Econ 208 Marek Kapicka Lecture 14 Capital Taxation Financial Intermediation

Next Week No class next Monday (Memorial day) No class next Wednesday as well PS5 will be posted on Wednesday

Ramsey Taxation Implications for Government Debt Example: Hence W = G = 1 The optimal tax rate

Ramsey Taxation Implications for Government Debt Tax collection each period: r / (1+r) Core Deficit Government Debt:

Ramsey Taxation WWII vs. Korean War WWII financed differently than Korean War Marginal Taxes % OF EXPENDITURES FINANCED BY Direct TaxesDebt and seignorage World War II41%59% Korean War100%0% % TAX RATES BEFORE/DURING THE WAR LaborCapital World War II9/1844/60 Korean War16/2052/63

Ramsey Taxation WWII vs. Korean War What if WWII were financed like Korean War (taxes only)? Labor taxes would be 64% rather than 18% Capital taxes would be 100% rather than 60% Welfare costs are 3% of consumption

Ramsey Taxation WWII vs. Korean War What if Korean War was financed like WWII (both taxes and debt)? Labor taxes would be 23% rather than 20% Capital taxes would be 50% rather than 62% Welfare gains are 0.4% of consumption Source: Lee Ohanian, “The Macroeconomic Effects of War Finance in the United States: World War II and the Korean War”, American Economic Review, vol. 87, (1), 1997, pp

Where are we? Introduction: A model with no Government The Effects of Government Spending Government Taxation and Government Debt Labor Taxation Taxation and Redistribution Government Debt Capital Taxation Financial Intermediation

Capital Taxation What does it mean to tax capital? Tax on the stock of capital (wealth tax, property taxes) Tax on the income from savings (tax on interest or dividends, tax on capital gains)

Capital Taxation The effect of capital taxation: It taxes future consumption more heavily than current consumption Example: You have income $2 An apple costs $1 The interest rate between today and tomorrow is 100%

Capital Taxation

Why is it bad to tax interest? Uniform Commodity Taxation: taxes should be spread evenly across goods Tax on capital violates this principle.

Capital Taxation What could be the reasons for capital taxation? 1. Capital returns are risky. Taxing capital provides social insurance. 2. (tax on dividends/profits): If investment is financed by retained earnings then (under certain conditions) a tax on profits/dividends have no effect on investment levels

Where are we? Introduction: A model with no Government The Effects of Government Spending Government Taxation and Government Debt Labor Taxation Taxation and Redistribution Government Debt Capital Taxation Financial Intermediation

Financial crises Economic crisis in : The largest recession since the Great Depression Associated with banking crisis The first banking crisis in the US since the Great Depression However, banking crises are recurrent Before 1913 In other countries Banking crises are nothing new!

Recent Crises Scandinavian Crisis Increase in asset and housing prices before the crisis : increase in oil prices and collapse of trade with Soviet Union triggered a crisis Sweden: took over major banks, recapitalized them and sold them later Japan 1990’s The Argentina Crisis The Russian Crisis, 1998

A. History of banking crises: U.S : Crises were a frequent phenomenon in the U.S. They have occurred at about 10 year intervals

A Banking Panic

Bank Runs

U.S. National Banking Era Panics

Why Financial Crises? Key insight: Banks are here to transform illiquid assets to liquid liabilities Depositors prefer to withdraw deposits easily (preference for liquidity) Borrowers need time to repay the loans Tension between both sides of the balance sheet: If everyone wants to withdraw deposits, there is not enough resources

A Liquidity Problem How to choose between liquid and illiquid assets? Liquid assets: can be converted into immediate consumption without any costs Illiquid assets: it is costly to convert them into immediate consumption People have preference for liquidity: they are unsure when they need to consume

A Liquidity Problem 1. Autarchic Solution 2. Market Solution 3. Efficient Solution 4. Banking Solution

A Liquidity Problem Timing

A Liquidity Problem Preferences

An Example of Early Consumers

A Liquidity Problem Preferences

1. Autarchic Solution

1. Autarchic Solution The Budget Constraint

1. Autarchic Solution