55 Tax Notes 1125

Tax Notes

MAY 25, 1992

LENGTH: 5795 words

DEPARTMENT: Special Report (SPR)

CITE: 55 Tax Notes 1125

HEADLINE: 55 Tax Notes 1125 - THE PRIVATE ADVANTAGE OF MONEY-LOSING INVESTMENTS UNDER CUT-RATE CAPITAL GAINS.

AUTHOR: Johnson, Calvin

SUMMARY:

Calvin H. Johnson is professor of law, University of Texas.

This article is the third of a trilogy of articles on proposals to cut capital gains tax rates. The articles argue that the proposed cuts would make the structure of tax worse. Professor Johnson argues here that the proposed cuts would allow investors to make acceptable profits, after tax, from projects that lose money from a public or policy perspective. Corporations, Johnson shows, would rationally invest their earnings in projects that lose money if it meant that shareholders got capital gain instead of dividend tax treatment when the earnings were distributed. Investors in real estate, Johnson shows, would rationally build or buy real estate in which the rents were too low to make the project worthwhile in absence of tax. Johnson argues that the misallocation of capital caused by the cuts is serious enough that corporate stock and depreciable assets should be excluded from the benefits of the proposed lower rates.

The author wishes to thank Doug Laycock, Eugene Steuerle, Joseph Dodge, Tom Evans, and Mark Gergen for helpful comments and to thank

TEXT: 25 MAY 92

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Table of Contents

A. Corporate Investment. . . . . . . . . . . . . . . 1125

B. 'Full' Recapture Depreciable Property. . . . . . .1129

Conclusion. . . . . . . . . . . . . . . . . . . . . . .1131

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The Bush administration proposal to cut the maximum tax rate on capital gains to 15.4 percent /1/ invites a review of the structural problems in the taxation of capital gain. Structural issues are separate from issues about the appropriate rate or distribution of tax. Within any given level or distribution of tax, design faults that give unintended or indefensible incentives need to be minimized. Whether revenue is to be raised or reduced, the structure of the tax system should not be made worse.

This article is the third of a trilogy dealing with the structural problems involved in the taxation of capital gains. The first, 'The Undertaxation of Holding Gains,' /2/ argued that holding gains are undertaxed. The second, 'The Consumption of Capital Gains,' /3/ argued that much, probably half, of the proceeds of capital gain sale would be lost to consumption or to consumption durables and would not be reinvested in some new productive investment.

This article argues that the proposed reduction in the nominal capital gains rate would induce inferior investments by corporations and inferior investments in depreciable assets. With the cuts, investments that are money-losing investments from a public perspective or as a matter of social policy would become privately rational to investors who benefit from the preferential tax on capital gains. The waste of resources in the distortion of the private incentives is serious enough that corporate stock and depreciable assets should be excluded from the benefits of lower tax rates on capital gain.

A. Corporate Investment

A tax rate for capital gains that is lower than the tax rate on ordinary income will induce corporate managers to hold on to earnings at the corporate level, awaiting an opportunity to give the shareholders capital gain, even when corporate investments are worse than the best investments available to the shareholders. Tax will exacerbate nontax biases by corporate managers in favor of businesses they specialized in. For an important range of cases, a 15.4-percent ceiling on capital gains tax rates would cause a corporation to invest its earnings in assets that lose money while in corporate hands.

Tax law allows a number of opportunities for a corporation to distribute its earnings in a form that will qualify as capital gain to the shareholder. A complete or partial liquidation of the corporation, for instance, leads to capital gain for the shareholder. /4/ Redemptions, that is, sales of stock by a shareholder to a nonliquidating corporation, can also qualify for capital gains. The redemptions must qualify as 'substantially disproportionate redemptions,' which leave the shareholder with a sufficiently reduced fractional interest in the corporation, or as 'complete redemptions.' /5/

A corporation can improve the after-tax position of its shareholders by waiting for an opportunity to distribute its earnings at capital gains rates. If the administration proposal for a 15.4- percent maximum tax rate on capital gain were enacted, the corporation could, for instance, rationally invest its earnings for three years in assets that give the corporation no profit and shareholders would still be better off than if they received the earnings immediately.

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A Numerical Example. Assume that a corporation, A Inc.,

makes $ 1 in earnings and that both A Inc. and its shareholders

pay tax on ordinary income at the 34-percent rate. /6/ At its

34-percent corporate rate, A Inc. has 66 cents after its tax for

every $ 1 of its earnings. Assume that the shareholders can make

10 percent per year pretax by investing their money in some

productive investment. Assume that A Inc. is contemplating

buying an asset, such as a corporate jet or luxury house, that

will generate no tangible or intangible value to the firm in

excess of its costs, but which will keep its value for sale at

the end of three years. At the end of the three years, the asset

will be sold at neither gain nor loss and the proceeds will be

distributed to the shareholders. The distribution will be in the

form of a redemption or liquidation that qualifies for capital

gain. The corporation must decide whether to distribute its 66

cents immediately for the profitable investment by the

shareholders or invest it in the nonproductive asset for three

years.

If the corporation distributes its 66 cents after tax

earnings immediately to the shareholders, the shareholders would

have to pay tax at their 34-percent rate, leaving them with only

44 cents to invest. /7/ The shareholders' pretax 10-percent

return would also be reduced to 6.6 percent after paying tax at

the same 34-percent rate. At the end of three years, the 44

cents invested at 6.6 percent per year will yield 52.8 cents for

each dollar of earnings.

The shareholders would do better, ending up with 55.8 cents

per dollar of earnings, if A Inc. kept its earnings in the

nonproductive asset for three years to take advantage of the

proposed 15.4-percent rate. The 66-cent after-tax corporate

earnings would not grow or shrink in the three years in the

corporation's hands. Upon sale, there would be 66 cents to

distribute to the shareholders. The capital gains tax on the

distribution at 15.4 percent would be 10.2 cents, leaving the

shareholders with 55.8 cents per dollar of earnings, which is

better than for the more productive shareholder investment.

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With a tax cut on capital gains, the tax system would induce the corporation, in loyalty to its shareholders, to make an investment with no profit or social benefit, foregoing an investment with a healthy profit and social benefit.

For any distributions made within just short of four years after the corporation has earned the money, the corporation can suffer a loss and still match the shareholders' 10-percent pretax return from their own investments. Table 1 shows the pretax corporate return that will leave a 34-percent shareholder as well off with the corporate investment as with a 10-percent shareholder opportunity, for various periods 'n' between the corporation's earnings and the termination of the investing: /8/

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Table 1: Rate of Return Needed by Corporation To Match

Shareholder 10% Rate of Return

Gain on Corporate Shares Taxed as Capital Gain

Years 1 2 3 4 5 10 15

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Rate of

Return -25.5% -8.9% -2.8% +0.3% +2.2% +6.0% 7.3%

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Table 1 shows that for accumulations of four years, the corporation could have a negligible three-tenths of a percent annual pretax return and still give the shareholders what they could get from their own 10-percent pretax return. For distributions in a period shorter than 3.9 years after the corporation earns the money -- on stock held by the shareholders for the three years necessary to achieve the 15.4- percent rate -- the corporation can even lose money and end up beating the shareholders' pretax 10-percent return. /9/ For distributions a year after the earning, the corporation can lose 25 percent of the earnings invested and still match the shareholders' alternate return. /9a/

As more than four years go by, the better shareholder returns (10 percent here) grow more weighty in the balance. The rate the corporation must receive on its accumulations to do as well as the shareholder can do with immediate distributions rises above negative and toward the shareholder rate. Greater periods of investment reduce the advantage of waiting in poorer corporate investments to give the shareholders capital gain. Even for 10- and 15-year corporate investments, however, the disparity between the shareholder rate at 10 percent and the corporation's rate, at six percent and 7.3 percent, respectively, remains significant. The corporate returns approach, but never have to be quite as high as, the shareholder returns if the corporation can convert the tax on earnings to the lower capital gains rate.

Some incentive for inferior investments exists even under current capital gains rates. In 1990, Congress, in reaction to administration prodding, reenacted a small rate preference for capital gain, giving it a ceiling rate of 28 percent in a system in which ordinary investment income typically bears a maximum tax of 34 percent. /10/ The 28-percent ceiling available under current law means that for a one-year investment, the corporation can lose 3.4 percent to convert corporate earnings to 28-percent shareholder capital gain. /11/

The tax forgiveness that flows from a shareholder's death /12/ only makes the above analysis worse. With zero shareholder tax the corporation could lose up to 45 percent of its investment to convert to zero tax rate capital gains. /13/ If a corporation knew that its shareholder would die within 6 years, it could invest in investments that lost some money and still make the shareholder do better after tax. /14/ A corporation that judges its accumulations looking to shareholders near death can rationally make some pretty terrible investments.

Table 2 summarizes the corporation's return for various tax regimes that will allow the corporation to match the shareholders' 10-percent rate of return:

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Table 2: Rate of Return Needed by Corporation To Match

10% Shareholder Return

Gain on Corporate Shares Taxed as Capital Gain

Years 1 2 3 4 5 10 15

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Capital

Gain Rate

at 15.4%, R= -25.5% -8.9% -2.8% +0.3% +2.2% +6.0% 7.3%

at 28%, R= -3.5% +3.1% +5.3% +6.5% +7.2% +8.6% 9.1%

at no tax, R= -45% -20% -11% -5.9% -2.9% +3.4% 5.6%

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The incentive for inefficient corporate investment is and would be restrained somewhat by the difficulties of arranging distributions that qualify for capital gain. Corporations do not liquidate, terminating their businesses, /15/ commonly enough to distribute annual earnings on a periodic basis. For a small family-held corporation, a capital gain redemption is difficult to arrange. /16/ Publicly held corporations have considerably less trouble giving their shareholders capital gain by buying shares on a public market, /17/ although, even for public corporations, redemptions that are 'part of a periodic redemption plan' are said to create tax on the remaining shareholders. /18/ Short-term corporate investments of one or two years are especially subject to legal limitation on periodic redemptions, but, as shown by Chart 2, those are also the cases where conversion to capital gain justifies the worst corporate investments. Both the economic demand for capital gain distributions and the legal restraints on distributions will be most dramatic for distributions shortly after the corporation receives the earnings. In any event, incentives that induce a corporation to choose interests inferior to the shareholders' best interests are unfortunate whenever they are available. It is especially bad to have a tax system that allows a rational corporation to lose money.

We could remove the distortions in favor of corporate investment of its own earnings, under current conditions, by removing the lower rate on capital gains. If capital gains were taxed at the same rate as ordinary income, a corporation's decisions about whether to distribute or accumulate its earnings would be made according to who could get the best return as a matter of economics and without regard to tax. For an important range of cases, a corporation and its shareholders now pay tax at the same rate (i.e., 34 percent). /19/ When shareholder and corporate rates on investments are equal, shareholders are indifferent, for tax purposes, as to whether they pay their tax fraction of distributions early (on immediate distributions) or later (after corporate investment of the earnings), so long as the fraction lost to tax remains the same. When the corporate and shareholder tax rates are equal and the shareholder tax rate on deferred distributions is the same as the rate on immediate distributions, the shareholders are indifferent for tax purposes as to whether the investment of corporate earnings takes place at the corporate or the shareholder level. When they are indifferent for tax purposes, the real economic returns govern their investment decisions. /20/ A world in which the economic returns govern investment decisions is a better world; by changing the after-tax results, a tax distorts the investment decisions.

The tax bias in favor of corporate rather than shareholder investment exacerbates nontax biases that managers of the corporation have in favor of retaining, rather than distributing, corporate earnings. Retained earnings increase the empire of the managers, and an increase in empire is correlated with an increase in management compensation. /21/ Managers tend to increase their own amenities -- like corporate jets -- even if it is at the expense of the shareholders who are the theoretical owners of the corporation. /22/ In any event, tax law would do as well to tax accumulations higher, not lower, than it taxes immediate distributions, so as to counterbalance the nontax biases.

Any lower shareholder tax on corporate distributions would reduce the overall burden of tax on doing business in corporate form. Stock in C corporations is penalized vis-a-vis corporate debt and vis-a-vis doing business as a partnership, sole proprietorship, or S corporation. The corporate tax, combined with a second shareholder tax on distributed corporate earnings, can mean that returns on corporate stock bear tax at the rate of 56 percent, whereas returns from the identical activity conducted with other legal forms bear tax at a rate of only 34 percent. /23/ The Treasury Department and the American Law Institute have both recently published excellent studies on the structural issues involved in moving to corporate integration, under which corporate equity would bear only a single level of tax. /24/

Still, while there is a strong case for bringing the total tax on stock income down to par with the tax on other forms of income, lower capital gains rates are not a helpful way to do it. The point of corporate integration is to improve the use of capital, not to strengthen incentives for corporations to make money-losing investments. A capital gains cut that worsens the allocation of capital is antithetical to the purpose of corporate integration.

B. 'Full' Recapture Depreciable Property

Advantageous tax rates for capital gains will also motivate investments in money-losing depreciable property. One of the major targets of the Tax Reform Act of 1986 was real estate shelters. Before the act, debt-financed investments in real estate had a negative tax -- that is, the return was higher after tax than it would have been in absence of tax. The costs, mainly interest and depreciation, generated losses deductible from ordinary income; the returns, mainly debt forgiven to the investor upon sale, were treated as low-tax capital gains. The mismatch between ordinary deductions for the inputs and capital gain for the returns meant real estate was treated better than mere immunity from tax. Before 1986, only about half of the value of a typical real estate project came from rents or real demand for the project; the other half of the value of real estate came from the tax system through one's accountant. /25/ The Tax Reform Act adopted a number of anti-real-estate-shelter remedies intended to end the negative tax from real estate shelters, but ending the differential rate on capital gain was the single most potent of the remedies. /26/ Real estate was hardly the only kind of tax sheltering available before 1986, but it was a kind of sheltering in which the conversion of ordinary income into capital gain was an especially important part.

The administration's proposal would require that depreciation be recaptured in full; that is, that gain on the sale of real estate be treated as ordinary income to the extent of all prior depreciation deductions. /27/ Under current law, only the excess of accelerated depreciation over the amount of the straight-line depreciation available over the owner's holding is recaptured as ordinary income on sale. /28/ Full recapture is part of the proposals because of concerns about the subsidy for real estate under prior law. /29/ Applying full recapture to real estate for the first time would improve the situation. But, full recapture would not prevent tax subsidies that turn negatively valued, nonmeritorious real estate projects into viable investments.

Look, for instance, at the strip shopping center project described in the cash flow chart in Exhibit 1, following. /30/ In absence of tax, the project is a terrible investment that should never have been built. At $100,000 per year, the net operating income from the project is not nearly large enough to pay off the $8,000,000 financing needed to buy the project. /31/ If the building lasts less than 80 years the building never returns its cost. The project appreciates at a fairly modest 5.7 percent per year, which is the minimum amount needed to generate enough capital gain to satisfy the investor. Even considering appreciation of the project (from $8,000,000 upon purchase to $10,532,000 upon sale five years later), the project has a negative net present value (at 10 percent) of $491,000 in absence of tax. In absence of tax, the internal return from the project after five years of ownership is negative 1.1 percent.

But, with depreciation and interest deductions, deductible against a 34-percent-taxed ordinary income, and capital gain taxed at 15.4 percent, the project meets the owner's necessary return rate for equity investments (here 10 percent) and becomes justified. Tax adds almost a half million dollars in value to the shopping center (i.e., $491,000 (at 10 percent)) and turns a loss investment into a healthy 10-percent return investment.

The shopping center in Exhibit 1 is taxed under a full recapture regime. Only the $2,531,000 appreciation (line 15) over the original purchase price gets the advantage of the 15.4-percent rate. The depreciation taken (five times $254,000 or $1,270,000 for the five years of the holding) is taxed as ordinary income (line 16) when it shows up as part of the gain on sale. The negative tax making a money-losing investment privately rationally occurs in spite of full recapture.

The strip shopping center has no meritorious claim to subsidy. A tax system that converts the pretax loss into a post-tax gain has wasted capital. Taking away the lower 15.4-percent tax on capital gain would meritoriously take $292,418 of present value away from the shopping project and reduce the return from the investment to a negative one percent. /32/ That meritoriously precludes the investment.

Negative taxes can occur whenever a part of the investment has been deducted or depreciated but not lost, and the return is eligible in part for capital gain. Even straight-line depreciation over 31.5 years is faster than the real economic depreciation of the real estate. Debt financing exploits the difference. /33/ To prevent negative taxes as a matter of theory, capital gain has to be denied to all of the return, both profit and original investment, attributable to the part of an investment that has been deducted but not lost. Ordinary income treatment for just the previously deducted portion of that investment is not sufficient. 'Full recapture' of amounts previously deducted is not a sufficient remedy to prevent negative taxes.

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A Numerical Example. Assume an investment with $ 100 input

and $ 121 revenue in two years. The investment has an annual

return of 10 percent because 10 percent is the discount rate

that will make the present value of the revenue equal the

present value of the cost:

[equation omitted]

Deducting the $ 100 input immediately is equivalent to

nontaxation of the profit from this investment, because the

return rate remains at 10 percent if tax reduces the costs at

the same 34-percent rate that tax reduces revenue by:

[equation omitted]

If we enact a lower capital gain rate (here 15.4 percent),

but apply it only after full recapture of the $ 100 deducted,

then only $ 21 would be capital gain. But the tax regime of

deducting the $ 100 cost, plus capital gain on the $ 21

nonrecaptured gain, yields a negative tax because the

investment's return increases from 10 percent to 12.7 percent by

the operation of tax:

[equations omitted]

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The capital gains tax, in sum, has turned a 10-percent pretax return into a 12.7-percent posttax return, even with full recapture of the prior depreciation deductions. The regime, combining deduction of amounts that remain as investments with preferential rates on capital gain, was not a tax, but an antitax or subsidy equal to a little over a quarter of the pretax rate of return. In a system that tries to raise revenue rather than give it away, capital gain rates of any preferential amount are inconsistent with accelerated depreciation or expensed investments.

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CONCLUSION

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The two examples shown here show that capital gain applied to some money-losing investments will make them advantageous to the private investor. It will thus induce wasteful investments. Capital gain applied to future corporate distributions will make it rational for a corporation to delay distributions, so as to convert ordinary income dividends into capital gain, even though the corporation loses money in the meantime. Capital gain, even with full recapture, will also justify wasteful investments in expensed or depreciable property, where the deductions of the investments exceed the loss of the investments. If advantageous capital gain rates are enacted to be applicable to investments like undeveloped land, they should be denied to corporate stock and assets for which accelerated depreciation or expensing is available.

This trilogy of articles on the structural problems in capital gains has emphasized the detriments to the tax structure from the proposals to cut the maximum tax on capital gains to 15.4 percent. The first article, 'The Undertaxation of Holding Gains,' /34/ argued that current law locks capital into existing investments because it gives investors a tax incentive to hold on to property. Low effective rates available with long holding periods also distort investment because investors avoid realized gain and seek out unrealized gain. The administration proposals exacerbate the lock-in problems of current law by increasing the incentive to hold on to property for the first three years. The article recommended an interest charge and a repeal of the step-up in basis at death so as to take away the advantage of holding property and avoiding realized income.

The second article of the trilogy, 'The Consumption of Capital Gains,' /35/ argued that too large a proportion of the capital benefiting from the tax cut will disappear from productive investments upon a capital gain sale. The major rationale behind the administration's proposal to cut capital gains taxes is to encourage taxable sales that will shift capital to better investments. The proposals, however, do not require reinvestment as a condition of the preferential rate and in absence of an explicit requirement, the presumption that sales proceeds will be fully reinvested is unfounded. Much of the sales proceeds benefiting from the cuts will be consumed, especially in those sales where the most tax is at stake. The article argued that a preferential rate be conditioned upon rollover of the sale proceeds from a capital gain sale into a productive replacement investment. All three articles raise serious questions about enacting the proposed capital gains cuts. Whether revenue is to be raised or lowered and whether the tax burden is to be redistributed upward or downward, the structure of the tax should not be made worse.

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Exhibit 1: Sample Shopping Center (purchase price = $ 8,000,000)

[table omitted]

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FOOTNOTES

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/1/ President Bush, 1992 State of the Union address, 92 Tax Notes Today Electronic Edition 92 TNT 20-5 (Jan. 29, 1992); Department of the Treasury, General Explanation of the President's Budget Proposals for Fiscal Year 1993 Affecting Receipts at 7 (Jan. 1992). The 15.4-percent rate is computed by excluding 45 percent of capital gain and applying a maximum tax of 28 percent to the remaining 55 percent. The 15.4-percent rate is available only for sales on property held for more than three years.

/2/ Johnson, 'Undertaxation of Holding Gains,' Tax Notes, May 11, 1992, p. 807 (hereinafter, 'Undertaxation of Holding Gains').

/3/ Johnson, 'The Consumption of Capital Gains,' Tax Notes, May 18, 1992, p. 957 (hereinafter, 'The Consumption of Capital Gains').

/4/ IRC sections 331, 302(a), (b)(4) & (e), and 1222.

/5/ IRC section 302(b)(2) & (b)(3). A substantially disproportionate redemption occurs when the shareholder drops the shareholder's percentage of ownership by 20 percent and ends up with less than 50 percent of the corporation. See also IRC section 303 (redemptions to pay estate taxes and expenses).

/6/ IRC section 11 provides for a 34-percent tax rate for corporations for taxable income in excess of $75,000. For calculation of the 34-percent tax rate on ordinary investment income for a typical individual shareholder, see Johnson, 'The Undertaxation of Holding Gains,' Tax Notes, May 11, 1992, p. 807 at n.8.

/7/ .66 - .34(.66) = .436.

/8/ The table is derived from the formula

[equation omitted]

See Warren, 'The Timing of Taxes,' 29 Nat. Tax J. 499 (1986). The left side of the equation describes an immediate ordinary distribution for shareholder investment and the right side a corporate retention of its earnings until capital gain is available for the shareholders. Solving for R, for various n's, (1) becomes

[equation omitted]

In Table 1, T is the corporate tax rate (34 percent), R is the corporate rate of return on its investments (derived figure), t is the shareholder tax rate (34 percent), t' is the shareholder capital gains rate (15.4 percent), and r is the shareholder rate of return (10 percent). The assumed t' is 15.4 percent, which means that the shareholder must have held the shares sold for three years before selling, although three years have not necessarily elapsed since the corporation's earnings.

/9/ Under equation (1), supra note 8,

[equations omitted]

/9a/ For negative returns in table (1) the formula assumes that the corporation will save immediate tax at rate 34 percent of the loss. That assumption is plausible for inventory with a high turnover; for other investments the tax-recognized loss may be considerably lower (or higher) than the economic loss of rate R.

/10/ Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101- 508, section 11101(c), adding IRC section 1(j). For calculation of the 34-percent tax rate on ordinary investment income, see Johnson, supra note 6, 'The Undertaxation of Holding Gains,' Tax Notes, May 4, 1992, at n.8.

/11/ The formula for the break-even corporate return, supra note 8, equation (2) is

[equation omitted]

Using .28 for t' (instead of .154) with n=1, means that R equals negative 3.5 percent.

Distributions more than 1.4 years after the corporate earnings require some positive return in the interim for the corporation. Using .28 for t' in the formula solving for breakeven 'n,' supra note 9, if

[equation omitted]

/12/ IRC section 1014.

/13/ [equation omitted]

See supra note 8, equation (2).

/14/ Under equation (1), supra note 8,

[equations omitted]

/15/ IRC sections 331 and 302(e).

/16/ IRC section 302(b)(2) and (3) requires a drop of 20 percent of the redeemed shareholder's fractional interest in the corporation (and to minority status) or else a complete termination of interest in the corporation. The rules aggregate families and related entities to see if there is a sufficient drop in fractional interest or a real termination (IRC section 302(c)(1) by reference to IRC section 318), although once a generation, family relationships can be ignored (IRC section 302(c)(2)).

/17/ See, e.g., Rev. Rul. 76-385, 1976-2 C.B. 92 (reduction in shareholder's interest from 0.0001118 to 0.0001081 of the corporation's stock held to be meaningful enough to qualify for capital gain).

/18/ Redemptions that are part of a periodic redemptions plan are said to create stock dividends to remaining shareholders who increase their fractional interest in the corporation, while isolated redemptions do not. Compare Treas. Reg. section 1.305-3(e) example 9 with examples 10 and 11.

/19/ IRC section 11 provides for a 34-percent rate when corporate taxable income exceeds $75,000; households with four exemptions pay tax at the rate of 33.8 percent for taxable income between $150,000 and $278,000 (for calculation of the 34-percent tax rate on ordinary investment income, see Johnson, supra note 6, Tax Notes, 809, at n.8.

/20/ A corporate investment for n years will leave the shareholder in a position equal to an immediate distribution followed by a shareholder investment for n years when

[equation omitted]

Equation (1), supra note 8. Where T = t = t', equation (1) simplifies to

[equation omitted]

Whether the left side (shareholder investment) or the right side (corporation's investment) is larger depends upon whether r (the shareholder's pretax return) or R (the corporation's pretax return) is higher.

/21/ See, e.g., W. Baumol, Business Behavior, Value, and Growth 46 (1959). At very least, shareholders are hurt less by the manager's salary as the assets managed to go up because the manager's salary is amortized over a larger amount of assets and shareholder net worth.

/22/ Even loyal managers specialize in the kind of businesses or assets they manage and they tend to reinvest earnings in their own specialty. Their specialization means that managers cannot diversify their risks as well as shareholders can: 'The manager cannot take as cavalier an attitude toward diversifiable risks of the corporation as the stockholder can.... If [the manger] loses his job, his company- specific skills or knowledge will become valueless and he will incur large adjustment costs in finding a new job.' Hu, 'Risk, Time and Fiduciary Principles in Corporate Investment,' 38 U.C.L.A. L. Rev. 277, 320 (1990). Managers do in fact diversify to offset risks, but unfortunately they seem to generate inferior returns from their investments when they diversify, undoubtedly because they lose the expertise value of specialization. Id. at 324; F. Lichtenberg, 'Industrial De-Diversification and its Consequences for Productivity,' NBER Working Paper No. 3231 (1990).

/23/ A corporation receiving $1 and paying 34-percent tax would be left with $.66 to distribute. If the distribution is then subject to 34-percent shareholder tax on ordinary income dividends (34 percent of $.66 is $.22), the shareholder would be left with $.44 per dollar of corporate income, meaning that the two taxes have taken $.56 per dollar.

/24/ Amer. Law Inst., Federal Income Tax Project: Integration of the Individual and Corporate Income Taxes: Draft Reporter's Study (Jan. 10, 1992); Treas. Dept., Integration of the Individual and Corporate Tax System: Taxing Business Income Once (Jan. 6, 1992).

/25/ Johnson, 'Financial Impact of the 1986 Act on Real Estate Investments -- A View from the Spreadsheets,' 36 Tax Notes 309, 313 (1987).

/26/ Id. at 322.

/27/ Department of the Treasury, General Explanation of the President's Budget Proposals for Fiscal Year 1993 Affecting Receipts at 7 (Jan. 1992).

/28/ IRC section 1250.

/29/ See, e.g., Johnson, supra note 25, at 322 (arguing for the necessity of full recapture when preferential capital gains rates return).

/30/ The assumptions underlying Exhibit 1 include: Net operating income of $100,000 and a purchase price of $8,000,000 (arbitrary givens). The property appreciates over five years at 5.7 percent annually, which is derived from the price a purchaser needs to get a 10-percent after-tax return rate. Appreciation at that level would be reasonable if demand or financing or tax conditions improve. Financing of the purchase price is assumed with a 25-year, constant payment mortgage bearing eight-percent interest (a reasonable assumption under current conditions). The tax assumptions include a 31.5-year useful life, required for nonresidential real estate, a 34- percent tax rate on ordinary income, and a 15.4-percent tax on capital gain.

/31/ The $100,000 annual net operating income is only 1.3 percent of the $8,000,000 purchase price.

/32/ The difference between 34-percent tax and 15.4-percent tax on capital gain (line 15) is 18.6 percent of $2,531,946 or $470,942. The extra tax, at ordinary rates, would reduce the net present value of the overall project from 0 (at 10 percent discount rates) to negative $292,418. Diminishing the year five cash flow by $470,942 reduces the internal return from the project from 10 percent to negative 1.3 percent.

/33/ See, e.g., Johnson, 'Soft Money Investing Under the Income Tax,' 1989 Ill. L. Rev. 1019, 1070 (1990).

/34/ Tax Notes, May 11, 1992, p. 807.

/35/ Tax Notes, May 18, 1992, p. 957.

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