The Equity Tax and Shelter∗
Leonid A. Levin
Boston University; Institut Des Hautes Etudes Scientifiques

Due to its limited scope, this article ignores
many important issues of taxation. Such are
matters, often discussed in the context of tax
reform, that concern the tax spending process
more than the tax levies – for instance the benefit
principle, or the incentive of democratic governments to use taxation for transfers from groups
with greater ability to pay to groups with greater
ability to vote. I ignore special externalities (harm
or benefit to others, specific to particular economic activities) which might call for special taxes,
tax breaks, or other remedies. I do not discuss
the (seemingly small) incidence effects of the reform and pay limited attention to the transition
problems.
My main goal is alleviation of distortive effects of general taxes on corporations and investors. It is prominent in economic literature
and lately in political media, though the proposals typically introduce greater distortions than
those they claim to remove.

arXiv:cs/0012013v17 [] 27 Mar 2018

Abstract. (A brief summary is in Appendix.)

Taxes have major costs beyond the collected revenue: deadweight from distorted incentives, compliance and enforcement costs, etc. A simple
market mechanism, the Equity Tax, avoids these
problems for the trickiest cases: corporate, dividend, and capital gains taxes. It exploits the
ability of the share prices to reflect the expected
true annual return (as perceived by investors,
not as defined by law) and works only for publicly held corporations. Since going or staying
public cannot be forced, and for some constitutional reasons too, the conversion to equity tax
must be a voluntary contract. Repeated reconversions would be costly (all capital gains are
realized) and thus rare. The converts and their
shareholders pay no income, dividend, or capital
gain taxes. Instead, they give the IRS, say, 2%
of stock per year to auction promptly. Debts are
the lender’s assets: its status, not the debtor’s,
determines their equity-tax or income-tax treatment. The system looks too simple to be right.
However, it does have no loopholes (thus lowering the revenue-neutral tax rate), no compliance costs, requires little regulation, and leaves
all business decisions tax neutral. The total capital the equity taxed sector absorbs is the only
thing the tax could possibly distort. The rates
should match so as to minimize this distortion.
The equity tax enlarges the pre-tax profit since
this is what the taxpayers maximize, not a different after-tax net. The wealth shelter is paid
for by efficiency, not by lost tax.

1.1

Corporate Income Tax Problems

Corporate income is spent in various ways: one
part (Expenses) is consumed by the needs of producing the current taxed income; another (Dividends) is divested to the shareholders; the third
(Reinvestment) is invested in growth, renovation,
debt or stock repurchase, etc.; the Masked part
is a hidden reinvestment, treated as expenses due
to the subtleties of the tax law and depreciation
rules. Most tax systems tax Dividends to the
shareholder and spare the Expenses. The U.S.
law also taxes Dividends and Reinvestment to
the corporation. The Reinvestment and Masked
1 Introduction
parts accumulate in the stock value; the current
system, as well as some new proposals, may tax
Casual readers may skip this section which does
them eventually when they are realized as capital
not discuss the mechanism at hand, but only
gains.
puts it in a context of problems faced by other
The income tax is distortive. The laws, howapproaches.
ever complicated, cannot adequately expose Masked
∗
Tax Notes 93(9):1203-1208, 11/26/2001.
income; it remains, whether large, small, or neg1

2

The Equity Tax and Shelter

ative. The incentive to maximize it stands behind many otherwise detrimental business decisions and probably behind double taxation of
capital gains, gifts, and estates. It may also motivate the double taxation of dividends without
which the double taxation of capital gains would
promote divestment through higher dividends to
avoid stock price appreciation. This distortions
reduce net profits and tax revenue, and convolute accounting and decision making.

1.2

Capital Gains and Dividends

The awkward double taxation can be avoided in
many ways, e.g., by adding the taxed corporate
income to the inflation-adjusted share cost basis, deducting the dividends from the latter and
taxing only their excess. Various proposals are
actively studied (see, e.g., [Graetz, Warren]).
This would not remove the disincentive to realize gains or any problems of corporate income
tax. If the corporate tax is dropped instead, the
dividends/gains disincentive becomes the main
deadweight and fairness problem. The dividend
and capital gain taxes may differ drastically for
firms of similar size and operation (and, thus, of
similar share in consumption of public goods) depending on their dividend policy and stock trade
frequency. This frequency determines how often
the nominal tax rate is compounded, which has
a major effect on the effective tax rate.
Suppose a stock portfolio gains 10% per year
and is taxed annually at 30% of gain, i.e., 3% of
value. It will grow at a 7% rate, ending up ten
times smaller than if taxed 30% after 95 years of
10% growth. The strong disincentive for moving
capital among investors and corporations harms
them with no public purpose.
Dividend and capital gains taxes are also almost voluntary. Nothing forces companies to pay
dividends and many do not. They can spend all
income (say, by buying their own stock) and let
the investors choose when to realize it by selling
shares. Much of the stock may avoid trade for
generations.

1.3

Leonid A. Levin

Radical Recipes

The oldest proposed remedy to the tax-caused
distortions is to reject taxation altogether along
with all other forms of coercion. This extreme
libertarian idea is far from even the libertarian
mainstream. I will mention its much discussed
faults since similar elements are present in more
popular proposals. The freedom from coercion,
far from being a natural right (and quite unknown in nature), is not free. Thus, private services must replace public goods such as defense
from extralegal and foreign would-be “tax collectors”. The decentralization of power would raise
many obvious issues, unimportant here. Another
aspect, however, is fundamental.
Unprotected economic power, like unrefrigerated food, creates major externalities in and
of itself. Not only it is hard to deny defenseless neighbors the free ride on one’s defense arrangements, it is also hard to prevent them from
increasing the pay-off to the conqueror and, consequently, the cost of an effective deterrent. The
sudden and unprotected affluence of “new Russian businessmen” breeds racket structures which
also endanger their neighbors and public order.
Kuwaiti oil tempts foreign aggression, endangering nonowners of oil and world peace. General
taxes remedy such externalities through coercive
funding of common defense, public order, and
other public goods. This coercion both is justified as a defense against negligently harmful
neighbors and violates no natural freedoms, since
the freedom from coercion does not come free.
The argument can even be stretched to justify
public provision of other public goods when demanded by efficiency: the conquest pay-off and
the cost of deterrent depend on the value of the
best possible use of the resources, including the
optimal level of publicly provided goods.
Many popular ideas about nondistortive taxation are mythical. Lump-sum taxes are an example. One cannot assign lump sums arbitrarily,
e.g., above taxpayer’s worth or even close to it,
lest he runs away or shoots the collector. So,
the lump sums must be based on some rational
method. Clever taxpayers will guess it beforehand and distort their behavior for tax advan-

Leonid A. Levin

The Equity Tax and Shelter

tage. There are myths of inelastically supplied
resources, such as land area, or head count. As
a tax base, they are supposedly immune to distortions: nobody would commit suicide or shrink
the Earth’s surface to escape a tax. Such ideas
are misleading: one cannot collect taxes from
unused land, unemployed people, or postponed
children; meanwhile, overtaxing can render these
resources quite elastic. In fact, in a long run,
adapting technology seems to confer great elasticity on all resources. Such tax systems avoid
distortion in allocation of untaxed resources at
the expense of an extreme distortion in the allocation between taxed and untaxed types.

1.4

Consumption Taxes

A less radical idea of similar nature is presently
popular. It would scrap the income tax system in
favor of one of the several forms of consumption
taxes, such as value-added, sales, flat, etc. These
taxes exempt all nonhuman resources from their
base which consists entirely of the cost of labor
(besides pre-existing capital). Their distinct aspect is the elimination of tax on reinvested income. (Investing labor income also defers its
taxation until the proceeds are withdrawn for
consumption.) Thus, companies reinvesting all
income grow tax-free, subsidized by other taxpayers through free public services.
Consumption taxes, too, remove the distortions in allocation of untaxed resources (investment in nonhuman capital) at the price of extreme distortion of the choice between investment (in nonhuman capital) and consumption
(i.e., investment in human capital). It is hard
to guess why this distortion is seen as acceptable. Perhaps the pressure toward a smaller (and
less educated) but richer population seems attractive. Or perhaps human capital is perceived
as a more evenly distributed base of taxation,
less deviant from taxpayers’ representation in the
budget process. Widespread confusion may also
play a role.

1.4.1

3

Progressivity

Some forms, such as value-added or sales taxes,
have an additional problem with valuation of the
labor tax base. Labor is a peculiar resource. Human mind admits only very inefficient external
control. Besides, organized humanity claims collective ownership of basic human rights and freedoms and outlaws their transfer. Due to this
public element in the otherwise private human
capital, it can be measured and taxed only indirectly through the income it generates. Even this
income is hard to determine. Haig-Simons concept of income includes personal consumption,
only part of which is investment in growth of
human capital through better education, bigger
families, etc.
The other part is the cost of sustaining it
against hunger, physical and psychological fatigue, illness, aging (by raising two kids), etc.
Progressive taxation of earnings attempts to exclude this part assuming some uniformity in the
structure of basic human needs. Proportional
taxes are most adequate for unearned income.
For earned income, however, their base includes
what is really an operating cost, creating a sort of
a head tax element. In the long run, when head
count becomes elastic, such taxes are too distortive to be used for general budget purposes.
(A benefit argument may justify their specialized use, e.g., financing social safety nets with
FICA.) This problem is addressed to some extent
in [Hall, Rabushka] through its 0-tax bracket.

1.5

Property Taxes

Another, rarely advocated, type of partial taxes
is based on wealth. They do just the opposite:
spare labor and target nonhuman capital. Since
the idea of pressing for larger but poorer population seems unattractive, a possible motive may
be to further shift the burden away from the electoral majority.
Unlike labor, wealth can be taxed based on
either its market value or the generated income.
The difference is not significant: investors, seeking the best return, price commercial property
according to its annual income potential includ-

4

The Equity Tax and Shelter

Leonid A. Levin

[Fraenkel, Lichtenstein] proved, must take computation time that is exponential in the size of
the chess board they treat as variable. Exponent
is quite a dramatic bound: the entire known Universe contains far fewer atoms than ten to the
number of letters in this sentence. Note that
this problem is unrelated to the sufficiently recognized and studied issue of the stochastic veil.
Life is more complex than chess and taxpayers cannot use valuation methods that powerful.
So, they must be inconsistent in their valuations
as is amply evident from the stock market behavior. How then can the Law valuate assets
in a way consistent with the motives of ratio2 A Different Mechanism
nal taxpayers (if such can be defined at all)? In
fact, it cannot, which may explain why a non2.1 Consistent Valuation is Impossible.
distortionary tax system has not been achieved
The long term elasticity of resources has a no- yet. What this article suggests is that for some
table exception: the resource the taxpayer max- assets such valuation is not necessary.
imizes. Based on it, a tax with a less than 100%
marginal rate would be non-distortionary. Let 2.2 In-Kind Taxation
us call this maximized resource the value of a
taxpayer’s assets.1 We can treat it as the mar- If tax liability is expressed in-kind, rather than in
ket value for alienable assets (which taxpayers national currency units, it could avoid the need
can sell if somebody else values them more) and for any distortive valuation methods. The use
ignore the difficulties of valuating human assets of a non-market mechanism for translation of
in-kind assets into the currency is the needless
discussed in section 1.4.1.
Since tax needs to be collected periodically, source of distortion.
An example of an in-kind tax is military draft,
it would help if taxpayers’ goals were consistent,
if
we
ignore that it singles out healthy human
say, for one and two years periods. However, here
lies a fundamental difficulty, full understand- males from all other assets. Draft, however, ining of which has not yet spread in the economic volves slavery and thus creates a far greater inliterature. Let me illustrate it with an example. efficiency than tax-caused distortions. This inefIn playing chess the first idea that comes to mind ficiency prevents in-kind taxation of human capis to understand how to compute the value of ital, which is not too bad since income taxes
each position, and to choose each move to max- can handle salaries reasonably well. Besides laimize this value. The value must be consistent bor, the earned income tax covers indirectly the
across a move, i.e., agree with the best value of earners’ personal property which supports their
the next position one move can achieve. Such ability to work. Only commercial property reconsistent valuation algorithms do exist, but as mains a candidate for in-kind taxation. However, its diversity, indivisibility, and difficulty of
1
Consumption is often added as a separate term of
distinguishing from personal property create mautility. This should not be done here since human assets
are included. Most consumption serves to maintain, re- jor problems.
store, and grow human capital and so, adding it explicitly
On some backgrounds, addition of a comwould amount to counting it twice. Consumption also in- mercial property tax would smooth, rather than
cludes economically useless waste, a negative income on
create, the distortive distinction between comhuman weaknesses. Whether it can be deducted against
taxed positive income, I do not discuss: the equity tax mercial property and other assets. An example
ignores human assets anyway.
would be a consumption tax background, e.g.,
ing value appreciation. Taxing the price or income, the whole iceberg or just its tip at a tenfold
rate, is the same.
Some assets such as a family home or a private business produce fruits that are hard to separate from those of the owner’s labor, rendering separate taxation of labor and wealth difficult. Combined, labor and wealth taxes form
an income tax, based on all income whatever
the source. Then, neither human uniformity nor
market value of wealth can help to assess their
economic power for a graceful taxation.

Leonid A. Levin

The Equity Tax and Shelter

[Hall, Rabushka] type, which defines commercial
property and exempts investment in it from taxation. To be eligible, the property must yield no
significant personal benefit besides taxable income. The diversity and indivisibility of property can be handled as follows.
The owner posts the property price and is
taxed at, say, 2% of it per year. He also faces
a 2.5% chance per year that the IRS takes and
auctions the option to buy the property for this
price. (The extra .5% of this rate encourages
accurate pricing, offsets auction costs, and can
be used to reward the second highest Vickrey
bidder who loses the bid but sets the payment.)
Taxpayers would face the auction of their commercial property typically once in a lifetime and
could minimize the risk by accurate pricing. This
stochastic tax may be too volatile for the US.
It is interesting as a thought experiment and
may provide a convenient complement to consumption taxes for countries where administrative structures are too rough to allow a smooth
function of income taxes. It has similarities with
the Swiss land tax system. However, Swiss authorities have the discretion to choose which properties to take and how to dispose of them; this
is not a matter of chance and auction and so is
open to distortive variations or even abuse.

2.3

Equity Tax

One major part of the economy, the corporate
sector, yields itself to in-kind taxation, the equity tax, quite gracefully. The conversion to the
system is a voluntary contract. The converts and
their shareholders pay no income, dividend, or
capital gain taxes. Instead, they give the IRS,
say, 2% of stock per year to auction. The effect
is roughly similar to lifting the corporate income
tax in exchange for somehow assuring the annual
realization of capital gains on all stock. A few
particularities need to be mentioned.
• The IRS accumulates the shares at a continuous rate. It receives distributions on
but cannot vote its shares: the taxpayer acquires its own shares or prints new ones for
the auction and transfers them to the winners; the IRS receives only the proceeds.

5

The auction timing and procedure may be
made more or less automatic to minimize
the IRS’s influence on the market.
• The tax applies to equity, which fluctuates
in value along with its issuer. Other longterm securities, such as bonds, issued by
equity taxed firms for income-taxed holders must have value readily computable from
contract terms and global economic parameters and be so depreciated or appreciated.
If default becomes a danger, securities cheapen
below what the IRS allows, encouraging
the holding of such low-grade securities through
equity taxed intermediaries, such as mutual funds.
• Equity-taxed corporations may own eachother’s shares, directly or through shares
of income-taxed intermediaries. To avoid
double taxation, the IRS waives the tax
on cross-owned shares, crediting it to the
shareholder. The income tax code may
provide a similar credit in the case when
the owned company is income-taxed; then
it must use a very conservative method of
allocating the income to the period of ownership.
• Since equity-taxed companies cannot accumulate untaxed gains, the gift and estate
taxes, too, should spare their shares.
• Equity tax needs less accounting regulation, but some is still needed to prevent
fraud, such as disproportional benefits to
major shareholders, unrecorded compensation for employees and other income taxed
partners, such as creditors, etc.
• Attracting multinationals would require a
protection from multiple taxation by different jurisdictions.
• The 2% rate is just an example. The actual
tax rates may vary with economic conditions to accommodate general constrains,
e.g., to keep public debt below public assets. Equity taxed firms are not affected
by the rate fluctuation, except for timing

6

The Equity Tax and Shelter
investments, divestments, or conversions.
So, what the income and equity taxes must
avoid is significant predictable rate mismatch.

2.4

Conversion Tax

Stocks have equal expected return, but varying
untaxed appreciation may be foreseen. To prevent tax savings via reconversions, it must be
recaptured, i.e., the convert’s capital gains realized. The formula may vary with specifics of
income tax; assume 20% income tax rate. A
company reconverting to income tax gives the
IRS put options for 20% of its shares at a price
which sets the new cost basis.
A company converting to equity tax issues
new shares, comprising 20% of all shares and the
IRS auctions a part of them. The other part is
returned to the old shareholders as a credit to
offset, at the auction price, the second taxation
of the cost basis. This basis includes, in constant
dollars, the share’s purchase price and all aftertax per-share corporate income reinvested after
the share’s acquisition.
The auction bids contain the upper limit for
the share price and the total dollar amount of
the purchase. When the bids are unsealed, the
shares are distributed for the price at which the
demand and supply meet. The cost-basis credit
is treated as an auction bid with infinite share
price limit.
Assume I have 2,000 shares bought for $75
each (prices in constant dollars) and going now
at $100. Since my purchase, the company reinvested $20 of after-tax income per share. My
cost basis is $(75+20) x 2,000 = $190,000 with
20% tax credit of $38,000. The company prints
me 500 new shares which is 20% of the new total
of 2,500. They would sell for $100 x (100%-20%)
= $80 per share. I shall keep $38,000/$80 =
475 new shares; the new owners will pay the IRS
$2,000 for the remaining 25.
Variations. The two given examples of in-kind
taxes consist of several largely independent elements that can be used in different combinations.
The investments in in-kind taxed sector can be

Leonid A. Levin

or be not tax-deferred, i.e. deducted from investor’s income tax in exchange of taxing future
withdrawals, such as dividends. The tax can be a
fraction of interest in the business or a chance to
take it in a lottery. It can apply to the business
itself or to an option to get it at a price set by
the owner. This price would be subject to a separate tax. It can be an asset tax, based on the
value or, in case investments are tax-deferred,
an income tax, based on its change. All these
variations work automatically, sparing the taxing authority any valuation responsibilities.

3
3.1

Effects
The Advantage

Let us define the corporate net return as the
stock price growth plus the dividends minus the
resulting stockholders’ tax liability. I assume
the companies and investors act rationally maximizing this return. Its near future expectation
drives the investors and determines the share
prices. Under the equity tax, the net and pretax (net plus all general taxes) returns are proportional: maximizing one, maximizes both. I
assume special externalities are offset by special
liabilities or otherwise do not affect my conclusions. Then maximization of each company’s
pre-tax return maximizes the one of the sector.
Under most other tax systems maximizations
of net and pre-tax returns are in conflict. Taxes
cannot be based directly on the taxpayer’s return to avoid games with the share prices. Yet,
the sector’s total return can be easily monitored
and kept in a monotone correspondence with the
total tax revenue. I assume this correspondence
is set independently of the tax system and taxpayers’ actions. Since the total tax would not be
lowered without lowering the net return, companies are thrown into a competition to shift the
tax onto each other at the expense of lower pretax return. This loss of efficiency makes the sector worse off than under the equity tax.

Leonid A. Levin

3.2

The Equity Tax and Shelter

Transition

The equity-taxed sector has a uniform tax burden, i.e., the ratio of tax to either return or the
stock price reflecting the expected return. The
burden of some income-taxed companies, however, is significantly lower than average. Such
favored companies (e.g., start-ups) would stay
under the income tax despite the efficiency loss.
The others would flock to the equity tax, escaping both the loss and the higher burden. The income tax laws would be easier to fine-tune to the
diminished sector, making its tax burden flatter
and further diminishing the favored layer. Above
this layer, the income tax will retain primarily
businesses that cannot go public.
This approach sets the equity and income tax
rates to equalize the sectors’ burdens.
A smoother transition would be achieved if these
rates are introduced gradually, starting from the
pre-reform income tax rate and the equity tax
rate that would be revenue-neutral once the bulk
of initial conversions is completed. Even these
rates would lower the burden imbalance: the efficiency bonus would raise the converts’ price, lowering their burden at the same tax revenue level.
While not as equitable or stimulating, these rates
leave no losers: the willing converts must think
themselves better off; the others pay the same
tax and the IRS still collects the same revenue.

3.3

Volatility

A small difference between the equity and income taxes lies in the effects of volatility. Shares
with the same expected return but lower volatility may be higher priced, though proliferation of
diversified mutual funds diminishes this effect.
Thus, some low volatility companies may have
an incentive to stay out of the equity tax, possibly counterbalanced by their lower ability to
mask reinvested income as deductible production
expenses. Another effect is that the share price
reflects the expected, not actual return. So, the
equity tax leaves its subjects fully exposed to
their fortune, while the income tax makes them
share part of the volatility with the public.

3.4

7

Dangers of Evolution.

An issue with any new tax is its possible evolution. Can the equity tax start as a voluntary
replacement for a wealth-based part of income
tax and end up its mandatory addition, stripped
of the income tax shelter feature? This seems unlikely. A smaller obstacle is the lack of motives.
The equity tax leaves no reason for corporate,
dividend, or capital gains taxes. The amount of
revenue collected is just a matter of rates, not of
eclectic additions. A serious rate imbalance (creating, in effect, a separate wealth tax) would be
a more real danger if the equity tax was mandatory. Such a mandate, though, might require a
constitutional amendment, as income tax did.
A greater safeguard is that corporations cannot be forced to become or stay public and meet
various requirements needed for the equity tax to
work. So, a mandatory version of the equity tax
would be a tax simply on the status of publicly
traded corporations. This status could not bear
much tax since corporations would just change
it. The damage to the economy would be great
and the revenue small. In some town the tax
classification of a building depended greatly on
its plumbing facilities. So, people just used the
woods, avoiding the larger tax!

Conclusion
Fundamental reasons preclude objective valuation of assets or income they generate. Resulting distortions can be avoided if tax liability is
expressed in-kind, leaving valuation to the market. Human and, closely related, personal assets
are hard to tax in-kind. Thus, only commercial
sectors of the economy are eligible for the tax
options discussed here. These instruments are
interesting at least as a thought experiment and
may have practical applications as well.
The in-kind taxes leave out personal earnings, though their more limited diversity mitigates the difficulties of taxation. This tax also, of
course, leaves alone the exempt sectors. Less fortunately, unlike its rougher stochastic variation,
it cannot add grace to the taxation of private
business. However, it frees the publicly traded

8

The Equity Tax and Shelter

Leonid A. Levin

sector from the tax games. This body of “demo- References
cratic capitalism” thus should grow more attractive and absorb an even greater part of economic [1] A.S. Fraenkel, D. Lichtenstein. Computing a
perfect strategy for n × n chess requires time
life. This “attractive distortion” is purely posiexponential
in n. J. Combin. Theory (Ser. A)
tive, without cost to other sectors.
31:199-214, 1981.

Acknowledgments

[2] M.J. Graetz, A.C. Warren, Jr. Integration of
the Individual and Corporate Income Taxes:
This article benefited from criticism of many.
The Treasury Department and American Law
I am especially grateful to Zvi Bodie, Michael
Institute Reports. Tax Analysts, Arlington
Manove, Oliver Oldman, Jayendu Patel , James
VI, 1998.
Poterba, Daniel Shaviro, David Weil, and Eric
Zolt. This gratitude does not imply their en- [3] R.M. Haig. The Concept of Income. In R.M.
Haig (ed). The Federal Income Tax, 1921.
dorsement of my opinions. This research was
partially conducted by the author for the Clay
[4] R.E.Hall, A.Rabushka. The Flat Tax. Hoover
Mathematics Institute and supported by NSF
Inst. Press, Stanford, 1983, 1995.
grant CCR9820934.
[5] L.A. Levin. The Century of Bread and Circus. Tax Notes, 77(7):858-860, 11/17/1997.
Sections “A Gentler Taxman,”
“A Straighter Taxpayer.”
http://www.cs.bu.edu/fac/lnd/civic/bread.htm

[6] W.S. Vickrey. Counterspeculation, Auctions,
and Competitive Sealed Tenders. J. Finance,
16, 1961.

Leonid A. Levin

Taxation and Valuation

1

Appendix: A brief summary (not in Tax Notes). Taxation and Valuation.
The greatest harm from highway robbers lies not in seized wallets but in inhibited travel. Similarly,
incentives for tax-reducing strategies put much sand in the wheels of the economy. Demands
to replace our monumental tax code with a simple, graceful one that does not distort economic
incentives heat up periodically in political debate, but such dreams never materialize.
A fundamental obstacle, not yet well understood in the economic literature, is the impossibility
of objectively evaluating the tax base – assets, income, etc. One can see this even in toy examples,
say, trying to assess the value of a position in Chess: great masters’ assessments will all differ.
(Here computer theory can add an insight not provided by classical economics tools.)
A way around is to avoid evaluations by expressing the tax in natural units, not in cash. For
publicly traded corporations these could be corporate shares. I discuss a simple (postcard-sized
in all details) corporate tax system that avoids any distortion of incentives. (Tax tools meant
to influence corporate policies should be set as explicit separate taxes or credits, open to public
scrutiny, not hidden between lines of an incomprehensible tax code.) Roughly, the system is to
periodically take a t·i fraction of shares to auction, where t is the tax rate, i is the interest rate. It
replaces all income taxes on publicly traded corporations, their subsidiaries, and shareholders.
(One way to view this is that tax on income invested in the public sector is deferred – treated as interest-bearing
debt. This obviates the need to determine which part of the corporate value is untaxed income: All of it is if either
investments into public sector are pretax, divestments taxed, or as in our equivalent but simpler case, vice versa.)

The interest rate is defined via specially-designed bonds, so that the whole system can be shown
precisely equivalent to a flat tax on investment return. Note that taxing the return directly
is impossible: it would invite manipulation of stock market prices.
The main feature is that nothing corporations and investors do can change their tax (t·i fraction
of shares), so they would do business exactly the same way they would without taxes.

Cash Taxes Cannot Avoid Distortion of Incentives.
Taxes have major costs beyond the revenues they collect: deadweight loss from distorted incentives,
costs of compliance, enforcement costs, etc. (The report of the 2005 President’s Advisory Panel on
Federal Tax Reform mentions a trillion dollar annual waste.) Countless attempts to alleviate these
effects invariably just shifted the distortions from one place to another.
Here is the key observation: Modern economics, based on classical game theory, assumes rational
optimization of some consistent, legally definable values such as assets or their growth (i.e. income).
This, however, fails to recognize the infeasibility of consistent valuations and other types of optimal,
rational behavior in many games (much more so in real life).2
For instance, to play chess the first approach 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 he best value of the next position one move can achieve. Indeed, each
position does have such a consistent {±1, 0} value: one side has a winning strategy or both have a
draw. Just keep moving to positions of the same value. What a silly way to pass the time!
What keeps it fun is the exponential computation any such strategy has been proven to require!
I argue that any feasible legal definition of the tax base value will be inconsistent with taxpayers’
motives and thus distortive. (Taxing any feasibly defined gain in chess positions would change the
game entirely.) There are, however, unusual but neat, sound, and practical ways around.
2
Economists do now recognize, besides grain, land, and coal, the relevance of another commodity: information.
I doubt all fully realize how subtle this concept is, but even a cursory attention to it has brought progress.
Yet, one more factor – intelligence – needs acknowledging. Even with full and perfect information the IRS couldn’t
match all taxpayers in intelligence, and thus in ability to evaluate their assets. Lacking such ability, t acts like a bull
in a china shop, vandalizing our economic life.

2

Taxation and Valuation

Leonid A. Levin

A Corporate Tax Code on a Postcard.3
First, the market-clearing interest rate i is set via TIPS bonds designed so that either side – the
Treasury and a Publicly Traded Corporation (PTC) – could unilaterally get any desired bond exposure at that rate. The Treasury must absorb all differences between supply and demand by buying
such bonds back at the (inflation-adjusted) purchase price or issuing more. But it can change i
at-will (with due notice, so customers can buy or sell bonds before the new rate takes effect). So
it controls the supply and demand to keep its desired bond exposure, too. The PTC tax rate t is
just set by the law.4 It should agree with the effective private sector rate, to keep the net capital
flow between the PTC’s and the private sectors tax-revenue-neutral. Now, the full PTC tax code:
At regular dates (also on in-dividend dates), PTCs give the IRS to auction a t·i fraction of external
(held outside the PTC sector) shares. They buy back shares for this or issue more. External shares
are registered in a separate pool: auctioned shares dilute only this pool, not PTC-owned shares.
Going public turns the cost basis of prior shares tax-deductible. But it triggers a conversion tax :
giving the IRS (to auction) options to buy a fraction t of shares at the strike price totaling all
corporate income tax to date. (Similar “strike price credits” can be used later for other taxes e.g.,
foreign taxes under US treaties.) Reconverting to private, a company can establish its shares’
cost basis b by giving the IRS put options for a fraction t of its shares at strike price b.
Bond-like securities with no voting rights can be taxed similarly if they are tradable in fractions.
But a simpler equivalent tax is to charge their proceeds the interest t·i, compounded for all the
time the security was held outside the PTC sector.
This code replaces corporate income tax on PTCs, their subsidiaries, and all taxes on their
shareholders’ dividends and capital gains. It distorts no incentives: boosting post- and pre-tax
values is exactly the same. Its enforcement and compliance costs are minimal. It requires no
complicated regulations, except those unrelated to taxes, say, protecting minority shareholders.
The impossibility of hiding or delaying liability lowers tax rates. A steady trickle of auctioned
shares may even have some stabilizing effect on the stock market. This Equity Tax (ET) emulates
the t-rate tax on (real) return5 : market pressures would keep the variable i close to return rates.
The precise match with tax on return is clearer via ET’s equivalent but a bit more cumbersome
variant: ET*. It differs from ET like IRAs from Roth IRAs: all investments (from private sector)
are income-tax-deductible and divestments are income-taxed (both at rate6 t). Then the entire
stock market capitalization V would be untaxed income, the deferred tax t·V on it – an enormous
loan from the Treasury. To finance it the Treasury can sell bonds and pay interest i·t·V on them,
compensated by ET* (proceeds from the i·t flow of auctioned shares). Similarly, any company can
spend this loan (deferred tax) on bonds, the interests on which would compensate its ET*. The net
expense would be t·r, to update the bond portfolio as the company’s worth grows by its return r.

3

L.Levin. “The Equity Tax and Shelter,” Tax Notes, 93(9).
Some wishful thinking: The US Constitution requires fair compensation for private property taken for public use.
This seems to imply spending taxes to fairly benefit the taxpayers, e.g., giving them a tax-weighted say in approving
public spending levels. Then, they would do a better job than the Congress in setting tax rates optimal for growth.
5
which cannot be taxed in cash based on stock prices, lest firms manipulate the market, undermining its integrity.
6
Personal tax is progressive. But it can be viewed as a flat rate t applied after deducting typical living expenses
which grow sublinearly with earnings.
4

Leonid A. Levin

Taxation and Valuation

3

Just One Issue in a Broader Scope.
The tools discussed work only for the PTC sector. The point was that the failure of all persistent
tax reform efforts had a cause which, while fundamental, can be circumvented in important cases.
The above tools cannot add grace to taxes on closely-held business or personal earnings. Yet those,
too, have aspects that can benefit from reforms. Some widely discussed examples:
Dividends and capital gains taxes have low rates but apply largely to income already taxed
at the corporate level. This is widely criticized. Making dividends (paid from taxed income) taxfree and allowing companies to deduct capital losses on share repurchase would be more consistent
than lower tax rates on dividends, capital gains, and corporate income.
Gifts/Estates also should avoid double taxation. Stock market income and gifts received can
be excluded, as they should have been fully taxed already. The rest, instead of a large standard
deduction, can get a tax credit for all income taxes the donor ever paid.
Taxes on medical expenses penalize deductibles in medical insurance. Needlessly low deductibles make one careless with expenses7 which is widely blamed for skyrocketing medical costs.
Taxing medical expenses up to the same cut-off level regardless of whether paid by the taxpayers
or by their insurance can rectify this harmful tax-induced distortion.
Many other concerns and ideas would, of course, resurface with the tax reform drive
heating up again. E.g., taxing housing rent expense depresses population mobility.
(As they say, “When a tenant marries the landlord, the national income shrinks.” :-)
The topic of the publicly traded sector is just one of a great many, however, it is a large one,
assuring that at least some significant improvements are achievable.

7

The insurance effect is diffusion of responsibility. This agrees with the general liberal ideology which has a reason:
Since society absorbs much of the rewards of one’s success, it should also absorb much of the pains of one’s failure.
Otherwise people would have a suboptimal risk tolerance. The conservative counterargument seems to be: “While
three lefts make a right, two wrongs do not.” :-). It seems general tax policies should be neutral on such issues.

