income identically) or as part of a‘dual’ income tax (applying a progressive tax to labour income and aflat tax to all forms of capital income). The choice of accompanying measures would evidently be key in shaping the overall distri-butional impact of the reform.
Fundamental change in the CIT treatment of debt and equity would proba-bly be too unsettling for some while, but movement to an ACE or cash-flow system is in this respect likely to be the less problematic route. Removing interest deductibility—even if only for ‘new’ debt—would risk amplifying financial distress. The alternative route of extending deductibility to equity finance, however, would have the opposite effect, and might make recapitali-zation of banks, for instance, more attractive than under current rules. The revenue impact, however, remains a concern, not least given the very deep fiscal challenges, amplified by the financial crisis and response to it, that many advanced countries now face.28
design schemes that tax on realization but mimic taxation on accrual, and there is some practical experience with them.30Greater neutrality in taxing capital income is likely to require more rather than less marking to market.
Though there are important overlaps, the objectives of tax policy need to be recognized as distinct from those of regulatory and accounting practices if each is to serve its proper purpose. Clearly, there are monitoring and compli-ance advantages in applying common definitions and concepts for tax and accounting purposes, and some see corporate governance advantages in closely aligning tax and book profits: this can create a helpful tension between the temptations to overstate profits for financial accounting purposes and to understate them for tax purposes. But the ideal tax base is not necessarily the most accurate measure of current income. For instance, valuing depreciation at (some reasonable approximation of) true economic rates is generally appro-priate forfinancial accounting, but there can be a case for encouraging invest-ment by allowing faster depreciation—or even full expensing—for tax purposes. It may also be appropriate to treat provisioning for bad debt differ-ently for accounting and tax purposes.
Recent proposals to move towards dynamic provisioning (as in the Turner Review (FSA 2009) and IMF 2009b, for instance)—meaning a systematic and mandatory counter-cyclical element of general provisioning—raise issues concerning the tax treatment of provisions for bad loans. The most common approach is to allow tax deductions only for specific provisions (related to the impairment of particular assets), not general. To the extent that dynamic provisioning would be analogous to depreciation allowances for physical assets that reflect their expected reduction in value (or sometimes more, if accelerated depreciation is allowed), deductibility could be argued to be appropriate. Other approaches might be needed if the CIT were to be fundamentally reformed.31
2.3 Housing
Housing is commonly subject to special tax treatment that may have increased household leverage and house prices. Taxation does not explain
30One such scheme, developed in Auerbach (1991), effectively charges tax on the excess of the actual sale value not over the acquisition price but over what that price would have been had the asset earned the risk-free rate, in effect taxing only the normal return while leaving the realization decision undistorted; Auerbach and Bradford (2004) describe a more general class of schemes achieving the same effect. Alworth et al. (2003) describe experience in Italy with schemes intended to mimic the effects of taxation on accrual.
31An incidental advantage of an ACE, for instance, is that tax incentives to overstate specific provisions would in principle be eliminated, since any increased deduction from doing so would be offset in PV by a reduction in Tier 1 capital and hence in the future imputed tax allowance on equity.
the widespread house price boom—that occurred in countries with very dif-ferent tax systems—and there are no obvious tax changes that might have triggered its collapse. But taxation does create substantial distortions in a market of central macroeconomic importance.
2.3.1 The tax treatment of housing
Within a comprehensive income tax, fully neutral taxation of owner-occupation would require full taxation of imputed rents and capital gains on housing, and deductibility of mortgage interest payments. Consider the alternative of, for instance, renting instead and investing in fully taxed assets: taxation of imputed rents—the consumption value of housing services—is needed to match the payment of market rents from taxed income; taxation of capital gains is needed to match the CGT liability on otherfinancial assets; and deduct-ibility of mortgage interest is needed to match the taxation of the interest available from investing in other assets.
In practice, imputed rents and capital gains on primary residences are rarely taxed, creating a general bias towards housing that mortgage interest relief—
where it remains—is likely to reinforce. Very few countries bring imputed rents into the income tax (the Netherlands and Switzerland being exceptions).32Some tax capital gains on owner-occupied housing, but typically more lightly than other income or only beyond a high threshold (or both). Even in the absence of distortions on thefinancing side, these features would tax-favour owner-occupa-tion relative to renting. And mortgage interest costs attract tax relief, subject to limits, in a number of countries (including Denmark, France, Italy, Spain, Italy, France, and the USA). Since borrowing to acquire other assets is generally not deductible, this makes investment in housing even more favoured.
Mortgage interest relief would not tax-favour mortgagefinance if the alter-native to borrowing were investing less in fully taxed assets and other interest were also deductible—but that is commonly not the case. If alternative invest-ments were fully taxed, mortgage interest deductibility would mean that the opportunity costs of acquiring housing by borrowing and by running down other assets would in each case be the after-tax interest rate—so mortgage finance would not be tax favoured. Many countries, however, tax other forms of saving (such as pensions) at reduced rates. In that case, if the return on those assets matches the pre-tax interest rate on mortgage debt, there is an arbitrage gain from leveraging against housing and investing own-funds in the non-housing asset. And, while interest on loans used to finance
32Several countries charge VAT onfirst sales of residences, which—to the extent that house prices are the present value of housing services—amounts to an implicit tax on imputed rents, though one that is not tailored to household circumstances in the same way that income tax is.
consumption is generally not deductible, home equity loans have provided (within limits) just such a tax-favoured way to borrow and spend.
The distributional impact of mortgage interest relief can be complex, but deductibility probably favours the better off. On the one hand, higher-income individuals may be more likely to face constraints on their access to tax-favoured assets (since this is often subject to caps), so that their opportunity cost of investing in housing is the after-tax return. This creates an argument for some tax relief to ensure that the less well off also pay an after-tax rate.
Against this, however, deductions are typically worth more to the better off, as they take them against a higher marginal rate of tax. The latter effect would be avoided if relief were provided—as many countries do—not as a deduction but as a credit (reducing tax paid, rather than the income taxed).
Ownership/occupation and transaction taxes are also important elements in the tax treatment of housing. Recurrent taxes based on ownership or occupation have potential appeal both as serving as user charges reflecting the value of local public services—and as such they are often allocated to lower-level governments—and, to the extent that these and other features are location specific, as being less vulnerable to interjurisdictional tax compe-tition than the CIT and other taxes on more mobile bases. There is indeed evidence that such taxes (along with consumption taxes) have significantly less adverse effects on growth than income taxation (Johansson et al. 2008).
Housing transactions themselves are often subject to tax, sometimes in signif-icant amounts (up to 9 per cent in Ireland).
2.3.2 Impact on prices and leverage
Tax policy can affect two key aspects of housing markets: house prices and households’ leverage. These are interrelated, as high house prices encourage removing equity through increased borrowing, the availability of cheap loans drives up house prices, and the expectation of price increases raises the ex-pected return on borrowing to acquire housing.33