Tax Simplification and Financial Markets

Four tax reforms have been proposed in recent years: BradleyGephardt, Kemp-Kasten, Treasury I and Treasury II. These reforms seek to improve economic efficiency by taxing different capital assets and sources of income more equally. Each reform is purported to be revenueneutral from the perspective of the U.S. Treasury ,and distributionally neutral across households. While this alleged neutrality is probably (certainly, in some instances) overstated, it is analytically convenient to assume revenue and distribution neutrality. It is also convenient to abstract from growth and inflation effects. Even with revenue and growth neutrality, the reforms could substantially affect financial markets. Reductions in investment incentives and marginal tax rates would tend to lower before-tax interest rates,1 and lower taxes on existing corporate capital would tend to increase stock prices.2 The pattern of security issues would be altered by resulting changes in the composition of investment between real estate and other assets and in desired loan-to-value ratios. The paper compares and