How do low real interest rates affect optimal tax policy?

Alan Auerbach and William Gale have a new paper on this topic:

Interest rates on government debt have fallen in many countries over the last several decades, with markets indicating that rates may stay low well into the future. It is by now well understood that sustained low interest rates can change the nature of long-run fiscal policy choices. In this paper, we examine a related issue: the implications of sustained low interest rates for the structure of tax policy. We show that low interest rates (a) reduce the differences between consumption and income taxes; (b) make wealth taxes less efficient relative to capital income taxes, at given rates of tax; (c) reduce the value of firm-level investment incentives, and (d) substantially raise the valuation of benefits of carbon abatement policies relative to their costs.

One core intuition here is that as the safe return goes to zero, capital taxes are not especially burdensome compared to consumption taxes.  Of course “the safe return” may not be entirely well-defined within a corporate context, and capital taxes often hit returns to risk as well, so this is a bit more complicated than the abstract alone would indicate.

The authors also offer this intuition, which I do not quite follow:

In simplified environments, a wealth tax can be written as an equivalent tax on capital income. As the rate of return falls, the equivalent income tax rate of any given wealth tax rises. That is, a given wealth tax rate becomes more distortionary relative to a given capital income tax as the rate of return falls.

One of my biggest worries about a wealth tax is that it takes resources away from people who at the margin seem to be good at generating extra-normal returns.  That comparative advantage might be more important as the safe rate goes to zero.  So I am fine with the conclusion of the authors, but not sure if their intuition is equivalent to mine (I suspect it is not).

This one is clearer to me:

A major focus of potential tax reform has been the treatment of capital gains, given their tax-favored status, their high concentration among the very wealthy, and the distortions that the current method of taxation causes. A key element of the current system of capital gains taxation
is the lock-in effect, which discourages the realization of gains to take advantage of deferral of taxation. With very low interest rates, the deferral advantage loses much of its relevance, and this can make relatively simple reforms (such as taxing capital gains at death) achieve results very similar to more complicated schemes (such as taxing capital gains on accrual, even when not realized).

Overall this paper is very interesting and thought-provoking.  Nonetheless, until we understand better why the safe rate of return has diverged so radically from “typical” (but still risky) corporate rates of return, I am not sure what implications we can draw from the model.



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