1. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 24 Copyright © 2010 Worth Publishers

2. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 2 of 24 Taxes on Risk Taking and Wealth F ERNANDO Q UIJANO AND S HELLY T EFFT P R E P A R E D B Y 23.1 Taxation and Risk Taking 23.2 Capital Gains Taxation 23.3 Transfer Taxation 23.4 Property Taxation 23.5 Conclusion

3. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 3 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H In June 2006, Warren Buffett, the world’s second-richest man, made the shocking announcement that he was giving 85% of his shares to charity rather than bequeathing it to his own children. Buffett has argued that allowing children to inherit all of their parents’ riches causes them to be spoiled and sapped of all motivation, and keeping the estate tax in force helps to preserve America’s meritocracy.

4. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 4 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H 23.1 Taxation and Risk Taking Basic Financial Investment Model expected return The return to a successful investment times the odds of success, plus the return to an unsuccessful investment times the odds of failure.

5. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 5 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Less-Than-Full Tax Offset tax loss offset The extent to which taxpayers can deduct net losses on investments from their taxable income. 23.1 Taxation and Risk Taking Real-World Complications Redistributive Taxation The idealized model of risk taking also assumes a constant rate of tax on investment income. In reality, tax systems are typically progressive, with higher marginal tax rates as income rises.

6. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 6 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H 23.1 Taxation and Risk Taking Evidence on Taxation and Risk Taking There is no clear prediction about how taxation will affect risk taking in the real world. Ultimately, what the effect of taxes is on risk taking is an empirical question. There is very little evidence about the effect of capital income taxation on risk taking. Labor Investment Applications Financial investments are not the only risky investments individuals make — they can also invest in human capital through education or other job training. Investing in human capital is risky because individuals are making an up-front sacrifice in return for some expectation of higher earnings in the future.

7. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 7 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H 23.2 Capital Gains Taxation capital gain The difference between an asset’s purchase price and its sale price.

8. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 8 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Current Tax Treatment of Capital Gains 23.2 Capital Gains Taxation taxation on accrual Taxes paid each period on the return earned by an asset in that period. taxation on realization Taxes paid on an asset’s return only when that asset is sold.

9. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 9 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Current Tax Treatment of Capital Gains 23.2 Capital Gains Taxation “Step-Up” of Basis at Death basis The purchase price of an asset, for purposes of determining capital gains. Exclusion for Capital Gains on Housing The tax code in the United States has traditionally featured an exclusion for capital gains on houses.

10. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 10 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Current Tax Treatment of Capital Gains 23.2 Capital Gains Taxation Capital Gains Tax Rates through the Years 1.From 1978 through 1986, individuals were taxed on only 40% of their capital gains on assets held for more than six months. 2.The Tax Reform Act of 1986 ended this difference and treated capital gains like other forms of income for tax purposes, with a top tax rate of 28%. 3.The Tax Reform Act of 1993 raised top tax rates on other forms of income to 39% but kept the tax rate on capital gains at 28%. 4.The Taxpayer Relief Act of 1997 reduced the top rate on long-term capital gains to 20% (though certain items, like collectibles such as art and coins, are still taxed at 28%). 5.The 2003 Jobs and Growth Act reduced the top rate further, to 15%, for gains realized after May 5, 2003 (collectibles are still taxed at 28%). Even with this long list of tax preferences for capital gains, this form of income has traditionally borne lower tax rates than other forms of income:

11. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 11 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Current Tax Treatment of Capital Gains 23.2 Capital Gains Taxation Capital Gains Tax Rates through the Years

12. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 12 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H What Are the Arguments for Tax Preferences for Capital Gains? 23.2 Capital Gains Taxation Although it may not seem fair to tax capital gains at a rate that is much lower than rates on other forms of income, three major arguments are commonly made for these lower tax rates: to protect asset owners against the effects of inflation; to improve the efficiency of capital markets; and to promote entrepreneurship. Protection against Inflation Because of inflation, current tax policy overstates the value of capital gains. For both capital gains and other forms of capital, the appropriate reaction to the inflation problem is not to lower the capital gains tax rate but to index the tax system. Improved Efficiency of Capital Transactions lock-in effect In order to minimize the present discounted value of capital gains tax payments, individuals delay selling their capital assets, locking in their assets.

13. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 13 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Encouraging Entrepreneurial Activity What Are the Arguments for Tax Preferences for Capital Gains? 23.2 Capital Gains Taxation prospective capital gains tax reduction Capital gains tax cuts that apply only to investments made from this day forward.

14. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 14 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Evidence on Taxation and Capital Gains What Are the Arguments for Tax Preferences for Capital Gains? 23.2 Capital Gains Taxation

15. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 15 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H What Are the Arguments against Tax Preferences for Capital Gains? 23.2 Capital Gains Taxation There are two arguments against the existing favoritism shown to capital gains income in most nations: 1.Capital gains taxes are very progressive. Capital gains income accrues primarily to the richest taxpayers in the United States. 2.Lower tax rates on capital gains violate the Haig-Simons principle for tax systems. The goal of taxation should be to provide a level playing field across economic choices, not to favor one choice over another, unless there is some equity or efficiency argument for doing so (such as a positive externality that justifies a tax preference).

16. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 16 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H 23.3 Transfer Taxation transfer tax A tax levied on the transfer of assets from one individual to another. gift tax A tax levied on assets that one individual gives to another in the form of a gift. estate tax A tax levied on the assets of the deceased that are bequeathed to others.

17. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 17 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H 23.3 Transfer Taxation

18. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 18 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Why Tax Wealth? Arguments for the Estate Tax 23.3 Transfer Taxation There are at least three arguments for taxing wealth:  It is an extremely progressive means of raising revenue.  It is necessary to avoid the excessive concentration of wealth and power in society in the hands of a few wealthy dynasties.  Allowing children of wealthy families to inherit all their parents ’ wealth saps them of all motivation to work hard and achieve their own success.

19. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 19 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H A “Death Tax” Is Cruel The Estate Tax Amounts to Double Taxation Arguments against the Estate Tax 23.3 Transfer Taxation There are four major arguments made against the estate tax as it is levied in the United States: It is morally inappropriate to tax individuals upon their death. You are taxed on income when you earn it and then your children are taxed on it again when you die. Administrative Difficulties To afford the tax, you may be forced to sell the asset. Compliance and Fairness Only those too unsophisticated to avoid the tax end up paying it.

20. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 20 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H 23.4 Property Taxation property tax A tax levied on the value of real estate, including the value of the land and any structures built on the land.

21. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 21 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Who Bears the Property Tax? 23.4 Property Taxation The property tax is a source of much debate at the state and local levels, with a number of states imposing limits on the ability of localities to raise their property taxes. This debate reflects the view that property taxes are costly burdens on average-income home owners. There are three schools of thought on the incidence of the property tax: 1. The “ traditional view ” is a partial equilibrium analysis of the property tax. 2. The “ capital tax ” view of property tax incidence (sometimes referred to as the “ new view ” ) recognizes the general equilibrium nature of tax incidence. 3. The “ benefits tax ” view mirrors our discussion of the Tiebout model.

22. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 22 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H Types of Property Taxation 23.4 Property Taxation Property taxes need not apply equally to all types of property. In particular, two important distinctions can be drawn in levying property taxes: Residential Homes vs. Businesses Some argue that to encourage economic development, property taxes on businesses should be lower than those imposed on residential homes. Land vs. Improvements The fundamental problem with tax systems that try to distinguish the value of land from the value of the assets on that land is that market values cannot be used for taxation.

23. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 23 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H APPLICATION  Property Tax Breaks to Businesses  23.4 Property Taxation  In recent years, a number of local governments have tried giving property tax breaks (as well as other tax breaks) to local businesses in order to convince them not to move their operations elsewhere:  Near the end of 2003, Cincinnati gave $52.2 million in tax breaks to Convergys Corporation, a customer service company, to keep the firm from moving its 1,700 jobs across the Ohio River to northern Kentucky, where tax rates were lower.  In Missouri, St. Louis County offered Packaging Concepts, Inc., $2.5 million in tax breaks so that the company, intent on leaving its site in the center of St. Louis, would settle nearby in the southern part of the county.  In February 2004, New York City granted Bank of America $42 million in tax breaks to convince the company to build its 51-story office tower in the center of Manhattan.  As recently as 2001, urban economist Ed Glaeser concluded that although location-based incentives “ seem to be a permanent part of the urban economic landscape, economists do not yet know why these incentives occur and whether they are in fact desirable. ”

24. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 24 of 24 C H A P T E R 2 3 ■ T A X E S O N R I S K T A K I N G A N D W E A L T H 23.5 Conclusion The impact of the tax code on decisions about how much to save, and in what form to save it, will always be central to debates over tax reform. Taxation doesn ’ t necessarily reduce, and under certain assumptions definitely increases, risk taking. The strongest arguments for the preferential tax treatment of capital gains are that: (a) lower capital gains tax rates will “ unlock ” productive assets, and (b) lower capital gains taxes will encourage entrepreneurship. The existing evidence on the former suggests that such unlocking is not large in the long run. The theoretical discussion suggests that the predictions for entrepreneurship are unclear. Even if lower capital gains taxation promotes risk taking and entrepreneurship, it does so at the very high cost of providing large subsidies to previous investments.