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Chapter 37

Chapter 37. Taxing the Returns on Capital. 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. General Issues Taxation.

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Chapter 37

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  1. Chapter 37 Taxing the Returns on Capital

  2. 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. 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. 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. 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.

  6. Earned income is generated in a more equal way than unearned income

  7. 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.

  8. 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

  9. A Interest rate (r) Supply C r* B Demand Investable Funds I* An Untaxed Market for Capital • Consumer Surplus • r*AC • Producer Surplus • Br*C

  10. A Interest rate (r) Supplyafter tax Supplybefore tax E Such a tax discourages investment so the deadweight loss is GEC r’ C r* r” G B Demand Investable Funds I* I’ Capital Markets When Only Capital Income Is Taxed

  11. A Interest rate (r) Supplybefore tax Supplyafter tax E C r* Such a tax over-encourages investment so the deadweight loss is GEC r’ G B Demand Investable Funds I* I’ Capital Markets When Only Earned Income Is Taxed

  12. 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.

  13. 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.

  14. 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.

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