1. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 37 Taxing the Returns on Capital

2. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline CAPITAL INCOME AND EARNED INCOME: WHO MAKES IT? HOW CAPITAL INCOME SHOULD BE TAXED THE CURRENT SYSTEM THE EFFECT OF CAPITAL TAXATION ON GROWTH

3. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. General Issues Taxation Which should be the most important economic issue of taxation? –the fairness of the tax, or –the 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.

4. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Who Earns Capital Income Capital Income –Income earned through investments. Types of Capital Income –Interest –Dividends –Capital Gains income generated by selling an asset for more than was paid for it The wealthy and high-income earners get a higher percentage of the income from investments than do the poor and low income earners.

5. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.

6. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Lorenz Curve A 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 income A straight line indicates perfect equality. The greater the bow, the greater the inequality.

7. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Earned income is generated in a more equal way than unearned income

8. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. A Gini Coefficient A 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.

9. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. How Capital Income Should Be Taxed Capital income should be taxed in such a way that it does not alter the incentive to –Save or invest –Invest in short term assets –Invest in long term assets –Invest in risky assets –Invest in safe assets –Work

10. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Untaxed Market for Capital Demand Supply r* I* Interest rate (r) Investable Funds A B C Consumer Surplus r*AC Producer Surplus Br*C

11. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Markets When Only Capital Income Is Taxed r* I* Demand Supply before tax Interest rate (r) Investable Funds A B C Supply after tax I’ r’ r” G E Such a tax discourages investment so the deadweight loss is GEC

12. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Markets When Only Earned Income Is Taxed r* I* Demand Supply before tax Interest rate (r) Investable Funds A B C G E Such a tax over-encourages investment so the deadweight loss is GEC I’ r’ Supply after tax

13. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Current System People 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 exempt –This encourages inefficiently high levels of consumption/ investment in homes.

14. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Net Result Though 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.

15. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Effect of Capital Taxation on the Economy as a Whole If 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.