+ Understand the simple theory of taxes
+ See how taxes create incentives and disincentives
+ Learn which investments are tax preferred
Lecture: Taxation of Investments.
Like death, taxes are inevitable. Everything else is optional… Taxes have two main purposes: to raise revenue to fund the taxing agency, usually the government, and to encourage, or discourage, certain behavior. Income taxes are designed to raise revenue while cigarette taxes are designed to reduce smoking (and raise revenue!)
Part I – A little theory
Check out this short video on how taxes affect markets.
Notes to accompany video:
1. Consider a simple market in equilibrium. Market for gas (for cars.)
2. Initial equilibrium price, P(0) and quantity, Q(0).
2a. Equilibrium condition: Q where Pd = Ps.
3. Tax on gas is 10% say. This is the equivalent to 30c on $3.00 per gallon.
4. Tax does NOT shift supply or demand curve (by definition price is not a shift factor.)
5. New equilibrium is Q(t) where Pd = Ps + t.
6. Equilibrium quantity falls to Q(t), while market price rises to P(t).
7. Price paid by consumers rises, price per unit received by producers falls.
8. Tax has “driven a wedge” between supply price and demand price.
9. Tax revenue is the tax rate, t multiplied by the taxable quantity traded, Q(t).
10. Consumer surplus is measure of benefit of paying one price for every unit of the commodity. Measured by the area under the demand curve above the demand price.
11. Producer surplus is measure of benefit of receiving one price for all units sold. Measured by the area below the supply price line above the supply curve.
12. Total market surplus is sum of consumer and producer surplus.
13. Tax causes consumer surplus to fall, and producer surplus to fall. Some of the reduction in surplus is “captured” by the tax revenue, but some is lost (the little triangle between demand curve, supply curve and tax quantity.)
14. Taxes cause “dead weight loss” of surplus. This is an efficiency loss. Bummer.
All taxes that cause prices to change for consumers and/or producers create inefficiency. The question for policy makers is how to raise revenue while creating the smallest efficiency loss.
Aside: A “perfect tax?”
Is it possible to raise revenue using a tax that doesn’t create an efficiency loss? Yes, and no. Theoretically yes, but practically no. Since the dead-weight loss of a tax is caused by the price changes created by the tax, a tax that does not change prices would not cause an efficiency loss. Simple: just design such a tax and use it raise revenue without any loss in consumer or producer surplus! Such as tax is called a lump-sum tax. Historically a poll tax (literally levied on the head of a person) is a lump sum tax–it affects the “price” of having a head which is practically meaningless. One way to avoid paying regular taxes, say on gasoline, is to stop buying the product on which the tax is levied. This is impossible with a head or poll tax (short of the extreme measure of removing one’s head!)
In practice head taxes (or similar lump sum taxes on gender, or age) are unpopular, and considered regressive. Regressive taxes burden the poor more than the rich. (For example, a $1000 head tax would be a bigger burden to someone earning $20,000 a year than someone earning $100,000 a year.)
Practically it’s very hard to find a commodity or a service, or an action that could be taxed that doesn’t have an explicit price, or an implicit price, or affect the price of something else. Consequently every tax will cause people to change their behavior in response to changes in the relative price of that which is being taxed. Since behavior responds to changes in relative price, one argument is to levy a tax on everything (like the New Mexico Gross Receipts Tax) but practically not everything is taxed, so some relative prices are changed by the tax. Taxes always create inefficiencies!
Part II – Incentives, avoidance and evasion
Taxes create incentives by altering the relative prices of things–commodities and activities. The reason the US has the highest rate of home ownership in the world is because mortgage interest is tax deductible. The cost of borrowing money to buy a house is lower in the US because a person can deduct the mortgage interest from their taxable income each year.
Because taxing something raises the price consumers pay for it (and the opposite of taxing is subsidizing, so for example by subsidizing higher education state governments encourage more students to attend college) consumers either pay the higher price, and the tax, or find alternatives that are taxed less, or not at all. By strategically altering what commodities are purchased, a person can avoid taxation. Avoidance is both legal, and rational. Evading taxes on the other hand is illegal (and should be avoided–unless you are a tax protester, or tax patriot as they call themselves.)
The world of personal finance and investment is full of tax incentives and disincentives. While the relevant tax code is massive (people seem to be unsure just how big the US tax code is, but it’s BIG) here are a few of the more obvious examples:
1. Capital gains are only taxed when realized. If your portfolio increases in value by $5000 this year, you do not have to pay tax on that gain until you actually sell the portfolio and realize the gain.
2. Capital gains realized within one year are taxed at the income tax rate. This applies particularly to mutual fund gains and REITs which must distribute gains as they occur.
3. Capital gains realized over a period longer than a year are taxed at the capital gains tax rate, which is generally lower than the income tax rate.
4. Losses are treated as the opposite of gains, so they can be used to reduce taxes, however there are limits on the deduction that can be taken in any year.
5. Earnings on certain government bonds, for example municipal bonds, are tax free at all levels of government (no federal or state income taxes owed.)
6. Home mortgage interest is tax deductible in the US. (Consider this: interest on credit card debt was deductible in the US until 1986. Bring back the good old days!)
7. Retirement accounts are tax-preferred. By deferring taxes on principal and earnings (traditional IRA,) or not having to pay taxes on earnings at all (Roth IRA,) the tax system attempts to encourage saving for retirement.
8. The tax code encourages saving to cover health expenses, and saving to pay for college (529 plans.)
Part III – Tax Reform
There have been many attempts at reforming the US tax code over time. One of the most important was the Tax Reform Act of 1986 (TRA 1986) under the Reagan Administration. The main goal was to simply the tax code, lower marginal tax rates and remove many deductions at the same time. In the end, it may have simplified the tax system, but like most reforms, there were two steps forward and one step back… The political call for tax reform is a constant part of election years (which happen every two years in the US) but few succeed in their original form, and what gets passed is usually pretty mild. Tax reform is more politics than economics.
Aside: A Perfect Tax System
The main problem with raising revenue through taxes, as we saw above in the video, is the dead weight, or efficiency, loss created by the tax. The value of the consumer and producer surplus lost is greater than the value of the tax revenue raised. A “perfect” tax system would raise a dollar of revenue with no efficiency loss. As the Perfect Tax aside argued, this is practically impossible. Short of a perfect tax and a perfect tax system, what are the desirable features of a tax system?
1. Taxes should be equitable. Equity is not easy to define, but there are two basic principles of tax equity:
+ Horizontal equity. This principle holds that people who are similar should be treated the same by the tax system. Usually this means that two people who earn the same income pay the same taxes.
+ Vertical equity. This principle requires that people who have more income or wealth should pay more tax.
2. Taxes should be based on an ability to pay, so that the wealthy should pay more taxes than the poor. This doesn’t mean that the wealthy should pay the same rate or proportionately more, just more in total.
3. Taxes should not be easy to avoid. This principle means that everyone should pay some amount of tax, as a “contribution” to support the government. As argued above, a broad base for taxation also helps reduce the efficiency loss
The Quiz is available on the Learn website.
1. Investopedia’s beginner’s guide to tax efficient investing:
2. How the reliance on the most wealthy paying a LOT of taxes is increasing in some countries, especially the US. So you want to belong to the 1%? Pay up…
Homework (due Friday Dec 9. Note this is early.)
Write up to a one page, typed (single spacing is fine) essay on the following topic:
Discuss how short term and long term capital gains are taxed. How are losses treated?
Within your groups, discuss one or all of the following questions:
1. President-elect Trump promised to lower taxes, and in particular the capital gains tax. Discuss the pros and cons of this promise. Can he keep this promise–that is, how can he lower taxes and spend billions on the military and much-needed infrastructure, another of his promises?
2. On the more general topic of taxes, the common view is that they are always bad. But they are used to fund the activities of the government, such as the judicial system, and for social infrastructure (dams, roads, etc.) and for national defense. How can taxes be bad, if all these things are essential, and in many ways, good?