Econ 309 Taxing Risk Taking and Wealth

For interest

• "Legacy for one Billionaire, Death but no Taxes" (New York Times, June 8, 2010)

Taxes on Risk Taking and Wealth

I.                   Taxes on risk taking

a.     What would be a good tax code?  I have in mind two things here.

b.     What effect does the tax code have on risk taking? 

                                                             i.      Increase it, if losses are fully deductible

1.     (Harrod-Musgrave model)

2.     People try to undo taxes to get to first best equilibrium

                                                           ii.      Reduce it

1.     Due to progressive nature of taxation (winning big brings heavy tax that’s not fully offset)

2.     Limitations on loss offsets (Full deductibility against other profits, but on limits on deductions against other current income and limited carry forward and back allowed)

II.                Capital gains taxation

a.     Capital gains = Profit from buying low and selling high

b.     A tax on risk taking

c.      The real story of Clinton’s budget surpluses

d.     Wages, profits, interest income are taxed upon accrual in the year you earn them, capital gains are only taxed only on realization, that is when the asset is actually sold. 

e.      Hard to tax capital gains any other way than on realization.

                                                             i.      How do we value idiosyncratic assets like homes or paintings?

                                                           ii.      Easier to value heavily traded uniform assets like stocks, but annoying to do so. 

                                                        iii.      Would we have margin accounts for taxes, the way we do for financial options?

                                                        iv.      Note:  Holders of appreciated assets can borrow against the value of these assets, make use of the money.

                                                           v.      Taxing realization effectively delays taxation of Haig-Simons income. 

1.     Important maxim:  A tax delayed is a tax reduced!

2.     Effectively an interest free loan from the IRS.

f.       Grim reaper loophole

                                                             i.      Stepped up basis” at death, those who inherit assets (below the estate tax threshold) owe no taxes on the capital gains

                                                           ii.      When they do sell the assets, the basis (effectively the “purchase price” for tax purposes) is set to the value of the assets at the time they were inherited, not when they were originally purchased.

g.     Sale of principle residence: No tax on first $2.5 million of value (Who loves that the most?  Oh, and it’s doubled for married couples.)

h.     Inflation distortion since capital gains are taxed on nominal increase, not real rise in value.  Distortion like that from the inflation effect on taxing interest income discussed last time.

i.       Effect on portfolios

                                                             i.      Sell assets that fall in value now and deduct losses against other income, but hold assets that rise in value to avoid capital gains taxes

                                                           ii.      Lock-in effect:  People are reluctant to sell assets with capital gains because of the tax, so these assets get too big a share in a portfolio

                                                        iii.      Unbalance portfolios:  My grandfather and dividend yield per share.

III.             Reforming capital gains taxation

a.     Cutting the capital gains tax rate on current assets is cutting a tax on a Ricardian Rent.  Cut on future capital gains would have more positive effect.

b.     Short run tax revenue gain, probably long run revenue loss, leads to classic time consistency problem

c.      Taxing capital gains income differently from income from sources like labor or interest creates incentives for people to try to get their compensation in lower taxed forms, and it’s not good if the tax code creates incentives to people to substitute away from bonds and into stocks.

d.     More when we talk about corporate taxation

IV.            Transfer taxes:  Gifts, Estates

a.     Gift limit now $11,000 per year per person, gift tax of 50% applies above that. 

b.     Estate tax: 

                                                             i.      18%-48% (average 26%) on estates over $1.5 million

                                                           ii.      Spouses can inherit tax free

                                                        iii.      Can borrow to pay it, even from IRS at low rates. 

                                                        iv.      Incurred by 2% of US population each year, on about 51,000 estates, of which 3% are farms or family businesses

                                                           v.      Collects $30 billion each year, that would have to be replaced by higher taxes elsewhere if eliminated.

                                                        vi.      Bush Tax Plan: 

1.     Estate Tax (“Death Tax”) rate drops to 0% in 2010,

2.     Rises back to old rates in 2011

3.     Get your rich relatives to die in 2010!

                                                      vii.      Incentive effects unclear

                                                   viii.      Capital gains basis step-up effect reduced taxes owed

                                                        ix.      Evasion through trust funds (up to $3 million per trustee), stock grants in family firms

                                                           x.      Charitable giving effect

V.               Property taxes

a.     Henry George, Georgists – “Single Tax”

b.     Deductible for those who itemize (mostly rich people)

c.      Capitalization effect

                                                             i.      Incidence of increased property taxes falls on current owners of property

                                                           ii.      Present discounted value of future taxes built into purchase price of house (in excess of the value of local public goods financed by the taxes)

d.      “Tax competition” effect on businesses and location decisions

                                                             i.      Lots of DWL here

                                                           ii.      Time consistency problem

                                                        iii.      Solution at federal level?