Tax On Capital & Savings Flashcards
Individuals market income
Z = wl + rk
Labour income inequality is due to… (3)
Differences in working abilities (education etc)
Work effort (hours, effort etc)
Luck
Capital income inequality is due to
Differences in wealth k
Rates of return r
Which is more concentrated
Capital income (since rich people own a large proportion of total capital)
So more wealth inequality!
How is there differences in wealth
Inheritance
Savings behaviour
Capital accumulation is correlated strongly with what
Growth
Which is more mobile internationally
Capital is more mobile internationally than labour
Residence vs source base capital taxation
Residence: tax based on residence of owner of capital (they may reside in a diff country to where the capital is)
Source: tax based on where the physical capital actually is
Most are residence based
Thus residence based tax means incidence falls on the owner: how can they avoid tax? (2)
Tax evasion (offshore tax havens)
Change residence to a place where residence based tax is low/zero
Which taxes are source based
B) who has incidence?
Real estate property tax
B) incidence is partly shifted to labour, and recall capital is mobile i.e capital can leave country, hurts wages of domestic workers (since less productive with less productive)
Wealth expression
Differences in wealth and capital income due to (4)
Age (older have more wealth?)
Past earnings and past saving behaviour
Net inheritances received
Rates of return (some make more successful investments)
In US 2012 top 1% wealthiest families contribute to how much of total wealth
40% total wealth
Life cycle vs inherited wealth
Life-cycle wealth is wealth from savings earlier in life (responsible for this)
Inherited wealth is wealth inherited (not responsible for this)
What has been happening to inherited wealth overtime
Recently growing
Life cycle model:
Individual lives 2 periods, works l, earns wl, consumes c₁ and c₂
What is savings expression (s) , if no taxes
S = wl - c₁,c₂ = (1+r)s
No tax!
What is utility function
U = u(c1,l) + δv(c2)
Utiltiy from consumption from period 1 and period 2 but discounted since impatient, value consumption today more than tomorrow
Maximimses utility where
max u (wl - c2/1+r, l) + δv(c₂)
Intertemporal budget
c1 + c2/1+r <=wl
present value of consumption has to equal labour income!
First order condition labour supply
first order condition savings
Savings: Saves up until where the MU is equal across time (MU₁ = present value of MU of consumption in period 2
What if we introduce a tax rate on consumption (tc)
what happens to the intertemporal budget constraint
just add 1+tc to the equation
(1+tc)[c1 + c2/1+r] <=wl
What if tax on labour tl
what happens to intertemporal budget constraint
c1 + c2/1+r <= (1-tl)wl
When would a consumption and labour income tax be equal?
b) what can we recognise (what variable is affected, and which is not)
if
1+tc = 1/(1-tl)
b) both taxes distort only labour supply (since reduce income reduces consumption and also labour supply) but not savings!!!
what if they tax capital income tk
c1 + c2/[1+r(1-tk)] <=wl
as recall r is capital income (i think.. double check)
What does a consumption tax distort
what does a labour income tax distort
what does a capital income tax distort
Both taxes distort only labour supply (since reduced income reduces consumption and also labour supply) but not savings!!!
Capital income tax only distorts savings (not labour supply)
what about a comprehensive income tax t on both labour and capital income
b) what is distorted
c1 + c2/[1+r(1-t)] <= (1-t)wl
b) both labour supply and savings (a double tax! taxes both earnings and savings)
Simpler model to show how capital tax distorts savings. For simplicity let c1 = w - s (earnings is fixed in C1, just w not WL!)
So
IBC: c1 + c2/[1+r(1-tk)] <=wl as shown earlier.
And c1 = w - s
Suppose tk increase: what happens?
Substitution effect: price of 𝑐2 ↑ ⇒ 𝑐2 ↓, 𝑐1 ↑ ⇒ savings 𝑠 = 𝑤 − 𝑐1 decrease.
2) Income effect: consumer is poorer ⇒ both 𝑐1 and 𝑐2 ↓ ⇒ savings 𝑠
increase.
Result: Net effect ambigious - both opposing effects
How can we express this capital tax diagramatically
Pg 18 shows initial status, pg 19 shows the capital tax introduction
Y axis c2
X axis c1
Reduced budget constraint slope, since can achieve less c₂ possible since now pay capital tax.
Draw new lower IC on the new BC
Pg 20 shows the substitution and income effets
Substitution effect is the fall in savings (so gap between c*1 and w gets smaller)
Income effect is overall less income so reduced consumption, so savings increase.
In this diagram example pg 20 we can see income effect outweighs substitution effect since overall consumption has fallen and savings has increased.
Current US tax system: what is taxed
B) what do some conservatives advocate for?
Income tax which taxes both earnings and capital (targets earnings and savings)
B) some want shift to consumption tax (think its wrong to discriminate/reduces future consumption) a consumption tax weights equally
Cons of going from this labour tax to consumption tax
It generates double taxation of transitional generation (those who paid labour tax when working, now also need to pay consumption tax when old - unfair)
Are consumption taxes progressive?
No, tend to be flat
Opposed to income tax which are generally progressive
2 models on optimal capital income tax
Life cycle (as explored) : wealth due solely to life-cycle savings
Models with bequests: wealth solely due to inheritances
Government can use labour income tax T(wl) and capital income tax (tk)
Assume individuals only differ occarding to their earning ability w
Recall the budget constraint
𝑐₁ + 𝑐₂/1 + 𝑟(1 −𝜏𝐾) ≤ 𝑤𝑙 − 𝑇 (𝑤𝑙)
Atkinson-Stiglitz theorem: what is the optimal tax tk on capital
Zero capital income tax (tk) , labour income tax T(wl) is sufficient
I.e savings should not be taxes
Atkinson-Stiglitz: so why is it efficient to only tax labour?
Recall assumption individuals only differ according to earning ability w. Thus inequality in life-time resources is due to differences in earnings ability, which can be reduced/addressed with labour income tax
Capital tax needlessly distorts saving (reduces future consumpption)
Another pro of Atkinson Stiglitz
From a justice view, its right to not discriminate against savers (through capital tax) if labour earnings is the only source of inequality
Limits of life cycle model:
Unrealistic to assume labour earnings is the only source of inequality. In reality capital income inequality can be due to other things
So an issue of life-cycle model is it is unrealistic to assume labour earnings is the only source of inequality.
In reality capital income inequality can be due to (3)
In reality capital income inequality can be due to:
Difference in rates of return across individuals (better advice/access to info)
Shifting of labour income into capital income
Inheritances
Differences in rates of returns across individuals can create capital income inequality.
Explain
In general, richer people can invest in higher return assets and have better advice!
How to reduce capital income inequality?
Tax capital income! I.e reduce the magnitude of inequality that this (richer people investing in higher return assets and have better advice!) creates!
Shifting of labour/capital income
Difficult to distinguis between capital and labour income.
E.g hedge fund managers receive fraction of profits which are really labour income but are taxed as capital gains
How to solve?
Tax capital income to reduce this tax avoidance opportunity!
