Università Bocconi A.A. 2005-2006

1. Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi

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

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

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

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

6. Alternative savings vehicles U.S.

7. Alternative savings vehicles U.K.

8. Alternative savings vehicles Italy

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)

10. Vehicle INot 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

11. Vehicle IINot 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

12. After-tax accumulations to savings vehicles I and II: R = 7%, t=30% 12 10 8 6 After tax accumulation 4 2 0 0 10 20 30 40 Years SV I SV II

13. After-tax accumulations to savings vehicles I and II: R = 15%, t=30% 200 180 160 140 120 100 After tax accumulation 80 60 40 20 0 0 10 20 30 40 Years SV I SV II MMA

14. Savings Vehicle IIINot tax deductible; Taxed annually; Capital gains • Examples: mutual funds • After n years = $K [1+ R(1-tg)] n

15. Savings Vehicle IVNot 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

16. Savings Vehicle VITax deductible; Deferred taxation; Ordinary income • The government act as a partner in the investment • PartnersInvestmentAccumulation • 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)

17. Summing up

18. Outline • Intertemporally constant rates • Changes in tax rates over time • Assets with differentially taxed components

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

20. Vehicle VI (Pension plans) • t0 relevant tax rate when contributions are made • tn relevant tax rate when withdrawals are made • Partners Investment Accumulation • Taxpayer 1-t0 (1-tn) (1+R)n • Government t0 tn (1+R)n

21. Vehicle VI (Pension plans) vs Vehicle V (Insurance policy) • After tax accumulation per after tax dollar invested • If tax rates are falling, (t0 > tn) Vehicle VI is superior • If tax rates are increasing, (t0 > tn) Vehicle V is superior

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

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

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-tn) • Rollover Roth accumulation = V (1+R)n - taxes paid at rollover - returns lost on taxes paid

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 t0 [(1+R)n (1-tn) + tn] • Rollover Roth accumulation = • V (1+R)n – V t0 [(1+R)n (1-tn) + tn]

26. Rollover into a different vehicle • Rollover Roth accumulation – Deductible IRA = • V (1+R)n tn – V t0 [(1+R)n (1-tn) + tn] • Greater than zero if t0 = tn • t0 < tn

27. Outline • Intertemporally constant rates • Changes in tax rates over time • Assets with differentially taxed components

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 RC • 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

29. Assets with differentially taxed components • Accumulation with no taxes • (1+d+RC)n • Accumulation after dividend tax: • (1+d(1-t)+RC)n • Accumulation after dividend and capital gains tax • (1+d(1-t)+RC)n – tg[(1+d(1-t)+RC)n – Base) or • (1+d(1-t)+RC)n (1-tg) + tg Base • Which is the Base?

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)+RC) • Third year: d(1-t) (1+d(1-t)+RC)2 • Base after n years:

31. Dividends and capital gains