pub econ_lecture_21 22 23_various taxes

8/3/2019 Pub Econ_lecture_21 22 23_various Taxes

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Public Finance

Dr. Katie Sauer

Taxes on:

Labor Supply

Savings

Wealth


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I. Labor Supply & Taxes

Consumption

Leisure Hours

Suppose a wage rate of$12.50 and a maximum

number of hours of 2000.

Slope =-12.5

Suppose individual

choose 900 hours ofleisure.

2000

25,000

900

13,750

BC1

IC1


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Consumption

Leisure Hours

Suppose a tax of 30% is

imposed.

After-tax wage:

12.50 x (1 - .30)

8.75

Slope of BC =

-8.75

2000

25,000

900

13,750

BC1

IC1

17,500

BC2


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Consumption

Leisure Hours

For the same amount of

work (1100 hours), the

individual only receives

income of

$9625

2000

25,000

900

13,750

BC1

IC1

17,500

BC2

9,625


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Will the individual work more or less?

Depends on which effect is stronger:

substitution effect

- because price of leisure has fallen, expectindividual to work less and have more leisure

income effect

- because individual is now poorer, expect

them to work more and have less leisure


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The Earned Income Tax Credit

(1976)

Two goals:- subsidize the wages of low-income earners

- increase labor supplied by low-income earners

Largest *cash* antipoverty program.


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Eligibility:

- annual earnings greater than zero

Household with no children

- annual earnings less than $13,400

With Children

- annual earnings less than $35,463 (one child)

$40,295 (more)

This is a refundable tax credit.


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For a single earner with 2 children (2010):

EITC

Earned Income

$5,036

Slope =

0.40

$12,549

Up to earned income of

$12,549, EITC is $0.40per dollar earned.

Max credit is $5,036

Plateau to $16,449

$16,449


9/38

EITC

Earned Income

$5,036

Slope =

0.40

$12,549

Phase-out:

$5,036 (0.21 )( Income $16,450)

None at $40,363

$16,449

Slope isroughly 0.21


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EITC and Labor Supply

Consumption

Leisure Hours

40,363

16,449

12,549

For people not in the labor force

(all leisure, no work), this policy

will likely raise labor supply.

BC with EITC


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Consumption

Leisure Hours

40,363

16,449

12,549

For people in the labor force,

earning less than $12,549:

SE: each hour of work brings a

higher wage than before so

work more

IE: workers are wealthier

as a result of the subsidy

so work less

ambiguous result for

labor supply


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Consumption

Leisure Hours

40,363

16,449

12,549

For people in the plateau region:

EITC does not change in this rangeso wage is constant

- no substitution effect

(BC has same slope)

EITC makes them wealthier

- income effect says theyll

work less (higher BC)

reduction in labor

supply


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Consumption

Leisure Hours

40,363

16,449

12,549

For people that earn between

$16,500 and $40,363:

SE: new BC is flatter price of

leisure fell work less

IE: new BC is higher wealthier work less

reduction in labor

supply


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II. Taxes on Savings

A. intertemporal choice model

Jack lives for 2 periods

period 1: working life, earn Y

consumes Cw

saves Sw =Y Cw , earns rinterest

period 2: retirement life, earn 0

consumes CR

CR = Sw (1 + r)

Jack has a tradeoff between consumption in period 1 and 2.


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Consumption in

Period 2

Consumption inPeriod 1Y

Maximum consumption in period 1:

Y

Maximum consumption in period 2:

- if all income from period 1 were

saved, there would be Y (1 + r) forperiod 2

Y(1+r)

BC


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Consumption in

Period 2


The slope of the budget constraint is

equal to:

- (1 + r)

Y(1+r)

BC


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Consumption in

Period 2


Suppose Jacks preferences are such

that he values consumption in thepresent.Y(1+r)

BCIC


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Consumption in

Period 2


Suppose the government taxes interest

income.

The maximum consumption in period

2 is now:

Y[ 1 + (r)(1 )]

slope of BC is now:

- [ 1 + (r)(1 )]

Y(1+r)

BCIC

Y(1+(r)(1-))

BC2


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Consumption in

Period 2


Two effects:

SE: BC is flatter price ofperiod 1 consumption falls

consume more in 1, save less

IE: BC is lower, have to savemore to have money in period 2

ambiguous effect

Y(1+r)

BCIC

Y(1+(r)(1-))

BC2


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B. Tax Subsidized Retirement Savings

When savings are tax-free until withdrawn, they are taxed

more lightly.

PDV of tax payments is lower

is the share of the tax burden that remains after the

accounting delay in tax payments.

Ex: suppose = 0.3 and = 0.33

Effective tax rate on savings is: 0.3 x 0.33 = 0.099


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The slope of the budget constraint is now:

- [ 1 + (r)(1 )]

SE: BC is now steeper (than BC2)

so the price of period 1 consumption

rises save more

IE: BC is now higher (than BC2)

so feel wealthier save less for

period 2

ambiguous result

Consumption in

Period 2


Y(1+r)

BCIC

Y(1+(r)(1-))

BC2

Y(1+(r)(1-))

BC3


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Many retirement savings plans have a limit on annual tax-

free contributions.

IRA $5000


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For the first $5000 of savings, the

preferential tax treatment applies.Consumption inPeriod 2


Y(1+(r)(1-))

BC

5000

BC2

slope = -[ 1 + (r)(1 )]

slope = - [1 + (r)(1 )]


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For an individual who already saved a lot:

SE: BC slope is same none

IE: BC is higher feels wealthier

saves less for period 2

Saves Less

Consumption in

Period 2


Y(1+(r)(1-))

BC

5000

BC2


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For an individual who saved less than

$5000:

SE: BC slope is steeper increased price

of period 1 consumption save more

IE: BC is higher feels wealthier saves less for period 2

ambiguous result

Consumption in

Period 2


Y(1+(r)(1-))

BC

5000

BC2


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III. Taxes on Risk Taking and Wealth

A. Domar and Musgrave 1944:basic model of risk taking and taxation

Choice between

risky asset that yields positive rate of return

safe asset that yields no real return

Governmenttaxes any positive return

allows deduction against taxable income for full

amount of a negative return


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The model finds that taxing the returns from the risky

asset would increase risk takingbecause any tax on the

returns could be undone by taking more risk.


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In reality, there are two complications:

1. Less-than-full Tax Offset

In the US, individuals are allowed to deduct $3000 ofinvestment losses in any tax year.

- cant just undertake a losing investment to wipe

out some of your tax burden


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2. Redistributive Taxation

The US tax system is progressive big winnings can

move you into a higher tax bracket pay more taxes.


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B. Capital Gains Tax

Many assets yield a return in the form of an increase in

the value of an asset.

Assets that earn interest are taxed on accrual.

Assets that appreciate in value are taxed on realization.

- taxed when asset is sold

- taxed on selling value minus basis(basis = purchase price of asset)


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Ex: Your purchase a painting for $100. It increases in

value by 10% each year.

After 7 years, you sell the painting.

It is worth:

End of Year 1: 100(1.1) = 110End of Year 2: 110(1.1) = 121

End of Year 3: 121(1.1) = 133.1

End of Year 4: 133.1(1.1) = 146.41

End of Year 5: 146.41(1.1) = 161.051End of Year 6: 161.051(1.1) = 177.1561

End of Year 7: 177.1561(1.1)= 194.87171

$195


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You must pay taxes on:

$195 - $100 = $95

If the capital gains tax rate is 20%:

95(0.20) = $19 in taxes

net return: 95 19 = $76


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Suppose instead you put $100 in a bank account earning

10% interest per year, for 7 years.

- interest earned is taxed at 20% annually

End of year 1: 100(1.1) = $110

110 100 = $10 earned interest

10(0.2) = $2 owed in taxesafter taxes = $108

End of year 2: 108(1.1) = $118.8

118.8 108 = $10.80 earned interest10.80(0.20) = $2.16 owed in taxes

after taxes = $116.64


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End of year 3: 116.64(1.1) = $128.30

128.30-116.64 = $11.66 earned interest

11.66(0.2) = $2.33 owed in taxesafter taxes = $125.97

End of year 4: 125.97(1.1) = $138.57

138.57-125.97= $12.60 earned interest12.60(0.20) = $2.52 owed in taxes


End of year 5: 136.05(1.1) = $149.66149.66-136.05 = $13.61 earned interest

13.61(0.2) = $2.72 owed in taxes



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End of year 6: 146.94(1.1) = $161.63

161.63-146.94 = $14.69 earned interest

14.69(0.2) = $2.94 owed in taxesafter taxes = $158.69

End of year 7: 158.69(1.1) = $174.56

174.56-159.69= $14.87 earned interest14.87(0.20) = $2.97 owed in taxes


net return: $71.59


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Savings in the form of capital gains-producing assetsreceive a tax preference.


37/38

For assets that are passed on to heirs, the basis is stepped

up to the value at the time of death.

Ex: You buy a painting for $100 now. 75 years later it is

worth $10,000.

If you sell it the day before you die, you must pay taxeson the $9,900 capital gains.

If you pass it on to your heirs, the basis value for the

painting is now $10,000.If they sell it the day after you die for $10,000, they

pay no capital gains.


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There is a capital gains exemption of $500,000 for sale

of a primary residence.

pub econ_lecture_21 22 23_various taxes

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