Taxing Wealth

Question 1

How has taxation of income vs. wealth developed over the last decades?

Answer 1

Taxation of labor income has increased significantly, while taxation of capital has gone down a bit

Question 2

What is skewed more: labor income or wealth?

Answer 2

Wealth! In NL, the 1% owns 25% of all wealth, whereas the 10% own 61%

But if pension funds are taken into account, the figures are reduced to 17% and 50%

Question 3

3 reasons we should tax wealth in addition to labor income?

Answer 3

1. The sum of all forms of income contributes to your power to consume
2. Consumption decided not only by your annual income, but your permanent income over many years
3. Due to random fluctuations, annual income may not reflect a person’s true ability to pay

Question 4

Two arguments for why we should not tax income from wealth

Answer 4

1. It is unfair because income (savings) has often already been taxed
2. Taxing prudent individuals more than others is unfair -> you are taxing people who are saving instead of spending

Question 5

What is an endowment point?

Answer 5

The point where you do not need to use capital markets to spread out your consumption

E.g., if you make 5000 in period 1 and 5000 in period 2, endowment is spending 5000 in period 1 and 5000 in period 2

If you earn 10,000 in period 1 and nothing in period 2, endowment is spending all 10,000 in period 1 and nothing in period 2

Question 6

What happens to spending vs. saving if we introduce a tax on income or consumption?

Answer 6

Net wages go down, meaning the budget constraint has the same slope but goes down. New indifference curve where you spend less both in the present and in the future

How it affects savings depends on the endowment point and your preferences to save

Question 7

What happens to spending vs. saving if we introduce a tax on income from wealth/savings?

Answer 7

The shift of the budget constraint is not parallel, but rotates at the endowment point -> it affects the relative prices of consumption in period 1 and 2, making consumption in period 1 “cheaper” (because savings are taxed again in period 2)

Question 8

Why does the budget constraint shift at the endowment point?

Answer 8

Because people that consume at the endowment point consume exactly their wages and exactly their pension -> they do not need to save and are not affected by interest rates

Question 9

What is the income and substitution effect of a tax on income from wealth?

Answer 9

Income effect: less money overall in both periods

Substitution effect: spending today becomes ‘cheaper’ than spending tomorrow -> incentive to notsave

Question 10

Prudent vs. imprudent: effect of tax on wealth

Answer 10

Prudent saves a lot and gets a lot of interest money -> pays high amount of taxes on the interest, thus a large reduction in the budget constraint

Imprudent borrows money from the future and since interest paid is deductible, they benefit from borrowing from the future -> budget constraint expands

Question 11

Which causes a higher excess burden: tax on labor income/consumption or tax on wealth?

Answer 11

Taxing consumption and labor income discourages labor supply -> it becomes less attractive to work more hours -> one distortion

Taxing wealth discourages savings as it makes consumption in the future more expensive and makes it less desirable to work -> two distortions -> larger excess burden

Question 12

Who has a higher tax burden when taxing wealth: Prudent or Imprudent?

Answer 12

Prudent because they prefer to save -> wealth tax taxes a preference

Question 13

5 reasons to tax income from wealth despite it being more distortionary than taxing income or consumption

Answer 13

1. Inequality in consumption originates from more than inequality in annual labor income -> people get income from elsewhere as well
2. The size of wealth is a signal of power to consume out of lifetime income
3. There is more inequality in annual income compared to annual consumption - if you have a year of low income, you do not change your consumption completely -> people that have persistently high income will be people who are able to save more, and the stock of wealth becomes a signal of how long you have had a high permanent income -> you want to target these people, not someone who randomly has high income in one year and low in others
4. Higher educated, more able individuals save more -> preferences are correlated with ability
5. Higher educated people are more able to obtain higher returns -> they manage their wealth in a smarter way

= taxing income from wealth allows a lower tan on other annual income

Question 14

3 arguments for why wealth should not be taxed at the same rate as labor income?

Answer 14

1. A tax on wealth yields an extra distortion compared to a tax on labor income (working hours + savings)
2. Inflation makes consumption in the future more expensive compared to today -> must correct for inflation before taxing
3. Very high rates lead to increased tax evasion -> income from labor better reported

Question 15

3 reasons for why we should tax wealth directly

Answer 15

1. Wealth signals cumulative “luck”
2. Wealth itself is enjoyed, represents ability to pay and political power, and wealth inequality has a direct impact on society
3. Wealthy individuals benefit more from state protection than others (police protection of their money, property etc.) -> they should pay more

Question 16

How are transfers of wealth taxed in the NL?

Answer 16

E.g., inheritance and gift taxes. Taxed but with a lot of exemptions -> every year you can give a certain amount to your child without being taxed

Question 17

4 reasons for why we should tax transfers of wealth?

Answer 17

1. Benefits society, not the government
2. Equality of opportunity
3. Less need for an inheritance tax if taxes on income from wealth reduce wealth inequality
4. Gift taxes are needed if society wants to tax inheritance, otherwise wealth is gifted before death

Question 18

What is the imputed returns of owning a house that is not taxed?

Answer 18

Saving rent payments

Question 19

Why are houses undertaxed?

Answer 19

House-owners are a strong lobbying group

Question 20

Under-taxation of houses causes an implicit…

Answer 20

Subsidy for owning a house

Question 21

Can subsidy of owning a house be defended by positive externalities?

Answer 21

Like being more involved in your surroundings and community -> does not match the scale of the subsidy

Question 22

Who bears the burden of property taxes?

Answer 22

Since the supply of land is very inelastic in the NL (it is almost impossible to buy new land) -> current owner benefits from subsidy of owning a house but also bears the burden of property taxes

Question 23

What is tax avoidance vs. tax evasion?

Answer 23

Tax avoidance is a legal search for a lower tax liability, whereas tax evasion is deliberately not complying with tax laws

Question 24

Who benefits the most from tax evasion in terms of wealth?

Answer 24

High income/wealth households

Question 25

What makes up the marginal cost and benefit of evading taxes?

Answer 25

Cost: Probability of detection * expected penalty + disutility cost of guilt and uncertainty

Benefit: amount evaded * marginal tax rate

Question 26

When can tax evasion have social benefits?

Answer 26

When evaders are poor or the labor supply of evaders is very elastic (meaning low-paying jobs)

Question 27

Who evades taxes the most?

Answer 27

High-income individuals - as seen through Amnesty programs

Older, wealthy men

Question 28

4 distortions created by the Dutch tax on income from wealth

Answer 28

1. Wealth invested in own house is subsidized
2. Pension savings subsidiced
3. Wealth invested in closely-held firm taxed differently from other wealth holdings (postponing realization of income)
4. Gift and inheritance taxes

Question 29

Mankiw’s 2 hypothetical CEOs - who should be taxed more?

Answer 29

Spendthrift should be taxed - he saves a little but loves the good life and influences political power

Frugal causes “positive externalities” by saving and living modestly

Question 30

What is the liquidity problem? And possible solution?

Answer 30

A wealth tax is a tax on unrealized gains instead of realized gains - but why should people pay taxes from income they haven’t received yet?

Solution: pay taxes when you realize the gain (e.g., sell the asset) -> but if it leads to people playing around with when they sell assets, you need to make them pay based on how long they wait