each year are the taxes that would be paid on economic income at the constant normal rate. If tax depreciation matched economic depreciation, the normal rate and each year's current rate would equal the statutory rate. But under current law (and rates of inflation), the current tax rate is below normal in early years and above normal later (because firms can deduct more than economic depreciation early and less than economic depreciation later). And the normal rate is below the statutory rate because present value gives more weight to earlier, below-normal taxes than to later, above-normal taxes.

Excess taxes each year are the difference between that year's actual taxes and normal taxes. Thus, excess taxes are negative early in the life of the capital and positive later. By the nature of the tax law, the present value of excess taxes on existing capital is always positive (assuming inflation is positive). Moreover, by the nature of its construction, the present value of prospective excess taxes at any time is equal to the negative of the present value of past excess taxes. (When the capital is new, the present value of its excess taxes is zero. Therefore, the present values at any time of past and prospective taxes must cancel each other.) That is, taxes paid at a rate below normal will have to be made up later with interest.

Assigning Taxes on Income from Capital

To assign prospective taxes on income from capital under current law, the accounts break it into two conceptual parts. The first is a one-time levy; it is the present value of excess taxes on income from now-existing capital. According to the accounts, the levy in 1991 amounted to $684 billion, which is prorated to current owners. The second is an annual flow; it is the tax that would be collected each year if the normal rate applied to income from all capital, existing now or installed later. The flow is prorated to prospective owners (including current owners who continue to hold their capital).

The adjustments account for all prospective taxes on income from capital. Current owners pay all excess taxes and pay normal taxes for as long as they hold their capital. All later owners (including current owners who buy more) pay taxes at the normal rate; they will have bought either new capital or old capital at a discounted price.

The adjustments also account for cases in which later buyers subsequently sell. Whether they bought new or then-existing capital, they will have paid a price that reflected the present value of taxes at the normal rate. And at the time they sell, the present value of prospective excess taxes is simply the negative of the present value of past excess taxes. The effect, therefore, is the same as if all later buyers always pay taxes at the normal rate.

A change in law that raises investment incentives also raises excess taxes on income from existing capital; its prospective taxes remain as before, but the normal rate falls. That raises the present value of excess taxes for current owners and reduces the annual tax at the normal rate for prospective owners. Thus, according to the accounts, the increase in incentives transfers resources from current owners (mostly old) to prospective owners (mostly young).
 

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