Follow these numbers, and the bold face is mine:
An example will illustrate the harmful effect of high
taxes on the income from savings and show how the tax reform could make
taxpayers unambiguously better off. Think about someone — call him Joe
– who earns an additional $1,000. If Joe’s marginal tax rate is 35%,
he gets to keep $650. Joe saves $100 of this for his retirement and
spends the rest. If Joe invests these savings in corporate bonds, he
receives a return of 6% before tax and 3.9% after tax. With inflation
of 2%, the 3.9% after-tax return is reduced to a real after-tax return
of only 1.9%. If Joe is now 40 years old, this 1.9% real rate of return
implies that the $100 of savings will be worth $193 in today’s prices
when Joe is 75. So Joe’s reward for the extra work is $550 of extra
consumption now and $193 of extra consumption at age 75.But if the tax rate on the income from saving is
reduced to 15% as the tax panel recommends, the 6% interest rate would
yield 5.1% after tax and 3.1% after both tax and inflation. And with a
3.1% real return, Joe’s $100 of extra saving would grow to $291 in
today’s prices instead of just $193.There are two lessons in this example, each of which
identifies a tax distortion that wastes potential output and therefore
unnecessarily lowers levels of real well-being. The first is that a tax
on interest income is effectively also a tax on the reward for extra
work, cutting the additional consumption at age 75 from $291 to just
$193. Because the high tax rate on interest income reduces the reward
for work (as well as the reward for saving), Joe makes choices that
lower his pretax earnings — fewer hours of work, less work effort,
less investment in skills, etc.The second lesson that follows from the example is
that the tax on interest income substantially distorts the level of
future consumption even if Joe does not make any change in the amount
that he saves. With the same $100 of additional saving, the higher tax
rate reduces his additional retirement consumption from $291 to $193, a
one-third reduction. If Joe responds to the lower real rate of return
that results from the higher tax rate on interest by saving less, the
distortion of consumption is even greater. For example, if Joe would
save $150 out of the extra $1,000 of earnings when his real net return
is 3.1% (instead of saving $100 when the real net return is 1.9%), his
extra consumption at age 75 would be $436, more than twice as much as
with the 35% tax rate. But the key point is that Joe’s future
consumption would be substantially reduced by the higher tax rate even
if he does not change his savings.Taken together, these two lessons imply that a lower
tax rate on interest income, combined with a small increase in the tax
on other earnings, could make Joe unambiguously better off while also
increasing government revenue. More specifically, if reducing the tax
on interest income from 35% to 15% had no effect on Joe’s earnings or
on his initial consumption spending, the government could collect the
same present value of tax revenue from Joe by raising the tax on his
$1,000 of extra earnings from $350 to $385. Although this would cut
Joe’s saving from $100 to $65 (if he keeps his initial consumption
spending unchanged), the higher net return on that saving would give
Joe the same consumption at age 75. In this way, Joe would be neither
better off nor worse off.
But experience shows that Joe would alter his behavior
in response to the lower tax rate. He would earn more at age 40 and
would save more for retirement. This change of behavior makes Joe
better off (or he wouldn’t do it) and the extra earnings and interest
income would raise government revenue above what it would be with a 35%
tax rate. So Joe would be unambiguously better off with the lower tax
rate on interest income and the government would collect more tax
revenue.
Here is the link. Elsewhere from The Wall Street Journal, here is a piece on bargaining theory, thanks to Chris Masse for the pointer.
this looks like fast and loose with discount rates to me; Feldstein is happy to move between “consumption today” and “consumption in thirty years time” at par in an economy with a hypothesised 2% discount rate.
Either I’m not following this, or Feldstein is playing fast and loose with his assumptions here.
Sure, a tax on interest pushes savings, and thus future consumption, down. But how does increased labor not do the same thing?
When Feldstein writes “the government could collect the same present value of tax revenue from Joe by raising the tax on his $1,000 of extra earnings from $350 to $385,” he seems to be assuming that this increase in the labor tax will have no effect on Joe’s output, but oh that increase in the interest tax will.
I’m very skeptical that armchair economics can tell us whether the effect of a change in the tax on interest will be greater or less than the same change in the tax on labor.
Anyway, isn’t a great deal of savings in the U.S. in the form of 401Ks, IRAs, home equity, and other tax advantaged vehicles? 401Ks and IRAs are taxed at withdrawal time at the labor rate, so they’re unaffected by your analysis.
Or if Joe is so averse to paying tax on interest, he should put his $100 in a Roth IRA, on which he’ll never pay interest. Or make an extra principal payment on his 30-year mortgage, because he can’t be taxed on the effective interest he earns on that.
Also, Prof. Cowen, if you want to convince us liberals of something (and I’m willing to be convinced on this), citing anything from the WSJ opinion section is unlikely to be effective.
There is a whole lot of chcanery in this one. First, Feldstein gets these numbers by assuming that the capital gain (CG) tax is paid by Joe EVERY YEAR instead of when he actuall realizes the gain. That means that Joe sells his portfolio every year, realizes the gain, pays the tax, and then reinvests what is left over. I just ran the numbers on a spreadsheet and that is the only way you get his numbers. If Joe is taxed only when he realizes the gain (when he sells the portfolio) then his return is a much larger $249. Further, if this money is put in an IRA, then his CURRENT tax is lowered and his CURRENT consumption can actually go up. Feldsein ignores the current tax advantages received by capital income completely.
Second, he ignore Joe SR who, when Joe is 40 and saving 100, is receiving his $193 and paid about $8 in taxes from his last years tax on his capital income (the bulk of his taxes were paid in previous years under Feldstein’s assumptions). Thus, the govt is collecting $358. If we lowered the tax rate we will need to collect an extra $5 from Joe’s income tax to pay for this. If Joe takes even part of this $5 out of savings then his future consumption comes down.
Feldstein is smart enough to know all this. I suspect he wrote this crap to get the WSJ people to salivate. But it does nothing to help the debate over taxation.
I agree with dsquared that something is going on with the discount rates here. The critical statement is: “the government could collect the same present value of tax revenue from Joe by raising the tax on his $1,000 of extra earnings from $350 to $385.”
I calculated the *nominal* stream of tax payments from age 40 to age 75 under his asumptions (tax payments range from $2.10 to $8.01); it takes a discount rate in excess of 9.5% to reduce the value of that stream of payments to $35.
Or am I missing something? I made annual tax payments and reinvested interest payments at the same 6% rate. But even if the 6% return were entirely tax deferred to age 75 (which doesn’t make much sense), the lump-sum tax would be $234, requiring a 5.6% discount rate to make his math work. I suspect he’s forgotten to tax the nominal increase in asset value, but that’s just a guess.
I’ve read the comments so far, but I still side with Marty! As set up, both taxes distort labor supply to the same expected value degree. The capital tax also distorts the savings decision.
The article also states that experience shows that reducing the tax on savings would caused Joe to shift more into savings. But we have been offering vechicles to lower taxes on savings for 20-25 years and over that period the savings rate has declined. So while theory suggest that this statement is correct, experience has shown it has not worked that way in the US over the last 20-25 years.
I posted my comment as Spencer was making the same point. If the marginal rate of saving was 15%, many more people would take advantage of the favorable tools for investment that already exist. The fact that they don’t indicates that they are not acting rationally or that when you give the average American $1000 of extra income, they probably will spend $1000!
Joe gets the same amount of aftertax money at virtually all interest rates because he won’t lend the money unless the after tax return is worth it. So a tax on interest or capital gains as interest equivalent are taxes on the borrower, not the lender.
You will note that the Republicans do understand that social security taxes are taxes on labor from the point of view of the corporation’s decisions on whether to automate or immigrate. Selective understanding is common.
Looks to me like some Liberals reject any data or experiment that conflicts with their beliefs.
Nice, Bernard
The oranges and apples argument falls apart as soon as you put it into the real world, where different people have different levels of “labor”, and different requirements for “oranges” and “apples”. (E.g. retirees live entirely off oranges, and the working poor spend nearly everything on apples)
And where you can buy one bag a year of “oranges” tax free using a 401Orange plan. So only those with higher “labor” benefit from reducing the tax rate on the second and third bags.
And where, pretty much whatever the cost, most people want to have at least 35 oranges when they retire, so that they can continue to get their Vitamin C intake through retirement.
To see this issue beaten to death, see the following comments section.
http://www.marginalrevolution.com/marginalrevolution/2005/12/what_is_the_evi.html
Huh?
That’s a weird response.
You’re calling for ending capital taxation. If there is an important difference between “capital” taxation and “capital goods” taxation that makes my argument invalid I’d like to hear it.
The point is that there is no argument that you as a volunteer lobbyist for capital income receivers are making that an automobile industry lobbyist could not make.
One weakness of this sort of analysis that I have noticed before but have never seen addressed is the effect of expected future tax rates, especially, for example, on interest. No matter what the tax rates are today, Congress or any state could enormously raise interest tax rates any time in the future, and the knowledge that that is possible has to have some effect on savings rates. As well as on how money is saved.
“Because the high tax rate on interest income reduces the reward for work (as well as the reward for saving), Joe makes choices that lower his pretax earnings — fewer hours of work, less work effort, less investment in skills, etc.”
As much as I hate to continue dignifying this with responses, can’t we consider wages the reward for work and the interest the reward for saving (which is indirectly the reward for capital)? Do we really have to stretch so that we are calling the tax on income saving a tax on labor?
Once we go there, taxes on labor reduce the reward for capital income. Because when I take my capital income and want to hire someone to drive me around, my reward for capital income is reduced by the amount of tax this guy has to pay and the increased salary he demands from me to compensate for that.
It starts to get so ridiculous.
If you want to help people who get income from labor, do not cause a massive tilt in the economy’s pricing mechanism away from labor. Let the economy reach about the same labor/capital allocation it would reach if there were no taxes – which is the most efficient possible labor/capital allocation.
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