Lecture Issues in economics today - Chapter 37

In this chapter, the following content will be discussed: How unequal is income distribution in the United States? What determines how income is distributed? How does the distribution of income differ from the distribution of wealth? How is poverty defined?

Chapter 37 Taxing the Returns on Capital   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved Chapter Outline • CAPITAL INCOME AND EARNED INCOME: WHO MAKES IT? • HOW CAPITAL INCOME SHOULD BE TAXED • THE CURRENT SYSTEM • THE EFFECT OF CAPITAL TAXATION ON GROWTH McGrawưHill/Irwin â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved General Issues Taxation Which should be the most important economic issue of taxation? – the fairness of the tax, or – the impact of the tax on economic growth – that impact of the tax on economic incentives • Many economists consider the latter issue to be very important   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved Who Earns Capital Income • Capital Income – Income earned through investments • Types of Capital Income – Interest – Dividends – Capital Gains • income generated by selling an asset for more than was paid for it • The wealthy and high-income earners get a higher percentage of the income from investments than the poor and low income earners   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved P e rc e n ta g e o f In c o m e Source of Incom Earned vs Capital 100 80 60 Salary 40 Capita 20   McGraw­Hill/Irwin 10000 20000 30000 50000 100000 500000 Income Level â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved Lorenz Curve A Lorenz curve which measures the inequality of income – A graph that maps the cumulative percentage of population against the cumulative percentage of another variable, like income • A straight line indicates perfect equality • The greater the bow, the greater the inequality   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved C u m m u la t iv e P e r c e n Lorenz Curves Earned Income and Capita 100 80 60 Earned Inc 40 Capital Inc 20 0 20 40 60 80 100 Cummulative Percentage of Retur Earned income is generated in a more equal way than unearned income McGrawưHill/Irwin â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved A Gini Coefficient A measure of economic equality ranging from zero to one • It is the ratio of the area under the bow of the curve to the total area possible under a line of perfect equality • For earned income it is 49 • For capital income it is 26   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved How Capital Income Should Be Taxed • Capital income should be taxed in such a way that it does not alter the incentive to – – – – – –   McGraw­Hill/Irwin Save or invest Invest in short term assets Invest in long term assets Invest in risky assets Invest in safe assets Work   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved An Untaxed Market for Capital Interest  A rate (r)  Supply C r* B Demand I*   McGraw­Hill/Irwin •Consumer Surplus •r*AC •Producer Surplus •Br*C   Investable  Funds © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved Capital Markets When Only Capital Income Is Taxed Interest  A rate (r)  r’ Supplyafter tax E C r* r”   Such a tax discourages investment so the deadweight loss is GEC G B McGraw­Hill/Irwin Supplybefore tax Demand I’ I*   Investable  Funds © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved Capital Markets When Only Earned Income Is Taxed Interest  A rate (r)  Supplybefore tax Supplyafter tax C E r* r’ G B   McGraw­Hill/Irwin Such a tax over-encourages investment so the deadweight loss is GEC Demand   I* I’ Investable  Funds â2002TheMcGrawưHillCompanies,Inc.,AllRightsReserved The Current System People owe a tax on all gains whether or not they are real – This means that we tax as income those returns from investment that merely compensate investors for inflation – This inefficiently discourages savings • Capital gains are taxed on realization rather than accrual – This means that a tax can be delayed – This inefficiently encourages people to hold assets they would ordinarily sell • Capital gains are forgiven at death – This means that a tax can be avoided altogether – This inefficiently encourages the elderly to hold assets they would ordinarily sell • The Capital gain on a home is exempt   – This encourages inefficiently high levels of consumption/ investment in homes   McGraw­Hill/Irwin © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved The Net Result • Though capital gains income is taxed at a lower rate the overall result is that capital generated income is taxed at a level that is somewhat higher than the efficient level • Correcting this would require that some other tax be raised which is politically problematic   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved The Effect of Capital Taxation on the Economy as a Whole • If the supply curve of capital is upward sloping (and not vertical) and if the tax rate on capital is higher than is efficient, growth is inhibited • Aggregate demand is less than it would otherwise be because of reduced savings and investment   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved  ... taxed in such a way that it does not alter the incentive to – – – – – –   McGraw­Hill/Irwin Save or invest Invest in short term assets Invest in long term assets Invest in risky assets Invest in. .. Earns Capital Income • Capital Income – Income earned through investments • Types of Capital Income – Interest – Dividends – Capital Gains • income generated by selling an asset for more than was... wealthy and high-income earners get a higher percentage of the income from investments than the poor and low income earners   McGraw­Hill/Irwin   © 2002 The McGraw­Hill Companies, Inc., All Rights Reserved