Solutions and Activities for CHAPTER 23 TAXES ON RISK TAKING AND WEALTH Questions and Problems 1. The tax system has a 50% tax rate on gains from risky investments, and also allows a deduction at a 50% rate of any losses from risky investments. Which tax policy would increase risk taking more: (a) allowing those deductions on any losses, or (b) limiting the deduction only to losses that offset other gains (no loss offset)? Allowing an investor to use the deduction for losses to reduce taxes on other gains will provide an incentive for the investor to take more financial risk, because the government is bearing some of that risk by protecting the investor against part of the loss. An investor has an incentive to take risks, particularly if he expects a large, otherwise taxable, gain from another source. If losses could not be used to offset gains, as in (a), the investor would bear a greater share of the risk of loss. 2. The Job Growth and Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced the rate at which capital gains are taxed, but it included a sunset provision whereby the tax rate returned to its original level in 2009. How was this sunset provision likely to have affected capital gains tax realizations and revenues in 2008 and 2009? Individuals with unrealized capital gains had a strong incentive to realize the gains in 2008, before the tax rates rose again. Indeed, an investor who anticipated realizing capital gains in 2009 had an incentive to realize the gains in December 2008 instead. This leads us to expect a boom in capital gains tax revenues in 2008 and a corresponding reduction in revenues in 2009. Offsetting this but probably only partly is the fact that the lower level of realizations in 2009 is taxed at a higher rate. 3. President Berry suggests changing the capital gains tax law such that taxes are assessed when the gains are accrued rather than when they are realized. Why would investors tend to oppose this policy change? The most obvious reason that individuals would not want taxes to be levied on accrual rather than on realization is that it would increase their effective tax rate. When taxes are levied only on realization, investors gain the benefit of compounding: if, for example, they earn a 10% rate of capital gains each year and they hold the asset for two years, a realizationbased tax allows them to earn a 10% return in the second year on both the initial investment and the 10% return from the first year. Taxing on an accrual basis would remove this advantage and increase the effective tax rate. In addition, accrued gains are those associated with increases in the value of an asset and thus are, in a sense, hypothetical. The asset is worth more, in terms of increasing the owner s ability to consume other things, only if it is sold. Investors would object to this policy change because they would not want to pay taxes on an increase in value that has not yet been realized. First, they may not have the cash on hand to pay the tax and thus may have to 1
CHAPTER 23 / Taxes on Risk Taking and Wealth - 2 - sell, or liquidate, the asset before they intended to. The timing of the sale of assets should not be dictated by tax bill dates. Second, the accrued value of some assets may be hard to determine (unless of course they are sold). Finally, the accrued value of some assets fluctuates a paper gain can be wiped out and regained repeatedly. Whether a tax is owed in any given tax year will depend on the date on which the value is determined. 4. Prior to 1997, many university professors who moved from expensive places like Boston or San Francisco to low-cost cities like Madison, Wisconsin, or Gainesville, Florida, tended to purchase extremely large houses upon their moves. This tendency was dramatically curtailed after 1997. What feature of the U.S. tax code encouraged this behavior? For many taxpayers, their homes are their most valuable asset, and homes can experience significant appreciation. Generally, when appreciated assets are sold, the appreciation, or gain, is taxed as a capital gain. For homes, though, there was an exception if the gain was used to purchase a taxpayer s next home. Housing prices in Boston and San Francisco are very high, so the appreciation on houses in those cities is also high, even if the appreciation does not represent a large percentage; a small percentage of $1 million is still a large amount. To shelter the gains from taxation, home owners had to use them to buy another house; to invest large gains in houses in a low-cost housing market, the home buyers had to buy pretty big or fancy houses. 5. What is the empirical evidence on whether capital gains tax cuts lead to a permanent increase in capital gains realizations? What does this evidence imply for the prospects of lowering capital gains taxes as a long-term revenue-generation tool? The empirical evidence indicates that lowering the tax rate on capital gains can induce a transient change in the realization of gains but not a permanent one. There was a temporary spike in sales of assets in 1986 because taxpayers knew that the tax rate would increase in 1987 (as shown in Figure 23-1). After the tax change in 1987, realized capital gains returned to their 1985 level, confirming that the spike in 1986 was temporary. Lowering capital gains taxes, then, seems only to shift the timing of asset sales, not to generate more revenue in the long term. In fact, because tax changes are announced in advance, people can plan to realize gains in the year with the lowest tax rate, reducing tax revenues. 6. When I spend money on my children s consumption, this transfer is not taxed, but if I make a large direct gift to my children, it is taxed. Why does this represent a horizontal inequity inherent in transfer taxes? Can you think of any policy modifications that could reduce this inequity? Horizontal equity requires that people with the same ability to pay taxes should pay the same amount in taxes. Whenever one taxpayer avoids taxation that another similarly situated taxpayer pays, it seems horizontally inequitable. Thus, when spending for the benefit of offspring is not taxed but an identical amount in the form of a cash gift is taxed, it violates horizontal equity. Two ways to address this problem would be to tax all expenditures (over some minimum amount) that benefit a taxpayer s children or to never tax any transfers to children. Taxing every child-benefiting transfer (educational expenses, family vacations, camp, musical instruments and lessons, soccer dues, prom dresses the list is endless) would be an accounting nightmare. But not taxing any transfers to children would create asset-sheltering incentives; parents who wanted to appear assetless to college financial aid offices or to Medicare administrators could simply move all their assets into their children s names. 7. Senator Crawford, arguing in favor of capital gains tax cuts, says that reducing capital gains tax rates will stimulate entrepreneurial activity. Senator Long, arguing against
CHAPTER 23 / Taxes on Risk Taking and Wealth - 3 - these tax cuts, suggests that they will encourage people to engage in riskier behavior and inefficient investment. Evaluate both senators arguments. Entrepreneurs are compensated by the increase in the value of their companies, which comes in the form of capital gains. Lowering the tax on capital gains may induce new investment and more entrepreneurial activity because the gains from the investment will have a higher net-of-tax return to the investor or entrepreneur. In addition, when capital gains are heavily taxed, people may keep their money in resources that are not particularly productive simply because selling those investments will trigger tax liability. Lowering the tax will contribute to resource mobility. Senator Long knows that capital gains are essentially returns to risk taking. When taxes on capital gains are sufficiently less than taxes on other income, people will choose capital gain income over labor income; that is, they will choose the riskier but lower-taxed behavior. 8. When Bill died in 2006, he left his children $200,000 in cash (generated from labor earnings), a $1.1-million-dollar home he had purchased (with labor earnings) for $100,000 in 1980, and $1.2 million in stock that he had purchased (with labor earnings) for $200,000 in 1985. Evaluate the argument that the estate tax represents double taxation of Bill s income. Bill s total estate is $2.5 million. The 2006 estate tax exemption was $2 million. So $500,000 of Bill s estate was taxed. Of his estate, $500,000 has already been taxed once the $200,000 in cash and the $300,000 paid for the house and the stock. The $2 million in capital gains on the house and stock have not been taxed. Because of the basis step-up at death provision in the tax code, that $2 million will never be taxed. Think of dividing the $2.5 million estate all of which was part of Bill s lifetime income in one way or another into three pieces: the $500,000 that has already been taxed, the $500,000 that is taxed under the estate tax, and the $1.5 million that has not been and will never be taxed. This calls into question the validity of the argument that the estate tax represents double taxation of Bill s income. 9. Why does the property tax, as implemented in the United States, provide a disincentive for property owners to improve their property? How would a land tax alter these incentives? The property tax is assessed on the value of land plus improvements, so the higher the value of the improvements is, the higher the tax is. A property tax increases the price of improvements or, similarly, reduces the net-of-tax return on making improvements. If only the land were taxed, owners would have an incentive to use the land as productively as possible because they would be able to keep more of the returns to productivity. Someone who wanted to use a given piece of land in a productive way would be more likely to acquire, improve, and use the parcel if he were not taxed on the improvements located on it. Furthermore, if someone were not using the land in its most productive way but had to pay taxes on the market value of the land, he or she would have an incentive to sell the property to some- who would put it to use. eone 10. The government of Lupostan introduced a policy in which all investments in college education and training are tax-deductible. Describe an empirical test of the effects of this policy on the level of human capital accumulation. What effects would you expect to find from such a policy? You would expect this policy to increase investment in human capital. First, deductibility would make those investments less expensive relative to other investments, and the substitution effect would induce relatively more acquisition of education and training. Second, the tax deduction would increase income, and the income effect would tend to increase investment in everything, including human capital.
CHAPTER 23 / Taxes on Risk Taking and Wealth - 4 - One test of the effects of this policy would compare education and training before and after the change in the tax. However, if other things were changing at the same time if educational attainment were generally increasing, for example this test would be biased. A differences-in-differences approach can potentially remove this bias. Noting that the benefits of tax-deductibility are bigger for households with higher tax rates and lower for households with lower tax rates, one can use the low-tax households as a control group for high-taxrate households. Comparing the differences in education and training among high-tax households to the differences in education among low-tax households should provide a better estimate of the effects of the policy on encouraging education and savings than looking only at the first difference would. Advanced Questions 11. Estoluania is considering replacing its progressive tax system with a flat tax that would raise equal revenue. How could this change encourage risk-taking behavior? How could it discourage risk-taking behavior? The move to a flat tax would reduce the top marginal tax rate, thereby increasing the upside to risky investments. With more to gain from a risky investment, individuals might find these investments more appealing. Under either tax system, the government provides insurance to investors by effectively sharing some of their risk: the government gets some of the benefit (more tax revenue) when the returns to a risky investment turn out to be high, and it bears some of the cost (reduced tax receipts) when returns are low. As in the Domar-Musgrave model described in the chapter, this risk sharing can lead to increases in risk-taking behavior relative to a no-tax world: an individual who wants to hold a portfolio with a certain level of risk must increase his or her exposure to risky assets when the government insures some of the risk. A similar argument applies when comparing a flat tax with a progressive tax. The latter provides more insurance than the former (it taxes gains more highly and losses less highly). It can therefore encourage individuals to take on more risk in order to achieve a given level of net after-tax risk in their portfolios. The movement to a flat tax may therefore reduce risk taking in Estoluania. 12. A researcher found that when the capital gains tax rate declined, the average bequest size fell as well. How does the tax treatment of capital gains in the United States explain this relationship? A high capital gains tax rate creates a deterrent to selling assets. When an asset is sold, if there has been any appreciation in value even if the appreciation is simply a result of general inflation the seller of the asset must pay capital gains taxes on the difference between the original price and the sale price. One exception to this law occurs when the asset is part of an estate. When someone inherits an asset, the original value of the asset is changed, or stepped up, to the value on the date of inheritance. Thus, the amount of appreciation that is taxable starts over at zero. This exception creates a strong incentive to pass on an appreciated asset to heirs. When capital gains tax rates are lower, it is not so critical to leave an asset in an estate; the original owner is more likely to sell the asset and take the gain for ehimself. As a result, the size of the bequest will decrease. 13. Pamplovia raised its estate tax rate from 30% to 50%. However, it grandfathered in families whose householders were over 80 years old, allowing these families to be assessed the original 30% estate tax. How could you go about estimating the effects of estate tax rates in Pamplovia on the magnitude of bequests. People who were 79 at the time of the change face a 50% estate tax; those just a year older face the 30% rate. This creates an opportunity to investigate the effect of the change in
CHAPTER 23 / Taxes on Risk Taking and Wealth - 5 - tax rates by comparing the bequests of those who face a 30% rate and those who face a 50% rate. Seventy-nine-year-olds are not very different from eighty-year-olds, and so by comparing those two groups a researcher could estimate the effects of the tax rates. A more refined approach would use a difference-in-differences approach. The control group could be those who were 80 and 81 at the time of the tax change (all of whom face a 30% tax rate); the treatment group would be those who are 80 and 81 the following year: the 81-year-olds will still face a 30% tax rate, but the 80-year-olds face a 50% tax rate. The size of a person s estate may shrink between the ages of 80 and 81, but having people of both those ages in each group would allow researchers to control for the change. An economic recession or expansion may reduce the value of investments between the two years, but considering data from both years would allow researchers to control for business cycle effects. By using these controls the researcher would be able to isolate the change in bequest associated with the difference in estate tax rate. 14. In some states, a local government that reduces its tax base receives additional aid for local public good provision from the state government. Why will cities be more likely to offer tax breaks in this circumstance? Why are tax breaks in this case particularly bad for overall welfare? A city would rather have the state government pay for local public goods than pay for them itself, because when the state pays the cost is spread over all state residents but the benefits are enjoyed primarily by the residents of that city. A city has an incentive to offer tax breaks to new industries to raise the employment and income level of its residents when the revenue lost from the tax breaks is made up for by state revenues (that is, with taxes paid by all state residents). This practice is individually rational for each city but collectively disastrous. As in any free rider situation, when everyone tries to free ride the entire group becomes worse off. In this example, each city competes with every other city to attract new businesses with tax breaks. When every city tries to pass the cost of its own tax breaks on to the state, the whole state suffers. 15. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) lowered the top marginal rate for estate taxation, called for a gradual increase in the estate tax exemption (the amount of an estate that is untaxed) to $3.5 million, and called for a complete elimination of the tax in 2010. However, a sunset provision in the law implies that the estate tax will reappear again in 2011, with an exemption of only $1 million and at a higher marginal rate. How should this sunset provision affect the savings and charitable giving rates of the elderly prior to 2011 and subsequent to 2011? For a wealthy individual who thinks she is likely to pass away before 2011 (and who values bequests), the high exemptions and complete repeal make the return to saving higher. As usual, this has offsetting substitution and income effects: the higher rate of return encourages additional savings, but this will be at least partially offset by the fact that a lower level of savings will still generate the same anticipated bequest. Assuming that the substitution effect dominates, however, we expect that the lower rates will encourage additional saving by these wealthy individuals. Similarly, an elderly individual who anticipates dying with a large estate may wish to make charitable donations to avoid some of the estate tax. The higher exemptions and lower rates will make these charitable donations less desirable, so they are likely to decline prior to 2011. However, in 2011, any wealthy individuals who did not die will find themselves with larger estates (assuming they gave less to charity and saved more, as described) and facing high marginal tax rates on their estates when they do die. This will encourage charitable donations and consumption and discourage savings. In summary, then, we expect higher
CHAPTER 23 / Taxes on Risk Taking and Wealth - 6 - savings and lower charitable giving prior to 2011 but a boom in charitable giving and a decrease in savings in 2011. e ote: The icon indicates a question that requires students to apply the empirical economics principles discussed in Chapter 3 and the Empirical Evidence boxes.