Taxes on Savings (Chpt. 22) Flashcards
What do savings decisions and income taxation determine?
Economic growth - Determine how much capital is available to businesses.
What’s capital income taxation
Taxation of the return from savings.
What are the two alternative models of saving?
Precautionary model (self-insurance against risk).
Self-control model (competition between short-run impatience and long-run patience).
What does taxation in this context affect?
The amount an individual will spend vs. save.
What’s meant by smoothing consumption?
Keeping consumption constant over time, so one doesn’t fully depend on income received in a given period (feasting and starving periods vs. always eating - diminishing marginal utility of consumption, as it’s a normal good).
Intertemporal choice model
The inverse of savings choice (a bad? - don’t get any direct utility) is consumption choice (a good.)
A savings curve is: Person’s income - current consumption.
Consumption in working life (Cw) =
Y [income] - Savings
Consumption in retirement (Cr) =
Savings (1 + r [interest on savings]).
Indifference curve
Set of bundles of consumption of Current consumption and Future consumption (Cr) that give you the same level of utility (between which you’re indifferent).
Intertemporal Budget Constraint
Set of bundles at which income is exactly exhausted.
Opportunity Cost
What you’re giving up for sticking with your choice.
According to the Intertemporal Budget Constraint (BC), what will be the current consumption if Cr =0? And the future consumption if Cw = 0?
Cw= Y
Cr = Y(1+r)
What’s the slope of the BC and why?
-(1+r), you can derive it. But it represents the opportunity cost of choosing to Consume all of your income during working (Y at Cw), you’re missing out on the second-period consumption and the interest rate on the savings.
How do we model savings?
We don’t. We model current consumption (Cw) and solve for savings as a residual.
What happens to the graph when a tax on interest income is introduced?
r becomes r(1-t).
BC flattens because slope goes from -(1+r) to -[1+r(1-t)].
Cr intersection goes down from Y(1+r) to [1+r(1-t)].
Cw intersection stays the same.
What does the flattening of the BC imply?
A lower relative price of Cw to Cr, making it more attractive to consume now, but also making the individual poorer. (Substitution and Income Effects).
What’s the substitution effect on a tax on savings?
S baja bc current consumption goes up bc it becomes relatively cheaper.
What’s the income effect on a tax on savings?
S sube to smooth out consumption over time (aunque tenga queue bajar both current and future consumption). Net effect is uncertain.
Explain Bracket Creep and how the U.S. tried to fix it
Increase in tax rate (higher tax bracket) despite no increase in REAL income. Nominal income is increased but it’s not adjusted for inflation. Solved in 1981 by indexing tax brackets (adjusting for inflation=real income).
Did indexing tax brackets remove inflation’s impact on income taxation?
No. Interest rate earned on bank accounts is determined by nominal interest rate, while improvement in purchasing power from saving is determined by real interest rate.
Inflation & Capital Taxation: What are the variables that savings income is affected by? Which one interests savers and does it work?
Nominal interest rate (earned on savings y la que se usa- ↑ Y) - fake
Inflation (↓Y, ↓ earnings i)
Taxation on earnings (↓Y)
Real interest rate (purchasing power - much lower than nominal) – INTERESTS SAVERS, BY HOW MUCH WILL MY PURCHASING POWER GO UP (no por mucho).
What’s the effect of higher inflation on savings?
Lower real after-tax return on savings.
What’s the formula for the BC?
BC: Y = Cw + (Cr/1+r)
Real interest rate (i) formula
(1 + Nominal i.r) / (1 + Inflation rate ) - 1
Explain tax subsidies/deferrals or tax-deferred savings accounts
Individuals shielded from taxation on their savings and interest. Individuals being taxed on savings only upon withdrawal as regular income (otherwise, you’d pay taxes as you earn the money).
What is the effect of tax subsidies/deferrals on savings or return on savings? And why?
Tax deferrals increase ↑ return on savings because
- Time Value of Money: Present discounted value (Money now is worth more than in the future because you can earn interest on it).
- Lower future marginal tax rate (highest tax bracket into which their income falls): Lower tax bracket than in working life because income is lower than when they worked.
