Università Bocconi, A.A: Mec – Comparative public economics 1 Università Bocconi A.A Comparative public economics Giampaolo Arachi

Università Bocconi, A.A: Mec – Comparative public economics 2 Alternative savings vehicles Intertemporally constant rates Changes in tax rates over time Assets with differentially taxed components References: M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 3

Università Bocconi, A.A: Mec – Comparative public economics 3 Alternative savings vehicles Intertemporally constant rates Changes in tax rates over time Assets with differentially taxed components References: M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 3

Università Bocconi, A.A: Mec – Comparative public economics 4 Different Legal Organizational Forms There are different legal organizational forms (Alternative Savings Vehicles) through which individuals save for the future –Different needs: insurance policies v. bank deposits –Different regulations or policy aims: short and long period Differences may be leveled out through new contractual arrangements or financial innovation

Università Bocconi, A.A: Mec – Comparative public economics 5 Four main tax attributes Is the deposit into a savings account tax deductible? –Immediately –Through time (depreciation allowances) Frequency that earnings are taxed –On accrual –Annually –On realization –Never Tax base –Selling or purchasing price –Difference between selling and purchasing price –Other Tax rate –Ordinary income PIT rate –Capital Gains tax –Schedular or exempt

Università Bocconi, A.A: Mec – Comparative public economics 6 Alternative savings vehicles U.S. Savings vehicle (example) Is the investment tax deductible? Frequency that earnings are tax Tax rate Money market fundNoAnnuallyOrdinary Single premium deferred annuity NoDeferredOrdinary Mutual fundNoAnnuallyCapital Gains Foreing corporationNoDeferredCapital Gains Insurance policyNoNeverExempt PensionYesDeferredOrdinary

Università Bocconi, A.A: Mec – Comparative public economics 7 Alternative savings vehicles U.K. Savings vehicle (example) Is the investment tax deductible? Frequency that earnings are tax Tax rate Money market fundNoAnnuallyOrdinary Single premium deferred annuity NoDeferredOrdinary Mutual fundNoAnnuallyCapital Gains Foreing corporationNoDeferred/ Annually Capital Gains/ Ordinary Insurance policyNoNeverExempt PensionYesDeferredOrdinary

Università Bocconi, A.A: Mec – Comparative public economics 8 Alternative savings vehicles Italy Savings vehicle (example) Is the investment tax deductible? Frequency that earnings are tax Tax rate Money market fundNoAnnually27% Single premium deferred annuity NoDeferred12.5% / Ordinary Mutual fundNoOn accrual12.5% Foreing corporationNoDeferredCapital Gains Insurance policy PensionYesAnnually11%

Università Bocconi, A.A: Mec – Comparative public economics 9 Comparisons  The same underlying investment will be held in each of the savings vehicles. As a result the before tax rates of return will be identical in each case  The after-tax rates of return will differ widely as the investment returns will be taxed differently across the alternatives Simplifying assumptions: - Intertemporally constant tax rates - No non-tax costs Notation: - R denotes the pretax rate of return - r denotes the after-tax rate of return - for a one-year investment in a simple interest-bearing savings account, the after-tax rate of return is r=R(1-t)

Università Bocconi, A.A: Mec – Comparative public economics 10 Vehicle I Not tax deductible; Taxed annually; Ordinary income Examples: Corporate bonds, money market accounts offered by banks Returns After 1 year: $K (1+R) - $K(1+R-1) t = $K + $K R – $KRt = $K [1+R(1-t)] After 2 years = [1 + R (1-t)] [1 + R (1-t)] After n years = [1 + R (1-t)] n

Università Bocconi, A.A: Mec – Comparative public economics 11 Vehicle II Not tax deductible; Deferred taxation; Ordinary income Examples: Single premium deferred annuity (US) After one year: $K (1+R) - (1+R-1) t = 1 + R (1-t) After 2 years: $K (1+R) (1+R) - $K [(1+R) (1+R) -1] t = $K (1+R) 2 - $K (1+R) 2 t + $K t = $K (1+R) 2 (1-t) + $K t After n years: $K (1+R) n - $K [(1+R) n -1] t = $K (1+R) n (1-t) + $K t

Università Bocconi, A.A: Mec – Comparative public economics 12 After-tax accumulations to savings vehicles I and II: R = 7%, t=30% Years After tax accumulation SV ISV II

Università Bocconi, A.A: Mec – Comparative public economics 13 After-tax accumulations to savings vehicles I and II: R = 15%, t=30% Years MMA After tax accumulation SV ISV II

Università Bocconi, A.A: Mec – Comparative public economics 14 Savings Vehicle III Not tax deductible; Taxed annually; Capital gains Examples: mutual funds After n years = $K [1+ R(1-tg)] n

Università Bocconi, A.A: Mec – Comparative public economics 15 Savings Vehicle IV Not tax deductible; Deferred taxation; Capital gains Examples: shares in corporations located in tax haven; After n years = $K (1+R) n - $K [(1+R) n -1]tg = $K (1+R) n (1-tg) + $K tg

Università Bocconi, A.A: Mec – Comparative public economics 16 Savings Vehicle VI Tax deductible; Deferred taxation; Ordinary income The government act as a partner in the investment Partners Investment Accumulation Taxpayer 1-t (1-t) (1+R) n Government t t (1+R) n Each dollar invested in the pension fund costs only (1-t) dollars after tax After tax accumulation per after tax dollar invested = $ K (l + R) n (l - t) = (l + R) n (l - t)

Università Bocconi, A.A: Mec – Comparative public economics 17 Summing up Savings vehicle Is the investment tax deductible? Frequency that earnings are tax Tax rateAfter tax accumulation per after tax dollar $ I Invested INoAnnuallyOrdinary $K [1 + R (1-t)] n IINoDeferredOrdinary $K (1+R) n (1-t) + $K t IIINoAnnuallyCapital Gains $K [1+ R(1-tg)] n IVNoDeferredCapital Gains $K (1+R) n (1-tg) + $K tg VNoNeverExempt $K (1 + R) n VIYesDeferredOrdinary $K (1 + R) n

Università Bocconi, A.A: Mec – Comparative public economics 18 Outline Intertemporally constant rates Changes in tax rates over time Assets with differentially taxed components

Università Bocconi, A.A: Mec – Comparative public economics 19 Changes in tax rates over time Simplifying assumption: future tax rates are known Returns depends on realization strategy: realize profit when taxes are low and losses when taxes are high Simple dominance relations no longer hold

Università Bocconi, A.A: Mec – Comparative public economics 20 Vehicle VI (Pension plans) t 0 relevant tax rate when contributions are made t n relevant tax rate when withdrawals are made Partners Investment Accumulation Taxpayer 1-t 0 (1-t n ) (1+R) n Government t 0 t n (1+R) n

Università Bocconi, A.A: Mec – Comparative public economics 21 Vehicle VI (Pension plans) vs Vehicle V (Insurance policy) After tax accumulation per after tax dollar invested If tax rates are falling, (t 0 > t n ) Vehicle VI is superior If tax rates are increasing, (t 0 > t n ) Vehicle V is superior

Università Bocconi, A.A: Mec – Comparative public economics 22 Rollover into a different vehicle Traditional deductible IRA An eligible taxpayer may contribute up to $2000 per year. Contributions are tax deductible and earnings in the pension account are tax deferred until the taxpayer makes withdrawals in retirement. Savings Vehicle VI

Università Bocconi, A.A: Mec – Comparative public economics 23 Rollover into a different vehicle Roth IRA An eligible taxpayer may contribute up to $2000 per year. Contributions are NOT tax deductible and withdrawals are tax free. Savings Vehicle V

Università Bocconi, A.A: Mec – Comparative public economics 24 Rollover into a different vehicle Since 1998 taxpayers with balances in deductible IRAs can rollover the balance into a Roth IRA. The amount rolled over is included in the taxapayer taxable income in the year of the rollover Is it the rollover profitable? Deductible IRA accumulation = V (1+R) n (1-t n ) Rollover Roth accumulation = V (1+R)n - taxes paid at rollover - returns lost on taxes paid

Università Bocconi, A.A: Mec – Comparative public economics 25 Rollover into a different vehicle Taxes due on rollover paid out of funds invested in Vehicle II taxes paid at rollover + returns lost on taxes paid V t 0 [(1+R) n (1-t n ) + t n ] Rollover Roth accumulation = V (1+R) n – V t 0 [(1+R) n (1-t n ) + t n ]

Università Bocconi, A.A: Mec – Comparative public economics 26 Rollover into a different vehicle Rollover Roth accumulation – Deductible IRA = V (1+R) n t n – V t 0 [(1+R) n (1-t n ) + t n ] Greater than zero if t0 = tn t0 < tn

Università Bocconi, A.A: Mec – Comparative public economics 27 Outline Intertemporally constant rates Changes in tax rates over time Assets with differentially taxed components

Università Bocconi, A.A: Mec – Comparative public economics 28 Assets with differentially taxed components Shares pay dividend and deferred capital gains Two additional issues Two different tax rates By reinvesting there is a change in the value of the stock Simplifying assumptions Dividend rate is constant and equal to d tdiv tax rate on dividends Return thruogh capital gains constant and equal to R C Capital Gains are tax when share are sold at rate tg After-tax dividends are invested in shares Dividend are paid at the end of the year

Università Bocconi, A.A: Mec – Comparative public economics 29 Assets with differentially taxed components Accumulation with no taxes (1+d+R C ) n Accumulation after dividend tax: (1+d(1-t)+R C ) n Accumulation after dividend and capital gains tax (1+d(1-t)+R C ) n – tg[(1+d(1-t)+R C ) n – Base) or (1+d(1-t)+R C ) n (1-tg) + tg Base Which is the Base?

Università Bocconi, A.A: Mec – Comparative public economics 30 Assets with differentially taxed components The Base to calculate the capital gains tax First year: d(1-t) Second year: d(1-t) (1+d(1-t)+R C ) Third year: d(1-t) (1+d(1-t)+R C ) 2 Base after n years:

Università Bocconi, A.A: Mec – Comparative public economics 31 Dividends and capital gains dRcRc tg/tdivAfter tax accumulated wealth $K=1000, n=10 10%0% % %10% %0%0.5%1967 5% 0.5%2150 0%10%0.5%2355