Capitalization and amortization of taxes

Encyclopaedia of the social sciences, editor in chief Edwin R.A.Seligman, New York, The Macmillan Company, vol. III, 1930, pp. 211-213

Readings in the economics of taxation, selected by a Committee of the American economic Association, London, George Alien & Unwin Ltd., 1959, pp. 389-392

The term capitalization of taxesis properly applied to the case of an object which, being totally or partially exempted from a given general tax, rises in value by a sum equivalent to a capitalization at the current rate of interest of the amount of tax saved. The inverse case, that of an object hit by a special tax and as a result reduced in value by the capital value of the tax, may best be described as one of tax amortization. In the first case a buyer would pay for the object its original value plus the capitalized tax saving; in the second case he would pay the original value less the capital value of the tax. Thus if a special land tax reduces the net yield of a farm from $ 5000 to $ 4500, the capital value shrinks from $ 100,000 to $ 90,000. One who purchases at the latter figure continues to pay over to the state $ 500, but this is in effect merely interest on the $ 10,000 saved on the purchase price. The abolition by the state of the $ 500 annual charge would be equivalent to the free gift of an annuity of this amount or of its capital value, since the farm’s value would again rise to $ 100,000.

The first conscious experiment in tax capitalization was made in 1788 by the Grand Duke Pietro Leopoldo of Tuscany. Landowners were required to pay into the treasury a sum equivalent to the capital value of the tax based on an interest rate of 3.5 percent. The amount of tax thus redeemed, in terms of capital value, was 8,250,000 scudi out of a possible total of 12,500,000. In 1790, however, the new grand duke, Ferdinand II, yielding to the clamor of the interested parties, canceled the edicts of his predecessor and ordered that the sums paid be refunded and the land tax restored. More successful and better known is Pitt’s Redemption Act of 1798 in England, which provided that the land tax, already fixed in 1775 at four shillings per pound, be made perpetual at that rate and that taxpayers be permitted to redeem it at the rate of twenty times the amount of the annual charge.

Amortization theory, as applied to the land tax, plays an essential part in the single tax doctrine of Henry George. Once the whole net income from land had been absorbed by taxation the capital value would have disappeared, and any purchaser would have paid only for improvements. Although the purchaser continued to pay the net rental value as a tax the burden would in effect have been thrown back on the one who owned the land when the tax was first imposed.

In 1814 it was pointed out by Craig that the amortization process was not peculiar to the land tax but extended to all «exclusive» taxes; Rau observed that sometimes the fall in capital value consequent on special taxation was obscured by a change in the rate of interest or other factors; and Schaffle stressed the general character of the theory. The classic theory received its most definite formulation at the hands of Seligman, who summarizes as follows the conditions under which amortization may take place: taxation must be unequal, since if there is no excess of a given tax over the general taxation level there is nothing to be capitalized; the object taxed must have a capital value which is susceptible of diminution; the object taxed must be relatively durable in character; the tax must not be capable of being shifted.

Of all these conditions the one which demands the most careful analysis is the first. To be amortized a tax must rest on the taxpayers with unequal weight; but this raises the question, what is equality in taxation? Clearly a flat rate general tax on all income from capital alone is not an equal tax, because it exempts labor incomes. It might lead to the investment of new savings in education, etc., and substract them from ordinary investments. Thus it might raise the rate of interest and to this extent might reduce capital values. This would mean that such a tax is in some measure amortizable. Are we to regard as equal a general tax on all incomes (capital as well as labor), which in almost all countries is progressive, with exemptions at the bottom, and which frequently differentiates against property incomes? It is obvious that equality of taxation is a very refined and complex idea, which allows for apparent inequalities, intended to equalize the psychological burden of taxation for different taxpayers. An equal tax may be a compound of very unequal separate taxes whose total impact on the several taxpayers is evenly distributed. As this ideal of equal taxation is very difficult of attainment there will always be a residuum of inequality to which the amortization process can be applied.

In the classic theory amortization depends on the circumstance that a special or differential tax does not reduce the general rate of interest in proportion to the rate of taxation. If the rate of interest is 5 percent a 10 percent tax on a particular form of income does not change the rate of interest, because new savings can be invested in non-taxed fields. If the tax is general and all fields are equally hit, taxpayers can nowhere find investments free of the tax. All investments will yield a lower net return on account of the tax, but since they all suffer alike the rate of interest will be uniformly reduced from 5 to 4.5 percent, capital values remaining therefore unchanged. In other words no amortization can take place.

It is tacitly assumed, in the classic theory of amortization, that whatever is taken from the taxpayer by either special or general taxation is lost to him completely. If $ 500 is taken from a $ 5000 income by a tax it is assumed that the situation of the taxpayer is the same as it would be if his income were diminished an equal amount by natural causes. This assumption has been challenged by Einaudi in a paper published in 1912 and republished in enlarged form in 1919. Einaudi points out that we cannot appraise the effects of an equal tax apart from the effects of the use of the proceeds of the tax. A 10 percent general tax, as such, reduces all incomes; but without the tax and its use to the furtherance of the state ends economic society could not exist and private incomes would not be forthcoming. An equal tax is not to be regarded merely as a subtraction from private income, but as the portion of the total social income which ought to go to the state if that total income is to reach a maximum. Optimum taxation may be a composite of equal or general taxes, with special or differential taxes on windfall incomes and others which may be deemed worthy of a special burden. The ultimate effect of the introduction of an optimum tax system would in theory be an increase in the total social income and in the flow of new savings, a fall in the rate of interest and a rise in most individual incomes and their capital values. In cases of differential taxation there would be a decrease in the relative amount of the incomes affected. If the effect of this decrease were not counterbalanced by the fall in the rate of interest and the general increase in total social income, the capital value of such specially affected incomes would decline, or in other words the principle of amortization would become operative.

Actual tax systems are far from optimum either as to their structure or as to the use of their yield. Assuming small additions to the existing tax structure, to the extent that such new taxes depart from the optimum they do not increase and may even reduce total social income. The effect on the rate of interest will probably be to raise it above the level which would have obtained without the additional increment of taxation. Most individual incomes would decrease and their capital values would fall. The fall would be particularly marked in the case of incomes subject to special taxation or disproportionately burdened by the general system. Incomes less than proportionately burdened might rise and their capital value increase. In the actual world the phenomena of capitalization and amortization of taxes rarely, if ever, present themselves in clear outline. Any extensive fiscal change, whether involving mere quantitative increase or a shift in the objects of taxation, is likely to involve both types of phenomena in more or less disguised form.