Public Sector Test 2
Week 8
Taxes on Capital
Why is capital interesting to study?
• The distribution of capital income is much more unequal than labor
income
• Capital is more mobile than labour
• Capital is global - opportunities to shift elsewhere
• Capital taxation is extremely complex and provides many tax avoidance
opportunities
• For example, read how Donald Trump has deployed income shifting
and loss write-offs to essentially avoid paying taxes for years
8% of all global wealth is held in tax havens
Offshore wealth in Africa results in $14bn of lost tax revenue
On average, wealth equaling 9.8% of GDP is held offshore
How is Capital Earned?
• Through savings and the interest returned
• Through dividends that accrue to shareholders in companies
• Through interest income on investments
• Through capital gains that result from the purchase, appreciation and
subsequent sale of assets
Motives for Savings:
1. Precautionary saving
• Individuals save to have self-insurance in some sense
• During difficult times, there may be liquidity constraints which prevent
individuals from accessing credit
• Precautionary savings is a way of saving for these difficult times, creating
a “buffer” against shocks
2. Self-control
• Individuals may not be able to save given self-control problems
• Saving as a commitment device
3. Intertemporal choice
4. Consumption smoothing
• The traditional view of savings – a way to smooth consumption across
time
• Individuals have more income in some periods and less income in others
• With no saving, consumption will have to decrease in periods with low
income
• However, this creates diminishing marginal utility
1
, • Preferable choice is to smooth consumption across time
• Reduce spending when income is large, save surplus and consume
surplus when income is low
A Model of Intertemporal Choice (i)
• Deciding how much to save is essentially an intertemporal consumption
choice problem
• How much to save, depends on much you want to consume today and
tomorrow
• Consider a two-period model: Income (Y ), consumption while working (c W )
and while retired (c R ¿
• Savings = the difference between income and period one consumption
W
S=Y −c
• Savings earns interest
( 1+r ) S=(1+r )¿ )
A Model of Intertemporal Choice (ii)
• Consume all savings in period two
c R=( 1+r ) ( Y −c W )
• Represents our intertemporal budget constraint
• The rate at which we trade off period one consumption for consumption in
period two
• Opportunity cost of period one consumption = ( 1+r ) Rand of period two
consumption
• The introduction of a tax will change the interest rate, which will affect the
budget constraint
c R=( 1+r × [1 - τ ] ) ( Y −c W )
A Model of Intertemporal Choice (iii)
2
, A Model of Intertemporal Choice (iv)
Substitution and Income effects
• Substitution effect
• Lower after-tax interest rates increase the price of second period
consumption
• Causes period one consumption to increase, reducing savings
• Income effect
• Lower after-tax interest rates reduce lifetime value of consumption
(makes the consumer poorer)
• Causes an increase in savings, reduces period one consumption
Substitution Effect
3
Week 8
Taxes on Capital
Why is capital interesting to study?
• The distribution of capital income is much more unequal than labor
income
• Capital is more mobile than labour
• Capital is global - opportunities to shift elsewhere
• Capital taxation is extremely complex and provides many tax avoidance
opportunities
• For example, read how Donald Trump has deployed income shifting
and loss write-offs to essentially avoid paying taxes for years
8% of all global wealth is held in tax havens
Offshore wealth in Africa results in $14bn of lost tax revenue
On average, wealth equaling 9.8% of GDP is held offshore
How is Capital Earned?
• Through savings and the interest returned
• Through dividends that accrue to shareholders in companies
• Through interest income on investments
• Through capital gains that result from the purchase, appreciation and
subsequent sale of assets
Motives for Savings:
1. Precautionary saving
• Individuals save to have self-insurance in some sense
• During difficult times, there may be liquidity constraints which prevent
individuals from accessing credit
• Precautionary savings is a way of saving for these difficult times, creating
a “buffer” against shocks
2. Self-control
• Individuals may not be able to save given self-control problems
• Saving as a commitment device
3. Intertemporal choice
4. Consumption smoothing
• The traditional view of savings – a way to smooth consumption across
time
• Individuals have more income in some periods and less income in others
• With no saving, consumption will have to decrease in periods with low
income
• However, this creates diminishing marginal utility
1
, • Preferable choice is to smooth consumption across time
• Reduce spending when income is large, save surplus and consume
surplus when income is low
A Model of Intertemporal Choice (i)
• Deciding how much to save is essentially an intertemporal consumption
choice problem
• How much to save, depends on much you want to consume today and
tomorrow
• Consider a two-period model: Income (Y ), consumption while working (c W )
and while retired (c R ¿
• Savings = the difference between income and period one consumption
W
S=Y −c
• Savings earns interest
( 1+r ) S=(1+r )¿ )
A Model of Intertemporal Choice (ii)
• Consume all savings in period two
c R=( 1+r ) ( Y −c W )
• Represents our intertemporal budget constraint
• The rate at which we trade off period one consumption for consumption in
period two
• Opportunity cost of period one consumption = ( 1+r ) Rand of period two
consumption
• The introduction of a tax will change the interest rate, which will affect the
budget constraint
c R=( 1+r × [1 - τ ] ) ( Y −c W )
A Model of Intertemporal Choice (iii)
2
, A Model of Intertemporal Choice (iv)
Substitution and Income effects
• Substitution effect
• Lower after-tax interest rates increase the price of second period
consumption
• Causes period one consumption to increase, reducing savings
• Income effect
• Lower after-tax interest rates reduce lifetime value of consumption
(makes the consumer poorer)
• Causes an increase in savings, reduces period one consumption
Substitution Effect
3
