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Public Finance
Dr. Katie Sauer
Taxes on:
Labor Supply
Savings
Wealth
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I. Labor Supply & Taxes
Consumption
Leisure Hours
Suppose a wage rate of$12.50 and a maximum
number of hours of 2000.
Slope =-12.5
Suppose individual
choose 900 hours ofleisure.
2000
25,000
900
13,750
BC1
IC1
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Consumption
Leisure Hours
Suppose a tax of 30% is
imposed.
After-tax wage:
12.50 x (1 - .30)
8.75
Slope of BC =
-8.75
2000
25,000
900
13,750
BC1
IC1
17,500
BC2
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Consumption
Leisure Hours
For the same amount of
work (1100 hours), the
individual only receives
income of
$9625
2000
25,000
900
13,750
BC1
IC1
17,500
BC2
9,625
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Will the individual work more or less?
Depends on which effect is stronger:
substitution effect
- because price of leisure has fallen, expectindividual to work less and have more leisure
income effect
- because individual is now poorer, expect
them to work more and have less leisure
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The Earned Income Tax Credit
(1976)
Two goals:- subsidize the wages of low-income earners
- increase labor supplied by low-income earners
Largest *cash* antipoverty program.
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Eligibility:
- annual earnings greater than zero
Household with no children
- annual earnings less than $13,400
With Children
- annual earnings less than $35,463 (one child)
$40,295 (more)
This is a refundable tax credit.
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For a single earner with 2 children (2010):
EITC
Earned Income
$5,036
Slope =
0.40
$12,549
Up to earned income of
$12,549, EITC is $0.40per dollar earned.
Max credit is $5,036
Plateau to $16,449
$16,449
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EITC
Earned Income
$5,036
Slope =
0.40
$12,549
Phase-out:
$5,036 (0.21 )( Income $16,450)
None at $40,363
$16,449
Slope isroughly 0.21
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EITC and Labor Supply
Consumption
Leisure Hours
40,363
16,449
12,549
For people not in the labor force
(all leisure, no work), this policy
will likely raise labor supply.
BC with EITC
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Consumption
Leisure Hours
40,363
16,449
12,549
For people in the labor force,
earning less than $12,549:
SE: each hour of work brings a
higher wage than before so
work more
IE: workers are wealthier
as a result of the subsidy
so work less
ambiguous result for
labor supply
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Consumption
Leisure Hours
40,363
16,449
12,549
For people in the plateau region:
EITC does not change in this rangeso wage is constant
- no substitution effect
(BC has same slope)
EITC makes them wealthier
- income effect says theyll
work less (higher BC)
reduction in labor
supply
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Consumption
Leisure Hours
40,363
16,449
12,549
For people that earn between
$16,500 and $40,363:
SE: new BC is flatter price of
leisure fell work less
IE: new BC is higher wealthier work less
reduction in labor
supply
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II. Taxes on Savings
A. intertemporal choice model
Jack lives for 2 periods
period 1: working life, earn Y
consumes Cw
saves Sw =Y Cw , earns rinterest
period 2: retirement life, earn 0
consumes CR
CR = Sw (1 + r)
Jack has a tradeoff between consumption in period 1 and 2.
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Consumption in
Period 2
Consumption inPeriod 1Y
Maximum consumption in period 1:
Y
Maximum consumption in period 2:
- if all income from period 1 were
saved, there would be Y (1 + r) forperiod 2
Y(1+r)
BC
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Consumption in
Period 2
Consumption inPeriod 1Y
The slope of the budget constraint is
equal to:
- (1 + r)
Y(1+r)
BC
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Consumption in
Period 2
Consumption inPeriod 1Y
Suppose Jacks preferences are such
that he values consumption in thepresent.Y(1+r)
BCIC
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Consumption in
Period 2
Consumption inPeriod 1Y
Suppose the government taxes interest
income.
The maximum consumption in period
2 is now:
Y[ 1 + (r)(1 )]
slope of BC is now:
- [ 1 + (r)(1 )]
Y(1+r)
BCIC
Y(1+(r)(1-))
BC2
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Consumption in
Period 2
Consumption inPeriod 1Y
Two effects:
SE: BC is flatter price ofperiod 1 consumption falls
consume more in 1, save less
IE: BC is lower, have to savemore to have money in period 2
ambiguous effect
Y(1+r)
BCIC
Y(1+(r)(1-))
BC2
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B. Tax Subsidized Retirement Savings
When savings are tax-free until withdrawn, they are taxed
more lightly.
PDV of tax payments is lower
is the share of the tax burden that remains after the
accounting delay in tax payments.
Ex: suppose = 0.3 and = 0.33
Effective tax rate on savings is: 0.3 x 0.33 = 0.099
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The slope of the budget constraint is now:
- [ 1 + (r)(1 )]
SE: BC is now steeper (than BC2)
so the price of period 1 consumption
rises save more
IE: BC is now higher (than BC2)
so feel wealthier save less for
period 2
ambiguous result
Consumption in
Period 2
Consumption inPeriod 1Y
Y(1+r)
BCIC
Y(1+(r)(1-))
BC2
Y(1+(r)(1-))
BC3
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Many retirement savings plans have a limit on annual tax-
free contributions.
IRA $5000
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For the first $5000 of savings, the
preferential tax treatment applies.Consumption inPeriod 2
Consumption inPeriod 1Y
Y(1+(r)(1-))
BC
5000
BC2
slope = -[ 1 + (r)(1 )]
slope = - [1 + (r)(1 )]
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For an individual who already saved a lot:
SE: BC slope is same none
IE: BC is higher feels wealthier
saves less for period 2
Saves Less
Consumption in
Period 2
Consumption inPeriod 1Y
Y(1+(r)(1-))
BC
5000
BC2
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For an individual who saved less than
$5000:
SE: BC slope is steeper increased price
of period 1 consumption save more
IE: BC is higher feels wealthier saves less for period 2
ambiguous result
Consumption in
Period 2
Consumption inPeriod 1Y
Y(1+(r)(1-))
BC
5000
BC2
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III. Taxes on Risk Taking and Wealth
A. Domar and Musgrave 1944:basic model of risk taking and taxation
Choice between
risky asset that yields positive rate of return
safe asset that yields no real return
Governmenttaxes any positive return
allows deduction against taxable income for full
amount of a negative return
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The model finds that taxing the returns from the risky
asset would increase risk takingbecause any tax on the
returns could be undone by taking more risk.
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In reality, there are two complications:
1. Less-than-full Tax Offset
In the US, individuals are allowed to deduct $3000 ofinvestment losses in any tax year.
- cant just undertake a losing investment to wipe
out some of your tax burden
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2. Redistributive Taxation
The US tax system is progressive big winnings can
move you into a higher tax bracket pay more taxes.
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B. Capital Gains Tax
Many assets yield a return in the form of an increase in
the value of an asset.
Assets that earn interest are taxed on accrual.
Assets that appreciate in value are taxed on realization.
- taxed when asset is sold
- taxed on selling value minus basis(basis = purchase price of asset)
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Ex: Your purchase a painting for $100. It increases in
value by 10% each year.
After 7 years, you sell the painting.
It is worth:
End of Year 1: 100(1.1) = 110End of Year 2: 110(1.1) = 121
End of Year 3: 121(1.1) = 133.1
End of Year 4: 133.1(1.1) = 146.41
End of Year 5: 146.41(1.1) = 161.051End of Year 6: 161.051(1.1) = 177.1561
End of Year 7: 177.1561(1.1)= 194.87171
$195
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You must pay taxes on:
$195 - $100 = $95
If the capital gains tax rate is 20%:
95(0.20) = $19 in taxes
net return: 95 19 = $76
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Suppose instead you put $100 in a bank account earning
10% interest per year, for 7 years.
- interest earned is taxed at 20% annually
End of year 1: 100(1.1) = $110
110 100 = $10 earned interest
10(0.2) = $2 owed in taxesafter taxes = $108
End of year 2: 108(1.1) = $118.8
118.8 108 = $10.80 earned interest10.80(0.20) = $2.16 owed in taxes
after taxes = $116.64
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End of year 3: 116.64(1.1) = $128.30
128.30-116.64 = $11.66 earned interest
11.66(0.2) = $2.33 owed in taxesafter taxes = $125.97
End of year 4: 125.97(1.1) = $138.57
138.57-125.97= $12.60 earned interest12.60(0.20) = $2.52 owed in taxes
after taxes = $136.05
End of year 5: 136.05(1.1) = $149.66149.66-136.05 = $13.61 earned interest
13.61(0.2) = $2.72 owed in taxes
after taxes = $146.94
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End of year 6: 146.94(1.1) = $161.63
161.63-146.94 = $14.69 earned interest
14.69(0.2) = $2.94 owed in taxesafter taxes = $158.69
End of year 7: 158.69(1.1) = $174.56
174.56-159.69= $14.87 earned interest14.87(0.20) = $2.97 owed in taxes
after taxes = $171.59
net return: $71.59
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Savings in the form of capital gains-producing assetsreceive a tax preference.
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For assets that are passed on to heirs, the basis is stepped
up to the value at the time of death.
Ex: You buy a painting for $100 now. 75 years later it is
worth $10,000.
If you sell it the day before you die, you must pay taxeson the $9,900 capital gains.
If you pass it on to your heirs, the basis value for the
painting is now $10,000.If they sell it the day after you die for $10,000, they
pay no capital gains.
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There is a capital gains exemption of $500,000 for sale
of a primary residence.