Consumption and Income Taxes MPA 622: Government Finance

Principles of Sound Tax Policy Adequacy Neutrality Fair or equitable Horizontal Vertical Ease of Administration and Compliance Accountability Administration and enforcement should be efficient and fair Government must enforce the laws Open, transparent tax policy

Haig-Simons Definition of Income Annual changes in the ability to consume Present consumption Future consumption

Income Tax and Savings Savings rate in the United States Income Effect Substitution Effect Increase in income tax rates Decrease in income tax rates Effect on savings

Two Period Consumption and Saving Two period model Consume now Save and consume later Choice Normal goods Increase in income means you will increase present and future consumption Decrease in income means you will decrease present and future consumption Income Effect Increase in the price of a good causes us to decrease consumption of that good and increase the consumption of the alternative Decrease in the price of a good causes us to increase consumption of that good and decrease the consumption of the alternative Substitution Effect

Interest Rate Example Budget: $1,000 Interest Rate: 10% $500 Now $550 Future Consumption Possibilities I $400 Now $660 Future Consumption Possibilities II $600 Now $440 Future Consumption Possibilities III

Effect of Increase in Interest Rates $500 Present Consumption $550 Future Consumption 20% Interest Rate $600 Future Consumption $510 Present Consumption $588 Future Consumption

Effect of Increase in Interest Rates More future income because of higher interest rates Substitution effect: save more (decrease current consumption) because the opportunity cost of current consumption has increased Income effect: save less (increase current consumption) still have enough income for more future consumption

Effect of Decrease in Interest Rates $500 Present Consumption $550 Future Consumption 5% Interest Rate $525 Future Consumption $480 Present Consumption $546 Future Consumption

Effect of Decrease in Interest Rates Less future income because of lower interest rates Substitution effect: save less (increase current consumption) because the opportunity cost of current consumption has decreased Income effect: save more (decrease current consumption) in order to make up for the decrease in future consumption

After Tax Interest Rate

Effect of Decrease in Income Tax Rate or Increase in After Tax Interest Rates More future income because of higher after tax interest rates Substitution effect: save more (decrease current consumption) because the opportunity cost of current consumption has increased Income effect: save less (increase current consumption) still have enough income for more future consumption

Effect of Incease in Income Tax Rate or Decrease in After Tax Interest Rates Less future income because of lower after tax interest rates Substitution effect: save less (increase current consumption) because the opportunity cost of current consumption has decreased Income effect: save more (decrease current consumption) in order to make up for the decrease in future consumption

Hall-Rabushka Flat Tax Single tax rate on labor income 01 Subtraction method VAT tax 02 Exempts all capital income 03 Fairness? 04 Middle class impact 05 Hall-Rabushka Flat Tax

David Bradford’s X-Tax Hall-Rabuska Proposal Graduated Rates David Bradford’s X-Tax

Savings is complete exempted from taxation Consumed Income Tax Savings is complete exempted from taxation We either consume or save our income

Savings Plans 401k savings plans Automatic enrollment Traditional IRA’s Roth IRA’s Relationship to consumed income tax

Effectiveness in Encouraging Savings Empirical evidence suggests that people aren’t sensitive to rate of saving Current consumption and future consumption Income Effect Substitution Effect