Lecture Issues in economics today - Chapter 37

Chapter 37
Taxing the Returns on Capital

 

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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
 

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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.
 

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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.
 

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P e rc e n ta g e o f In c o m e

Source of Incom
Earned vs Capital

100

80
60

Salary

40

Capita

20

0

 

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1 10000
20000
30000
50000
100000
500000
Income Level

 

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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.
 

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C u m m u la t iv e P e r c e n

Lorenz Curves

Earned Income and Capita

100
80
60

Earned Inc

40

Capital Inc

20
0
0

20
40

60
80
100
Cummulative Percentage of Retur

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

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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.
 

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How Capital Income Should
Be Taxed
• Capital income should be taxed in such a way
that it does not alter the incentive to
–
–
–
–
–
–

 

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Save or invest
Invest in short term assets
Invest in long term assets
Invest in risky assets
Invest in safe assets
Work

 

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An Untaxed Market for Capital
Interest  A
rate (r) 

Supply

C
r*

B

Demand
I*

 

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•Consumer Surplus
•r*AC
•Producer Surplus
•Br*C

 

Investable 
Funds
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Capital Markets When Only
Capital Income Is Taxed
Interest  A
rate (r) 
r’

Supplyafter tax
E

C

r*
r”

 

Such a tax discourages
investment so the
deadweight loss is
GEC

G

B

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Supplybefore tax

Demand

I’

I*

 

Investable 
Funds
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Capital Markets When Only
Earned Income Is Taxed
Interest  A
rate (r) 

Supplybefore tax
Supplyafter tax
C

E

r*
r’

G

B

 

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Such a tax over-encourages
investment so the
deadweight loss is
GEC

Demand

 

I* I’

Investable 
Funds
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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.
 

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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.
 

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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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