1 Taxation and Personal Saving, G 22 Since 1960's, U.S. personal savings rate (fraction of income saved) averaged 7%, lower than 15% OECD average. Why? Why do we care? Efficiency issues 1. Negative consumption (status) externality: more spending by one makes others whose spending stayed same feel worse off. 2. Technology externality: Saving facilitates investment in capital (productive durable inputs); speeds development and adoption of new technology. 3. Taxes on capital income are distortionary and the distortions accumulate over length of investment.
2 Taxation and Personal Saving, G 22 Possible reasons for low U.S. saving: 1. Capital income taxes a little higher than in many OECD countries. Probably reduces saving, but effect in theory is ambiguous. 2. Periods of lowest saving rate were periods of large unrealized capital gains (rising house and stock prices), so true income and saving rate was higher, close to but still less than in other OECD countries. 3. Easy access to credit cards and other forms of consumer credit.
3 Taxation and Personal Saving, G 22 Life cycle model of saving for retirement:
4 Taxation and Personal Saving, G 22 Compounding yields higher rate of return: $1 saved at age 25, earning 5% real interest for 40 yrs yields $7 (1.05) 40 at age 65; at 3% interest, yields $3.25 (1.03) 40. Lower interest, flatter budget line: C R slope = 7 slope = 3.25 C W
5 Taxation and Personal Saving, G 22 Lower return can be due to 40% capital income tax: $100 invested earns $5 interest in 1 yr. Pay 40% = $2 tax. Keep $3 after-tax interest, so get 3% after tax return in 1 yr. After 40 yrs, $1 pays gross return 1+r = 7, after tax return $3.25 = 1+r(1 t) = 1+ 6(1.625), t= effective tax rate 62.5% Compounding raises effective tax. C R slope = 7 = (1+r) slope = 3.25 = [1+r(1 t)] C W
6 Taxation and Personal Saving, G 22 Capital tax can raise consumption, reduce saving: A B
7 Taxation and Personal Saving, G 22 Here capital tax lowers optimal consumption, raises saving: A C
8 Taxation and Personal Saving, G 22 Taxing capital income increases saving when the consumer wants to keep nearly constant ratio of consumption levels in the two periods (more common for poorer consumers want enough consumption each period). Taxing capital income reduces saving if substitution effect is bigger than income effect: more likely when substitution effect is big (consumer does not care so much when consumption occurs), more likely for richer people. Many richer people also have capital income while they are working. Capital income tax has an additional income effect by reducing their endowment both now and the future, so it is more likely to reduce current consumption. Since rich are biggest savers, the total effect of taxing capital income is probably to reduce saving. Social insurance reduces need for precautionary saving (for rainy day). Expanded Medicaid probably reduces saving, Gruber, Yelowitz 1999, Jones, et. al
9 Taxation, Capital Income and Inflation, G 22 Inflation above 13% in 1980 raised nominal incomes. With progressive tax, marginal tax rates rose. Since 1981, tax rates are indexed for inflation. Example: Suppose income up to $40000 is taxed at 10% and income above that is taxed at 15%. A worker with $40000 income in yr 1 pays $4000 in tax. If there is 10% inflation for all goods and services, then in yr 2, the worker's income is $ If taxes are not indexed, then the nominal income above $40000 is taxed at 15% and the tax is $4000+(.15)(4000)=$4600, higher than 10%. Indexing for inflation raises the cutoff for 15% tax by the 10% inflation rate. Then income up to $44000 is taxed at 10%. But this indexing does not remove the effect of inflation on taxation of capital income. Suppose someone owns a $50000 bond that pays 4%/yr interest, or $2000/yr. If interest is taxed at 10%, the tax is $200. If instead, there is 10% inflation, then with the same real interest rate, the nominal interest is about 14%/yr, or $7000/yr and the tax is $700 even though the inflationadjusted return is the same as before. There is the same effect for capital gains. A $50000 asset could increase in value at the 10% inflation rate. Its real value hasn't changed, but the $5000 increase in nominal value is a taxed capital gain if the asset is sold.
10 Tax Incentives for Retirement Saving, G (k) Account: Offered by employers. Up to $16500 in employee deposits deducted from taxable income, often partially matched by employer. Employer contribution also tax deductable. Principal and returns taxed only when withdrawn. Penalty if withdrawn before age 59 1/2. Employer determines available assets (often own stock). Over 60% of workers aged have account; median value less than 1/4 what needed to maintain current consumption. Individual Retirement Account (Traditional IRA, started 1974): Deposits up to $5000 limit ($6000 if age over 50) deducted from taxable income. Limit falls to 0 for AGI (incomes) in ranges $ for singles, $ for married. Noncollectible assets allowed. Principal and returns taxed only when withdrawn. Penalty if withdrawn in under 5 yrs or before age 59 1/2. Withdrawal must start at age 70.
11 Roth IRA: Like traditional except deposit not tax deductible; return tax free. Limit is on total traditional and Roth deposit; Roth limit falls to 0 in AGI ranges $ for singles, $ for married. r = rate of return on saving without tax; t 1 and t 2 are current and future marginal tax rates on capital income. Without IRA, $1 saved earns gross return 1+r(1 t 2 ). Gross return 1+r with Roth IRA (future tax is removed). But saving over $5000 limit gets after-tax gross return 1+r(1 t 2 ). Roth IRA budget line is kinked. Roth IRA tax break reduces future tax revenue. future consumption 5000 slope = [1+r(1 t 2 )] budget line with Roth IRA slope = (1+r) budget line without IRA, slope = [1+r(1 t 2 )] current consumption
12 Traditional IRA BUDGET LINE: Each $1 put in traditional IRA can be deducted from taxable income. It reduces the current tax due by t 1 so current consumption falls by 1 t 1. The $1 deposit earns pretax gross return 1+r. Consumer pays tax on all of it and keeps (1+r)(1 t 2 ). So the slope of the budget line with traditional IRA is (1+r)(1 t 2 )/(1 t 1 ) up to $5000 deposit, which reduces current consumption by 5000(1 t 1 ). Beyond the limit, additional $1 reduction in current consumption gives gross return 1+r(1-t 2 ). future consumption slope = [1+r(1 t 2 )] budget line with Traditional IRA slope = (1+r)(1 t 2 )/(1 t 1 ) budget line without IRA, slope = [1+r(1 t 2 )] 5000(1 t 1 ) current consumption
13 Tax Incentives for Retirement Saving, G 22 If t 1 = t 2 so marginal tax rate when the money is deposited equals marginal rate when the money is withdrawn, then the traditional IRA budget line has same slope (1+r) as Roth IRA when saving is below the limit. If t 1 < t 2 (later marginal tax rate is higher), then Roth IRA is more favorable. Slope of its budget line for saving below the limit is steeper than for traditional IRA. If t 1 > t 2 (later marginal tax rate is lower), then traditional IRA has steeper budget line for saving below its limit. But Roth IRA allows bigger reduction in current consumption, so it may still be more favorable for saving near the limit.
14 Effect of IRA on Saving: For large savers, most money going into IRA would be saved anyway (reshuffling). Current consumption rises; saving falls due to rise in wealth (parallel shift in budget line). future consumption budget line with IRA current consumption
15 Effect of IRA on Saving: For large savers, most money going into IRA would be saved anyway (reshuffling). Current consumption rises; saving falls due to rise in wealth (parallel shift in budget line). Consumers who save less than limit might lower current consumption, save more future consumption current consumption
16 Effect of IRA on Saving: For large savers, most money going into IRA would be saved anyway (reshuffling). Current consumption rises; saving falls due to rise in wealth (parallel shift in budget line). Consumers who save less than limit might lower current consumption, save more; or might raise current consumption and save less. future consumption current consumption
17 IRA Effect on Saving: Theory is ambiguous. Must estimate. How? Compare IRA depositors' saving before and after deposit? Problem: income and stock price rise; saving could rise without IRA. Compare depositors' saving with nondepositors' saving. Problem: different preferences; depositors are bigger savers. Compare different cohorts' saving; later ones had IRA available longer. Problem: rising income+stock prices, falling marginal tax rates. Compare new depositors' consumption to past depositors' consumption. estimate 0 to 25% of IRA deposits induced saving, Attanasio, DeLeire '02. Comparing 401(k) eligibles to similar ineligibles, Benjamin '03 estimates 25% of 401(k) deposits are induced saving. Duflo et al '06 experiment: e-filers offered 20% or 50% match of IRA deposits deposited 4 or 7 times as much as control group without match. Much bigger effect than IRA itself. Related to tax advice in experiment.
18 Subsidy for Employer Provided Pensions Employer provided pension: like traditional IRA; deposits deductible. Principal and return taxed only when withdrawn. Defined Benefit: benefit formula depends on worker's time and earnings from employer (like SS). Defined Contribution: benefit determined by return on pension investments. Pensions and 401(k)s help workers with self control problems. Saving is deducted automatically from paycheck. Evidence of self control problems: Workers allowed to commit fraction of future wage increases to 401(k) increase saving; amount depends on default option, Thaler et al 2004.
19 Taxation, Risk Taking, Entrepreneurship G 23 Ambiguous Effect of Progressive Tax: Lowers expected return to effort and investment, but also lowers variance in returns. Same ambiguous effect on investment in human capital (education and job training). Important factor: education reduces average future income risk (more educated usually have less unemployment). Tax loss offset: Investment losses deducted from taxable income. Full loss offset provides more insurance. But to limit fraud, only limited losses are deductible and tax is not allowed to become negative. Income typically varies more than wealth, so income tax (with full loss offset) provides more insurance than wealth tax with same expected revenue. Income tax is more efficient than wealth tax if there is no fraud.
20 Capital (Cap) Gains Tax G 23 Accrued capital gain in a period: Increase in market value of owned durable good during period. Tax on accrual: tax due on accrued capital gain in each period. Realized capital gain: difference between durable good's cost when bought and its sale price when sold. Tax on realization: tax due on realized capital gain only when good is sold. Favored tax treatment for capital gains? 15% federal income tax rate for most cap gains; 0% for low incomes. Tax on realization (when good is sold) lowers effective tax rate; delayed tax payment is like interest-free loan of the tax due. The effective tax reduction is bigger the longer the good is held. This creates lock-in: To delay tax payment, taxpayers hold assets longer than if there was no tax. Step-up basis at death: Unrealized cap gains at death untaxed (taxed through estate tax, in 2010 on wealth above $5M). "Cost" to heirs (called cost basis) for future cap gains tax is market value when they get the good. $250,000 cap gain on primary residence untaxed ($500,000 for married).
21 Capital (Cap) Gains Tax G 23 Accrued capital gain in a period: Increase in market value of owned durable good during period. Tax on accrual: tax due on accrued capital gain in each period. Realized capital gain: difference between durable good's cost when bought and its sale price when sold. Tax on realization: tax due on realized capital gain only when good is sold. Favored tax treatment for capital gains? BUT part of gain is inflation. Cap gains tax is on nominal gain (unadjusted for inflation) instead of real gain. Inflation raises effective tax rate, making cap gains less favorably treated than if real gain were taxed. NOTE: Inflation does NOT make capital gains less favorably treated than other types of capital income, just less favorably treated than if there were no inflation. Nominal interest, dividends, and rent are taxed (interest rate is normally higher due to inflation).
22 Capital (Cap) Gains Tax and Inflation G 23 We now consider whether taxing on realization (delaying the tax payment) compensates for the extra tax burden due to inflation. Suppose the real rate of increase in the value of a capital asset is r per year, the rate of inflation is i per year, and the tax rate on capital gains is t. If the tax is on the nominal realized capital gain, an asset worth $1 initially has real value 1+r and nominal value (1+r)(1+i) after 1 year, since a price of 1 rises to 1+i after 1 year. If the asset is held for a total of 3 years, then sold, its nominal sale value is (1+r) 3 (1+i) 3. The nominal capital gain is (1+r) 3 (1+i) 3 1 and the tax is t[(1+r) 3 (1+i) 3 1], so the investor keeps nominal value (1+r) 3 (1+i) 3 t[(1+r) 3 (1+i) 3 1] = (1+r) 3 (1+i) 3 (1 t) + t. If instead the tax was on real accrued capital gain, then the real after-tax value of the asset after 1 year would be 1+r rt = 1+r(1 t). After 3 years, the real after-tax value is [1+r(1 t)] 3 and the investor keeps nominal value [1+r(1 t)] 3 (1+ i) 3. If r =.05, i =.01, and t=.15, then the investor keeps $ under a tax on nominal realization and keeps $ under a tax on real accrual. The tax on realization becomes less favorable if the inflation rate is higher, but more favorable if the asset is held for a longer time, delaying the tax payment.
23 Capital (Cap) Gains Tax Rate Changes G : tax on only 40% of long term cap gains (assets held over 1/2 yr) Tax Reform Act (TRA86): 28% top marginal rate on all income Tax Reform Act: 28% top cap gains rate, other income 39% Taxpayer Relief Act: 20% top long term noncollectible cap gains rate Jobs and Growth Act: 15% top long term noncollectible cap gains rate. Tax revenue rises after tax cut: assets sold, cap gains realized at lower rate. Tax revenue falls over longer term. Opposite short run + long run effects.
24 Capital (Cap) Gains Tax on Realization G 23 Lock-in keeps capital in older, slower growing firms. Why tax on realization? 1. Hard to tell market value of many goods until they are sold. 2. Tax liability on accrual could force owner to sell to pay tax (possibly inefficient trade due to tax). Alternative: Retrospective accrual tax (Auerbach 1991). Pay tax when good is sold, but tax liability is adjusted to be what it would have been if assessed on real (inflation adjusted) accrual each year. Assume constant growth in value if real accrued capital gain is unknown. This removes most of lock-in effect of tax on realization and removes distortion from inflation. Leaves some lock-in if cap gain untaxed at death. Problem: finding cap gain of business.
25 Capital (Cap) Gains Tax on Realization G 23 What are arguments for favoring capital gains? 1. Reduce inflation and lock-in distortions. Retrospective accrual tax weakens these arguments. 2. Improve incentives for entrepreneurs. Capital gain is main source of return on investment in innovations and new businesses. Incentive issue most important for already successful entrepreneurs; quite rare. These arguments do not apply to hedge fund managers who can treat their income from managing others' capital as capital gains. What are arguments against favoring capital gains? 1. Favored treatment distorts investment toward activities with expected income growth vs. activities with steady profits. 2. The tax is partly on luck; provides efficient partial insurance.
26 Wealth and Transfer Tax: Gift and Estate Tax G 23 Gifts up to $13,000/yr per recipient are tax exempt. Estate tax before 2001: 46% of estate value above $2M in '11 $; About $30B/yr before reform raised exemption yr by yr, eliminating tax in 2010 (basis step-up also removed) : 35% tax on estate value above $5M. Bequest to spouse untaxed. Spouse estates taxed separately. $2B-3B compliance+avoidance cost, Munnell '88, ' probate lawyers; but planning costs remain without tax. Evasion: 60% of audited estates assessed more tax; total underpayment 40-50%, Wolfe '94, Erard '98. Tax may affect saving + labor supply of estate builders + heirs. $350,000 more inheritance lowers labor supply 12%, Holz-Eakin
27 Wealth and Transfer Tax: Gift and Estate Tax G 23 Estate tax effect on builder's saving depends on reasons for saving: (a) retirement; (b) precautionary; (c) targeted expenses; (d) wealth for status, power; (e) heirs' receipt. Arguments in favor of estate tax: Very progressive (paid only by very wealthy); limits concentration of wealth and power in few dynasties. Progressive lump sum tax on heirs if (e) not main saving motive. Reduces work+saving disincentive for heirs. But many estate builders may have partial motive (e). Evidence: estate tax avoidance; motives (a), (b), (c) cannot account for wealth of richest. Other motives like (d) can. Arguments against estate tax: "Unjust"--Nozick. Income was already taxed (except for unrealized cap gains); tax reduces return to saving for (e); big compliance cost; heirs may have to sell illiquid estate assets to pay tax.
28 Wealth and Transfer Taxes G 23 Responses: Tax can be paid over 14 yrs. Estate value is in current use, not market value, for farm and business real estate. Family farm value over 1/2 of estate is deductible. 58% of inheritors can pay estate tax out of financial assets. Rest can pay on average 80% of tax, Holz-Eakin, et. al. '99. Tax effect: Average 1998 donation $13M by estates over $20M. Property Tax on land and structures; most often charged by local govs; affects mobility across localities: property values rise in attractive localities, raising tax revenue or allowing lower tax rates. Theory suggests lower tax on more mobile (supply elastic) capital is efficient for a locality, ignoring externalities across localities. Many govs give businesses property tax breaks or subsidies to attract jobs. Examples: '03 Cincinnati-Convergys $52M; '04 NYC-Bank of Am $42M. Cost-benefit analyses suggest that in many of these incentive plans, the benefits do not compensate for lost revenue. In most other cases, there is special synergy between the firms and localities, Glaeser survey 2001.
29 Conclusions Tax impacts on saving are a central issue in public finance. Tax rate on income from capital accumulates when asset is held longer. Capital income tax probably reduces saving, but may sometimes raise saving and risk-taking since it also reduces variance of risky capital returns. Tax favored accounts (IRA, 401(k), pensions) probably increase saving but by substantially less than the amounts deposited in them. Favorable tax treatment of capital gains distorts investment toward riskier projects with chance of high returns. Strongest argument in favor: encouraging entrepreneurship; but the effect is unclear. Reducing capital gains tax gives windfall gains to past investments. Evidence: bigger rises in stock prices of older, slower growing firms. Lock-in can be reduced by retrospective accrual tax. Estate tax may reduce saving by estate builders who care about heirs' receipt It is a progressive lump sum tax on saving for other motives. Lower property tax on mobile business capital than on residences is efficient for localities, but imposes negative externality on other localities.