Chapter 37 Taxing the Returns on Capital

Chapter 37Taxing the Returns on CapitalChapter OutlineCAPITAL INCOME AND EARNED INCOME: WHO MAKES IT?HOW CAPITAL INCOME SHOULD BE TAXEDTHE CURRENT SYSTEMTHE EFFECT OF CAPITAL TAXATION ON GROWTHGeneral Issues TaxationWhich should be the most important economic issue of taxation?the fairness of the tax, orthe impact of the tax on economic growth. that impact of the tax on economic incentives.Many economists consider the latter issue to be very important.Who Earns Capital IncomeCapital IncomeIncome earned through investments.Types of Capital IncomeInterestDividendsCapital Gainsincome generated by selling an asset for more than was paid for itThe wealthy and high-income earners get a higher percentage of the income from investments than do the poor and low income earners.Lorenz CurveA Lorenz curve which measures the inequality of income.A graph that maps the cumulative percentage of population against the cumulative percentage of another variable, like incomeA straight line indicates perfect equality. The greater the bow, the greater the inequality.Earned income is generated in a more equal way than unearned incomeA Gini CoefficientA measure of economic equality ranging from zero to one.It is the ratio of the area under the bow of the curve to the total area possible under a line of perfect equality.For earned income it is .49.For capital income it is .26.How Capital Income Should Be TaxedCapital income should be taxed in such a way that it does not alter the incentive to Save or investInvest in short term assetsInvest in long term assetsInvest in risky assets Invest in safe assetsWorkAn Untaxed Market for CapitalDemandSupplyr*I*Interest rate (r) Investable FundsABCConsumer Surplusr*ACProducer SurplusBr*CCapital Markets When Only Capital Income Is Taxedr*I*DemandSupplybefore taxInterest rate (r) Investable FundsABCSupplyafter taxI’r’r”GESuch a tax discourages investment so the deadweight loss isGECCapital Markets When Only Earned Income Is Taxedr*I*DemandSupplybefore taxInterest rate (r) Investable FundsABCGESuch a tax over-encourages investment so the deadweight loss isGECI’r’Supplyafter taxThe Current SystemPeople owe a tax on all gains whether or not they are real.This means that we tax as income those returns from investment that merely compensate investors for inflation. This inefficiently discourages savings.Capital gains are taxed on realization rather than accrual.This means that a tax can be delayed.This inefficiently encourages people to hold assets they would ordinarily sell.Capital gains are forgiven at death.This means that a tax can be avoided altogether.This inefficiently encourages the elderly to hold assets they would ordinarily sell.The Capital gain on a home is exemptThis encourages inefficiently high levels of consumption/ investment in homes.The Net ResultThough capital gains income is taxed at a lower rate the overall result is that capital generated income is taxed at a level that is somewhat higher than the efficient level.Correcting this would require that some other tax be raised which is politically problematic.The Effect of Capital Taxation on the Economy as a WholeIf the supply curve of capital is upward sloping (and not vertical) and if the tax rate on capital is higher than is efficient, growth is inhibited.Aggregate demand is less than it would otherwise be because of reduced savings and investment.