Public Economics Dr.

Sauer

Chapter 21 22 23: Taxes on Labor Supply, Savings, Risk Taking and Wealth I. Labor Supply & Taxes
Consumption

Suppose a wage rate of $12.50 and a maximum number of hours of 2000. Slope of BC =

Suppose individual choose 900 hours of leisure. Suppose a tax of 30% is imposed. After-tax wage:

Slope of new BC =
Leisure Hours

For the same amount of work (1100 hours), the individual only receives income of

Will the individual work more or less? Depends on which effect is stronger: substitution effect - because price of leisure has fallen, expect individual to work ________ and have ______leisure income effect - because individual is now poorer, expect them to work ______ and have ______ leisure ____________________________________________________________________________________ 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. 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) This is a _____________________________ tax credit.

$40,295 (more)

For a single earner with 2 children (2010):

EITC

Up to earned income of $12,549, EITC is $0.40 per dollar earned. Max credit is $5,036 Plateau to $16,449 Phase-out: $5,036 (0.21 )( Income $16,450) None at $40,363

Earned Income

________________________________________________________________________________ EITC and Labor Supply

Consumption

For people not in the labor force (all leisure, no work), this policy will likely _____________ labor supply.

For people in the labor force, earning less than $12,549: SE: each hour of work brings a higher wage than before so work ________________
40,363 16,449 12,549

IE: workers are wealthier as a result of the subsidy so work _______________ ___________________________ for labor supply

Leisure Hours

For people in the plateau region: EITC does not change in this range so wage is constant - no substitution effect (BC has same slope) EITC makes them wealthier - income effect says theyll work _______________ (higher BC) _______________________ in labor supply 2

For people that earn between $16,500 and $40,363: SE: new BC is flatter price of leisure fell work ______________ IE: new BC is higher wealthier work _______________ _________________________ in labor supply

___________________________________________________________________________________ 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 r interest period 2: retirement life, earn 0 consumes CR CR = Sw (1 + r)

Jack has a tradeoff between consumption in period 1 and 2.

Consumption in Period 2

Maximum consumption in period 1:

Maximum consumption in period 2: - if all income from period 1 were saved, there would be Y (1 + r) for period 2

The slope of the budget constraint is equal to:

Suppose Jacks preferences are such that he values consumption in the present.

Consumption in Period 1

Suppose the government taxes interest income. The maximum consumption in period 2 is now: slope of BC is now: 3

Two effects: SE: BC is flatter price of period 1 consumption falls consume more in 1, save ______ IE: BC is lower, have to save _______ to have money in period 2 _________________________ effect

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

Consumption in Period 2 Y(1+r)

The slope of the budget constraint is now: SE: BC is now steeper (than BC2) so the price of period 1 consumption rises save ______________ IE: BC is now higher (than BC2) so feel wealthier save ________________ for period 2

Y(1+(r)(1- ))

_____________________ result

IC BC BC2 Consumption in Period 1

Many retirement savings plans have a limit on annual tax-free contributions. IRA $5000
Consumption in Period 2

For the first $5000 of savings, the preferential tax treatment applies.

For an individual who already saved a lot: SE: BC slope is same ____________
Y(1+(r)(1- ))

IE: BC is higher feels wealthier saves ____________ for period 2 Saves __________________

BC Y Consumption in Period 1

For an individual who saved less than $5000: SE: BC slope is steeper increased price of period 1 consumption save ____________ IE: BC is higher feels wealthier saves ______________ for period 2

______________________ result ____________________________________________________________________________________ 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 Government taxes any positive return allows deduction against taxable income for full amount of a negative return The model finds that taxing the returns from the risky asset would increase risk taking because any tax on the returns could be undone by ________________________________. 5

In reality, there are two complications: 1. Less-than-full Tax Offset In the US, individuals are allowed to deduct $3000 of investment losses in any tax year. - cant just undertake a losing investment to wipe out some of your tax burden 2. Redistributive Taxation The US tax system is progressive big winnings can move you into a higher tax bracket pay more taxes.

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 ________________. Assets that appreciate in value are taxed on __________________. - taxed when asset is sold - taxed on selling value minus basis (basis = purchase price of asset)

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) = 110 End 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) = 161.051 End of Year 6: 161.051(1.1) = 177.1561 End of Year 7: 177.1561(1.1)= 194.87171 You must pay taxes on: If the capital gains tax rate is 20%: net return:

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 taxes after taxes = $108 End of year 2: 108(1.1) = $118.8 118.8 108 = $10.80 earned interest 10.80(0.20) = $2.16 owed in taxes after taxes = $116.64 6

End of year 7: 158.69(1.1) = $174.56 174.56-159.69= $14.87 earned interest 14.87(0.20) = $2.97 owed in taxes after taxes = $171.59

net return:

Savings in the form of capital gains-producing assets receive a tax preference.

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 taxes on 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.

There is a capital gains exemption of $500,000 for sale of a primary residence.