Martin Feldstein on capital taxation

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
, 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

Here is the link.  Elsewhere from The Wall Street Journal, here is a piece on bargaining theory, thanks to Chris Masse for the pointer.


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