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23
23.1 Taxation and Risk Taking
23.2 Capital Gains Taxation
23.3 Transfer Taxation
23.4 Property Taxation
23.5 Conclusion
Taxes on Risk Taking and Wealth
23
Taxes on Risk Taking and Wealth
In June 2006, Warren Buffett, the world’s second-richest man, made the shocking announcement that he was giving 85% of his shares in Berkshire Hathaway, Inc., to five foundations.
The decision to donate the vast majority of his wealth to charity rather than bequeathing it to his own children was seen by many as a culmination of Buffett’s long-standing advocacy against the transfer of large estates from generation to generation.
In keeping with this position, Buffett, along with other wealthy Americans such as William Gates, Sr., and George Soros, has long been an outspoken critic of moves to repeal the estate tax, a tax levied on large estates upon the death of their owners.
23
Taxes on Risk Taking and Wealth
Buffett has argued that allowing children to inherit all of their parents’ riches causes them to be spoiled and sapped of all motivation, and keeping the tax in force helps to preserve America’s meritocracy.
Many others have also defended the estate tax for its progressivity: they note that because of the high exemption levels, the tax affects only a very small portion of the wealthiest citizens upon death.
Opponents of the estate tax argue it is double taxation which leads the wealthy to earn and save less. They also view it as a “death tax” that imposes a government penalty for the act of dying itself.
23
Taxes on Risk Taking and Wealth
In this chapter, we focus on two other aspects of taxation that might affect the savings decisions of taxpayers.
The first is the taxation of risk taking. Individuals not only decide how much to save but also what form their savings will take.
A particular tax policy that might affect risk taking is the taxation of capital gains, the earnings realized on the sale of capital assets.
23
Taxes on Risk Taking and Wealth
Second, individuals can also be taxed not only on the return from their savings in each period but on the amount of wealth they have accumulated through past savings.
The first form of wealth tax consists of transfer taxes, a set of taxes on gifts from one party to another, including the contentious estate tax discussed.
The second type of wealth tax is the property tax. Because the major source of savings for most Americans is their homes, property taxation can significantly affect the level of savings as well.
23.1
How do taxes on risk-taking affect behavior
Taxing gains, deducting losses doesn’t affect behavior.
But progressive taxes, or taxes without an offset for losses, do affect behavior.
Tax loss offset: The extent to which taxpayers can deduct net losses on investments from their taxable income.
Overall, no clear prediction on how taxes affect risk taking, and little empirical evidence.
Basic Financial Investment Model
23.1
Consider a $100 investment opportunity that pays out $120 half the time and $80 half the time.
This has an expected return of zero.
Expected return: The return to a successful investment times the odds of success, plus the return to an unsuccessful investment times the odds of failure.
Basic Financial Investment Model
23.1
Some Taxes on Risk Taking Can Be Undone
No Tax Tax Loss Offset No Loss Offset Progressive Tax
Investment $100 100 200 200 200
Payoff if win $20 20 40 40 40
Payoff if lose $20 20 40 40 40
Tax rate if win 0% 50% 50% 50% 75%
Loss deduction 0 50% 50% 0 50%
After-tax gain $20 $10 $20 $20 $15
After-tax loss $20 $10 $20 $40 $20
By investing more in a risky asset (column 4, Loss Offset), Sam has completely undone the government tax scheme and arrived back at the after-tax winnings and losses (column 2, No Tax), where there were no taxes to be paid or losses to be deducted.
23.1
The amount of a loss that can be deducted is called a tax loss offset.
In the United States, individuals are allowed to deduct only $3,000 of investment losses in any tax year from their other taxable income.
A taxpayer cannot simply undo government taxation by making increasingly risky investments, because the losses from these investments will not be fully deductible from taxation.
Real-World Complications: Less-Than-Full Tax Offset
23.1
Real-World Complications: Less-Than-Full Tax Offset
No Tax Tax Loss Offset No Loss Offset Progressive Tax
Investment $100 100 200 200 200
Payoff if win $20 20 40 40 40
Payoff if lose $20 20 40 40 40
Tax rate if win 0% 50% 50% 50% 75%
Loss deduction 0 50% 50% 0 50%
After-tax gain $20 $10 $20 $20 $15
After-tax loss $20 $10 $20 $40 $20
If Sam raises his investment to $200 in the small business, there is a 50% chance that he will earn $40, which is $20 after tax, and a 50% chance he will lose $40, which cannot be deducted against taxable income, and so remains a loss of $40 after taxes (column 5, No Loss Offset).
23.1
Tax systems are typically progressive, with higher marginal tax rates as income rises.
If investors win a large gamble, they can move themselves into a higher tax bracket.
If they lose a large gamble, they can move themselves into a lower tax bracket.
Thus, winning gambles may be taxed at a higher rate than the rate at which losing gambles are deducted.
This can lead investors to reduce their risk taking.
Once again, a taxpayer cannot simply offset the tax policy by raising his investment.
Real-World Complications: Redistributive Taxation
23.1
Real-World Complications: Less-Than-Full Tax Offset
No Tax Tax Loss Offset No Loss Offset Progressive Tax
Investment $100 100 200 200 200
Payoff if win $20 20 40 40 40
Payoff if lose $20 20 40 40 40
Tax rate if win 0% 50% 50% 50% 75%
Loss deduction 0 50% 50% 0 50%
After-tax gain $20 $10 $20 $20 $15
After-tax loss $20 $10 $20 $40 $20
If he raises his investment to $200 and the investment outcome is a good one, he takes home only $15 after tax: 50% of the first $20 in earnings and 25% of the next $20. If the investment outcome is a bad one, he loses $20 after tax (column 6, Progressive Tax).
Taxation and Risk Taking: Labor Investment Applications
23.1
Education is a risky investment.
Each year of schooling increases earnings by about 7% on average, but the actual returns vary.
Labor taxes affect the after-tax return to education.
Progressive income taxes may discourage investment in education.
23.2
Taxes apply to capital gains as well as earned income.
Capital gain: The difference between an asset’s purchase price and its sale price.
Currently, capital gains are taxed on realization.
Taxation on realization: Taxes paid on an asset’s return only when that asset is sold.
Interest income is taxed at accrual.
Taxation on accrual: Taxes paid each period on the return earned by an asset in that period.
Capital Gains Taxation
23.2
Two large preferences for capital gains:
“Step-Up” of Basis at Death: Assets transferred at death get a new basis, tax free.
Basis: The purchase price of an asset for purposes of determining capital gains.
Exclusion for Capital Gains on Housing: The tax code in the United States has traditionally featured an exclusion for capital gains on houses.
Current Tax Treatment of Capital Gains
23.2
Capital gains have generally been taxed at a lower rate than earned income:
1978 1986: Tax applied to only 40% of capital gains on assets held for more than six months.
1986: Treated capital gains like all other income.
1993: Raised top tax rates on other forms of income to 39%, kept the top capital gains rate at 28%.
1997: Top rate on long-term capital gains fell to 20%.
2003: Top rate fell to 15%.
Capital Gains Tax Rates Through the Years
23.2
Protection Against Inflation
Because of inflation, current tax policy overstates the value of capital gains.
But better to index for inflation.
Improved Efficiency of Capital Transactions
To reduce present discounted value of capital gains tax, individuals delay sale of assets.
But this reduces the fluidity of the capital market, and may hurt its performance.
What Are the Arguments for Tax Preferences for Capital Gains
What Are the Arguments for Tax Preferences for Capital Gains
23.2
Encouraging Entrepreneurial Activity
Entrepreneurs earn income by increasing the value of their companies, which is a capital gain.
Capital gains tax rates are a crude instrument for encouraging entrepreneurship. Instead, use a prospective capital gains tax reduction.
Prospective capital gains tax reduction: Capital gains tax cuts that apply only to investments made from this day forward.
23.2
Evidence on Taxation and Capital Gains
How does the capital gains tax rate affect capital gains
Key question in determining how capital gains should be taxed.
In 1986, a capital gains tax increase was announced, to go into effect in 1987.
Capital gains spiked in 1986…
…But didn’t fall below their 1985 levels in 1987.
The tax hike had no long-run effect on capital gains.
23.2
Evidence on Taxation and Capital Gains
There is a clear effect of tax changes on capital gains realizations. Realizations peaked in 1986 in anticipation of the increase in capital gains tax rates scheduled for 1987. Realizations peaked again during the stock market booms of the past decade
23.2
Capital gains taxes are very progressive.
Capital gains income accrues primarily to the richest taxpayers in the United States.
Lower tax rates on capital gains violate the Haig-Simons principle for tax systems.
The goal of taxation should be to provide a level playing field across economic choices, not to favor one choice over another, unless there is some equity or efficiency argument for doing so.
What Are the Arguments Against Tax Preferences for
Capital Gains
23.2
Republican presidential candidate Mitt Romney paid an average tax rate of 14% on $42 million of income in 2010 and 2011.
His income was taxed as “carried interest” earned on the assets he managed at Bain Capital.
Preferential treatment of “carried interest” intended to compensate for high risk that asset managers face.
But it is a violation of the Haig-Simons principle, and many economists oppose it.
APPLICATION: Capital Gains Taxation of “Carried Interest”
23.3
Transfer taxes are an important capital tax in the United States.
Transfer tax: A tax levied on the transfer of assets from one individual to another.
Gift tax: A tax levied on assets that one individual gives to another in the form of a gift.
Estate tax: A tax levied on the assets of the deceased that are bequeathed to others.
Transfer Taxation
23.3
Transfer and Wealth Taxes (% of Government Revenue)
Transfer Taxes Wealth Taxes Transfer and Wealth Taxes
Australia 0% 0% 0%
United Kingdom 0.6 0 0.6
United States 0.6 0 0.6
Spain 0.7 0.4 1.1
France 1.1 0.5 1.6
Switzerland 0.5 4.2 4.7
OECD Average 0.4 0.5 0.9
The use of transfer taxes and wealth taxes varies widely around the world. On average, the United States has higher transfer taxes than the typical developed nation but lower taxes on wealth.
23.3
Why tax wealth rather than income
Extremely progressive means of raising revenue.
Necessary to avoid the excessive concentration of wealth and power in a few wealthy dynasties.
Allowing children of wealthy families to inherit all their parents’ wealth saps them of all motivation to work hard and achieve their own success.
Why Tax Wealth Arguments for the Estate Tax
23.3
Why not tax wealth
A “Death Tax” Is Cruel: It is morally inappropriate to tax individuals upon their death.
The Estate Tax Amounts to Double Taxation: You are taxed on income when you earn it and then your children are taxed on it again when you die.
Administrative Difficulties: To afford the tax, you may be forced to sell the asset.
Compliance and Fairness: Only those too unsophisticated to avoid the tax end up paying it.
Arguments Against the Estate Tax
23.4
Property taxation is the major source of revenue for local governments.
Property tax: A tax levied on the value of real estate, including the value of the land and any structures built on the land.
Tax burden based on the assessed property value, but homeowners only pay taxes on the assessment ratio.
Assessment ratios vary widely across the United States, from 4% in Columbia, South Carolina, to 100% in Providence, Rhode Island.
Property Taxation
23.4
Three views on the incidence of the property tax:
Traditional (partial equilibrium): Property tax falls on landowners and on structures’ owners and users, according to elasticities.
“Capital tax” (general equilibrium): Tax reduces return to capital, drives capital out of localities. Falls on capital owners.
“Benefits tax:” Property tax finances local government spending, benefitting local homeowners. In Tiebout equilibrium, no burden of taxation.
Who Bears the Property Tax
23.4
Two important distinctions in levying property taxes:
Residential Homes Versus Businesses
Some argue that to encourage economic development, business property taxes should be lower than residential.
Land Versus Improvements
Land is inelastic supply, so it should be taxed.
Hard to separate land value from structure value, so structures and land are both taxed in practice.
Types of Property Taxation
23.4
Property tax breaks for businesses are ubiquitous.
Cincinnati gave $52.2 million to a company to keep its 1,700 jobs from moving to low-tax Kentucky.
St. Louis County, Missouri, offered a company $2.5 million in tax breaks to settle in the county.
New York City granted Bank of America $42 million to build its 51-story office tower in Manhattan.
Wages and property values rise faster in cities that successfully attract industrial plants, suggesting these property tax breaks may be valuable.
APPLICATION: Property Tax Breaks to Businesses
23.5
Treatment of savings is a central part of the tax code.
Taxation can increase or decrease risk taking.
Cutting capital gains taxes wouldn’t reduce lock-in, and it is unclear if it would encourage entrepreneurship.
Capital gains tax cuts provide large subsidies to previous investments.
The estate tax is a very progressive source of revenue, but it raises horizontal equity concerns.
Local governments rely on property taxes, which have an uncertain incidence.
Conclusion

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