Interest Income Tax Research Articles

Optimal Income Taxation with a Risky Asset - the Triple Income Tax

We show in a two-period world with endogenous savings and two assets, one of them exhibiting a stochastic return that an interest adjusted income tax is optimal. This tax leaves a safe component of interest income tax free and taxes the excess return with a special tax rate. There is no trade-off between risk allocation and efficiency in intertemporal consumption. Both goals are reached. As the resulting tax system divides income into three parts, the tax can also be called a Triple Income Tax. This distinction and a special tax rate on the excess return is necessary in order to have an optimal risk shifting effect.

Evaluation of interest tax policies in a model of finance and growth

We develop an overlapping generations model with an active financial sector to differentiate loan from deposit rates and to allow for endogenous credit rationing. We evaluate the macroeconomic consequences of two interest tax policies, an increase in interest tax exemption and a reduction in the interest income tax rate, with and without credit market imperfections. While these policies have different effects in unconstrained equilibrium, they are identical in credit-constrained equilibrium. While these policies may encourage growth with credit rationing when the speed of human capital accumulation is sensitive to education, no such conclusion can be reached in unconstrained equilibrium.

Simple Criteria for Growth-Enhancing Social Security Systems

It has been believed that a social security system (SSS) is harmful to economic growth. However, it has been recognized recently that a SSS can encourage economic growth if the engine of the growth is human-capital accumulation. This paper uses an analytical model a la Uzawa/Lucas to examine the growth effect of SSS, focusing on the financing method. We have four analytical results. First, the SSS with wage income tax is more (less) likely to encourage economic growth than the SSS with interest income tax if the income share of physical capital is relatively small (large). Second, at least one of the two SSSs is growth-enhancing. Third, the SSS with comprehensive income tax is more likely to encourage economic growth than the SSS with wage income tax. Fourth, the growth effect of a SSS is enhanced if the social security benefit is based on the household account. The results imply that an appropriate reform in the financing of SSS would be useful for encouraging economic growth.

Taxation and growth with overlapping generations

This paper examines the growth effects of wage and interest income taxation in an endogenous growth model, which is characterized by diminishing point-in-time returns in human-capital producing technology and overlapping generations of two-period-lived individuals. We show that the greater the long-term learning time of individuals the more individuals inherit human capital from the previous generation. We demonstrate that a flat-rate wage tax stimulates economic growth, while interest income taxation does not necessarily foster such growth. Intergenerational redistribution induces individuals to change both physical and human capital accumulation, affecting the growth rate through changes in factor prices.

Taxation of Interest Income

Why is interest income taxed more heavily than other forms of capital income? This differential tax treatment has generated substantial tax arbitrage, resulting in lower tax revenue, efficiency costs, and apparently net gains to rich borrowers and net losses to poor lenders, together suggesting that this tax treatment makes no sense on welfare grounds. In examining this argument more formally, this paper reveals two omitted considerations that can help explain the existing tax treatment. First, the forecasted increase in the market interest rate results in a redistribution from rich borrowers to poor lenders. Yet this redistribution comes at no marginal efficiency cost, starting from a situation with no distortions to portfolio choice, so at the margin dominates further redistribution through the income tax. In addition, information about an individual's portfolio choice reveals information about her earnings ability, even controlling for observed labor income, if those who are more able tend to be less risk averse. By making use of this extra information about earnings ability, the tax system can be better tailored to redistribute from able to less able, for any given efficiency cost.

Tax Competition and Profit Shifting: On the Relationship between Personal and Corporate Tax Rates

The residence-based taxation of interest income in the EU faces the difficulty that taxpayers may evade taxation by holding bank accounts in other countries. The EU therefore makes considerable efforts to achieve cooperation among EU member states in order to improve tax enforcement. The present paper argues that international cooperation in tax enforcement may not be sufficient to implement an effective taxation of interest income. The reason is that taxpayers may also avoid income taxes by holding financial assets in the corporate sector. If corporate tax competition reduces corporate income tax rates below personal income tax rates, taxpayers will increasingly shift income from the personal to the corporate sphere. We show that this type of income shifting is empirically important. According to our results, a one percentage point increase in the personal income tax rate increases the fraction of private savings held within corporations by approximately 2.6 percentage points.

Classical Corporation Tax as a Global Means of Tax Harmonization

Classical corporation tax entails double taxation of corporate income. The alternative practice of imputing corporation tax to the domestic recipients of dividends is shown, in the case of a company with international owners, to effectively convert the imputation system back to a classical corporation tax. It also requires complex rules for exempting flow-through dividends from equalization tax to avoid the cumulation of corporation tax internationally. In contrast, classical corporation tax maintains its simplicity and can be designed so as to be neutral in respect of the financing and dividend decisions of multinationals, by adopting double taxation of interest income. Broad tax bases, flat-rate taxes on personal income from capital, and low statutory tax rates are advocated as general policy.

The Finnish Corporate Income Tax Reform and the Financial Strategy of Firms: A General Equilibrium Approach

This paper simulates the effects of the recent Finnish corporate tax reform with a computable general equilibrium model. It shows that the impact of the reform on the capital stock depends on the reactions of firms. If the financial strategy is changed to prefer dividend distribution and share issues, the cost of capital falls and the capital stock increases. On the other hand, if the criterion of financial policy is to minimise the welfare loss of current shareholders, the earlier financial behaviour should be continued. In that case,the induced higher cost of capital leads to a lower capital stock. The overall welfare evaluation of the tax reform is not sensitive to the regime shift: the reform should not have been implemented. This is because the increase in interest income taxation distorts saving decisions, expands the net foreign debt of the economy and weakens the terms of trade.

Long-Run Implications of Social Security Taxation for Growth and Fertility

This paper compares long-run implications for growth and fertility of four types of taxation for social security with positive bequests. A tax rise under lump-sum taxation enhances growth but lowers fertility, while other types of taxation do so under additional restrictions. A tax rise under consumption taxation is less likely to stimulate growth and to reduce fertility than under payroll taxation. Arise in an interest income tax raises fertility, reduces both savings and human capital investment, and hence is harmful for growth. The case with zero bequests is also discussed.

Long‐Run Implications of Social Security Taxation for Growth and Fertility

This paper compares long‐run implications for growth and fertility of four types of taxation for social security with positive bequests. A tax rise under lump‐sum taxation enhances growth but lowers fertility, while other types of taxation do so under additional restrictions. A tax rise under consumption taxation is less likely to stimulate growth and to reduce fertility than under payroll taxation. A rise in an interest income tax raises fertility, reduces both savings and human capital investment, and hence is harmful for growth. The case with zero bequests is also discussed.

Taxation in an Overlapping Generations Model with Human Capital

We examine the impact of flat-rate taxes on intergenerational equity in an overlapping generations model of a small open economy, assuming the intergenerational externality of human capital accumulation. The externality may cause the difference between the growth rates in private human capital and in average human capital of the economy. If the externality is sufficiently small, the introduction of an interest income tax will benefit all future generations. In contrast, if it is sufficiently great, the introduction of a wage tax could harm all generations by raising financial asset holdings and thereby reducing consumption.

Redistribution with Unobservable Bequests: A Case for Taxing Capital Income

This paper addresses the question of the optimal taxation of labour and interest income in an overlapping generations model with two unobservable characteristics, ability and inheritance. We assume realistically that saving can only be taxed anonymously, whereas the tax on labour earnings can be individualized and made non‐linear. In such a setting, we show that a withholding tax on interest income along with a non‐linear tax on labour income is desirable. The role of interest income taxation is to indirectly tax inherited wealth.JEL Classification D63, H2

Taxation and Monetary Aggregation

This study examines the correspondence of the Divisia and Currency Equivalent (CE) measures of money to the optimal aggregate under contemporaneous taxation of interest income. We show that although this behavior can violate a condition regarding monetary aggregation under uncertainty and risk aversion, several important results continue to hold. The conventional Divisia index exactly tracks the theoretically determined aggregate. With strong separability of currency in the aggregator function, the Currency Equivalent measure emerges from this framework. Even under contemporaneous taxation of interest income, the theoretically correct Divisia and CE measures are based upon pre-tax interest rates.

Prospects for Co‐ordination of Corporate Taxation and the Taxation of Interest Income in the EU

AbstractThis paper evaluates the recent proposals for a co‐ordinated capital tax policy in the European Union, focusing on an EU‐wide minimum withholding tax on interest income and alternative ways to increase the effective tax rate on corporate profits. The analysis draws on current theoretical and empirical research and views the recent capital tax reforms undertaken by individual member countries as rational adjustments to changing conditions in capital markets. Special emphasis is placed on the constraints for EU tax policy imposed by the possibility of shifting capital income to third countries. The paper concludes that some aggregate efficiency gains can be expected from the EU co‐ordination proposals, but additional tax collections will be limited largely to the group of small savers while highly mobile large‐scale investors are likely to avoid the EU tax.

Prospects for Co‐ordination of Corporate taxation and the Taxation of Interest Income in the EU: A Comment

After a break of a few years, the European Union has recently again become active in the area of co-ordinating capital income taxes between Member States. In December 1997, the Council of Finance Ministers agreed to establish a highlevel Working Party to implement a Code of Conduct on business taxation. In March 1998, the Commission proposed a revised draft of the 1990 Directive to liminate withholding taxes on interest and royalty payments between associated companies within the EU. In May 1998, the Commission proposed a Directive designed to ensure minimum effective taxation of savings income within the EU, by ensuring that all Member States either apply a withholding tax of at least 20 per cent on cross-border interest payments to EU-resident individuals or provide information on interest income to other Member States.

Tax Evasion and the Time Consistency of the Government's Income Tax Policy

It is shown that it is not necessarily optimal for the government to tax capital income at a high rate even when capital is in fixed supply because the supply of capital for tax purposes may be elastic if capital income tax evasion occurs. An example is given where the wage tax rate is positive and greater than the interest income tax rate even though capital is in fixed supply. Conditions are also derived under which the capital income tax rate is lower in the closed-loop policy game, where capital is fixed, than in the open-loop game, where it is not. JEL Classification Numbers: E61, H26.

Tax Evasion, Tax Competition and the Gains From Nondiscrimination: the Case of Interest Taxation in Europe

This paper uses a game-tlieoredc approach to analyse the taxadon of interest income in Europe in the presence of tax evasion. The model allows tis to assess the success of various reform proposals. We argue tbat the tax treatment of nonresidents' interest income plays a crucial role. When decisions on discriminatio n and on withholding tax rates are made noncooperadvely, the outcome is similar to a prisoners' dilemma. All countries discriminate, but in equilihrium internationally mobile portfolio capital evades taxation successfully. In contrast, if all governments did not discriminate, tax competition leads to less tax evasion. The integration of capital markets in Europe has hrought various benefits. At the same time, however, governments struggle to contain tax evasion. International capital flight as an attempt to evade taxes is particularly relevant in the area of taxation of interest income. Banking secrecy laws in some EU countries and low tax rates in small countries like Luxembourg, which hoost its role as financial centre, have led to the effective elimination ofthe taxation of interest income for some investors. The Economist speaks, not surprisingly, about 'The Disappearing Taxpayer' (May 31, 1997). Several proposals have been made in order to overcome this situation.' The European Commission supports the introduction of a minimum tax rate and/ or the status of a community resident. Under the concept of a community resident a country's tax on interest income is independent of the residence of the investor (practically realising the source principle). By contrast, a proposal of the OECD (1977) argues in favour of a maximum withholding tax rate on interest income. None of these proposals has been unanimously accepted since gains and losses from non-coordinated policies differ greatly across member states. The main beneficiary of the present situation is Luxembourg which attracts large amounts of foreign capital, in particular from Germany. The United Kingdom opposes any coordination for political reasons and because tax coordination may also threaten London's role as the leading financial centre in Europe. In contrast, Germany sticks to its traditional bank secrecy law which enables resident investors to evade German taxation by investing abroad.

Transition to an Aging Japan: Public Pension, Savings, and Capital Taxation

This paper examines the effects of public pension policies on savings and economic welfare in the transition to an aging Japan by applying a simulated method in the expanded life cycle growth model. It also places a special emphasis on the fact that interest income taxation produces a higher level of utility of younger generations (born after the beginning of the 1970s) than does consumption taxation, both of which are taxation schemes financing the public pension scheme in Japan.J. Japan. Int. Econ., Sept. 1998,12(3), pp. 204–231. Faculty of Economics, Shiga University, 1-1-1 Banba, Hikone, Shiga 522, Japan, and Department of Economics, University of Essex, Wivenhoe Park, Colchester, Essex, CO4 3SQ, United Kingdom.Copyright 1998 Academic Press.Journal of Economic LiteratureClassification Numbers E21, H55.

Would a Consumption Tax Reduce Interest Rates?

Although there is substantial professional and public interest in the recent proposals to replace the existing personal and corporate income taxes with a consumption tax, there has been little attention to the effect of such a tax change on pre-tax interest rates and other pre-tax factor incomes. Despite the general absence of formal analyses, some economists have concluded that shifting to a consumption-type tax would lead, because such a tax would exempt interest income and encourage additional saving, to lower pre-tax interest rates. The most widely cited such statement is by Hall and Rabushka (1995), who say that long-term interest rates would decline by 20 percent if the existing U.S. tax system were replaced by a consumption tax of the type that they advocate. Hall (1996) presents the only formal analytic model of the effect on the interest rate of shifting to a consumption tax. His analysis deals with an economy of infinite-lived individuals in which the net-of-tax interest rate would be a constant determined by the time preference parameter of the representative individual. Eliminating the interest income tax in such an economy would therefore reduce the pre-tax interest rate to the equilibrium net interest rate. In this paper, I explain why the opposite may well be true: substituting a consumption tax for the existing personal and corporate income taxes may raise pre-tax interest taxes. The analysis indicates that whether the pre-tax rate of interest rises or falls depends on the strength of the personal saving response and the nature of the capital-market relation between debt and equity yields. With plausible parameter values, the analysis suggests that the shift from an income tax to a consumption tax is more likely to raise interest rates than to lower them. An important common feature of all the current consumption-tax proposals is to eliminate the tax on corporate profits. Corporations would, under some proposals, continue to make tax payments, but the tax collected from the corporations would become either a tax on the firm's non-cash labor compensation or a consumption-type value-added tax. The failure to take the elimination of the corporate tax into account has led much of the discussion of consumption taxes to wrong conclusions about the impact on interest rates of shifting to a consumption tax. Although there appear to be several different types of consumption taxes--consumed income taxes that permit a deduction for all net saving but continue to tax investment income, taxes that exclude investment income but do not allow a deduction for saving, value-added taxes, and national retail sales taxes--all of these different variants are in fact equivalent in the sense that after the transition they all define the same consumption opportunities for individuals who have the same wage income (i.e., they imply the same lifetime budget constraints). This equivalence is demonstrated explicitly in Appendix A to this paper. The paper itself uses the term consumption tax to refer to a tax that excludes all investment income at the corporate and personal level, but exactly the same conclusions would follow for a consumed-income tax, a national retail sales tax, or a value-added tax. The paper begins in section 1 by discussing the effect that shifting from the existing income-tax system to a consumption tax would have on the rate of interest if individual saving remained unchanged. Section 2 then extends the analysis to an economy in which the saving rate responds to changes in the net of tax rate of interest. The analysis of these two sections emphasizes that the shift to a consumption tax would eliminate the corporate tax on investment income as well as the personal tax on interest and dividends. Eliminating the corporate tax raises the capital income available at the company level to pay interest and dividends. Section 3 examines the sensitivity of the results to the assumed relation between debt and equity yields. Section 4 introduces the role of inflation. The fifth section then brings together these separate analyses to discuss the effects of changing the tax structure in a growing economy with inflation and with interest-sensitive saving behavior. There is a brief concluding section that comments on the generalization of this analysis to recognize international capital flows and different types of domestic borrowers and lenders.

OPTIMAL INCOME TAXATION, DYNAMIC EFFICIENCY, AND THE SOCIAL COST OF PUBLIC EXPENDITURE

An interest income tax and a publicly provided private good are introduced into the Hamada overlapping-generations model consisting of heterogeneous individuals where the government can use a wage-income tax, an identical lump-sum transfer, and the public debt. Two interesting problems are studied: (a) what relation exists between the optimal interest rate and the population-growth rate and (b) how dynamic efficiency affects the optimal-decision rules of taxes and the publicly provided good. We show that (i) if the government can (not) tax the interest income, then the optimal interest rate is (not) equal to the population-growth rate, (ii) without the availability of the interest tax the difference between these two rates is mainly caused by the income-distribution effect of the public debt and (iii) the dynamic efficiency effects on the optimal rules of the wage tax and the publicly provided good depend on not only such a difference but also the average substitute-complement relations among leisure, the second-period consumption and the publicly provided good.