Tax Holidays

• In Event: Realization

Abstract

A growing literature on capital taxation focuses on the problem of credible government commitment not to appropriate private wealth. This literature largely ignores, however, the risk of a one-time capital tax “holiday”—a dramatic temporary cut to capital tax rates. A capital tax holiday may be ex-post optimal under certain conditions, creating time-inconsistency challenges that are similar to expropriation. For example, anticipation of future tax holidays can distort household savings and asset allocation choices in ways that significantly reduce social welfare.

This paper presents a new framework for analyzing the holiday problem. We begin by modeling the decision to declare a holiday, explaining when and why a holiday may be ex-post optimal. We further enrich the model by adding a public-choice component, identifying conditions under which a reelection-motivated policymaker may favor a holiday even when the holiday is not socially optimal.

We apply this analytical framework to the current U.S. landscape, highlighting features that reduce the risk of holidays, reduce the risk of expropriation, and—in some cases—exacerbate the risk of both. Perhaps most importantly, the United States’ realization-based capital tax system may increase the risk of both holidays and expropriations by enabling capital owners to accumulate vast quantities of untaxed wealth while imposing only soft constraints on policy change.

These conclusions lead naturally to questions about the best direction for reform. We show how an annual accrual-based income tax can reduce both holiday and expropriation risk. We also explore the implications of our analysis for other credible commitment problems.

Authors

• Brian Galle, brian.galle@Berkeley.edu

• Daniel Hemel, New York University School of Law