Gruber4e ch23

Public Finance and Public Policy Jonathan
CopyrightGruber
© 2010Fourth
WorthEdition
Publishers
Copyright © 2012 Worth Publishers 1 of 25
Taxes on Risk Taking and Wealth 23
23.1 Taxation and Risk Taking
23.2 Capital Gains Taxation
23.3 Transfer Taxation
23.4 Property Taxation
23.5 Conclusion
PREPARED BY
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 2 of 25
CHAPTER 23 ■ TAXES ON RISK TAKING AND WEALTH
23
Taxes on Risk Taking and Wealth
• Warren Buffett plans to give away 85% of his wealth to

charity rather than bequeathing it to his own children.
• Buffet argues that enormous bequests spoil children.
The estate tax preserves America’s meritocracy.
• Others oppose the estate tax because it constitutes
double taxation.
• How should wealth and risk taking be taxed?
23.1
Basic Financial Investment Model
How do takes on risk-taking affect behavior?

• Taxing wins, deducting losses doesn’t affect behavior.
• But progressive taxes, or taxes without an offset for
losses, do affect behavior.
o Tax loss offset: The extent to which taxpayers can
deduct net losses on investments from their
taxable income.
• Overall, no clear prediction on how taxes affect risk
taking, and little empirical evidence.
23.1
Basic Financial Investment Model
• Consider a $100 investment opportunity that pays out

$120 half the time and $80 half the time.
• This has an expected value of zero.
o 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
23.1
Some Taxes on Risk Taking Can Be Undone
No Tax Tax Loss No Loss Progressive

Offset Offset Tax
Investment $100 100 200 200 200
Payoff if win $20 20 40 40 40
Payoff if lose −$20 −20 −40 −40 −40
Tax rate if win 0% 50% 50% 50% 75%
Loss deduction 0 50% 50% 0 50%
After tax gain $20 $10 $20 $20 $15
After-tax loss −$20 −$10 −$20 −$40 −$20
23.1
Taxation and Risk Taking: Labor Investment
Applications
• Education is a risky investment.

• Each year of schooling increases earnings by about 7%
on average, but the actual returns vary.
• Labor taxes affect the after-tax return to education.
• Progressive income taxes may discourage investment
in education.
23.2
Capital Gains Taxation
• Taxes apply to capital gains as well as earned income.

• Capital gain: The difference between an asset’s
purchase price and its sale price.
• Currently, capital gains are taxed on realization.
• Interest income is taxed at accrual.
o Taxation on accrual: Taxes paid each period on the
return earned by an asset in that period.
o Taxation on realization: Taxes paid on an asset’s
return only when that asset is sold.
23.2
Current Tax Treatment of Capital Gains
Two large preferences for capital gains:

• “Step-Up” of Basis at Death: Assets transferred at
death get a new basis, tax free.
o 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.
23.2
Capital Gains Tax Rates through the Years
Capital gains taxed at a lower rate than earned income:

• 1978−1986: Tax applied to only 40% of capital gains
on assets held for more than six months.
• 1986: Treated capital gains like all other income.
• 1993 : Raised top tax rates on other forms of income
to 39%, kept the top capital gains rate at 28%.
• 1997: Top rate on long-term capital gains fell to 20%
• 2003: Top rate fell to 15%.
23.2
Arguments for Tax Preferences for Capital Gains
• Protection against Inflation

o Because of inflation, current tax policy overstates
the value of capital gains.
o But better to index for inflation.
• Improved Efficiency of Capital Transactions
o To reduce PDV of capital gains tax, individuals
delay sale of assets.
o But this reduces the fluidity of the capital market,
and may hurt its performance.
23.2
Arguments for Tax Preferences for Capital Gains
• Encouraging Entrepreneurial Activity

o Entrepreneurs earn income by increasing the value
of their companies, which is a capital gain.
o Capital gains tax rates are a crude instrument for
encouraging entrepreneurship. Instead, use a
prospective capital gains tax reduction.
o Prospective capital gains tax reduction: Capital
gains tax cuts that apply only to investments made
from this day forward.
23.2
Evidence on Taxation and Capital Gains
How does the capital gains tax rate affect capital gains?
• Key question in determining how capital gains should
be taxed.
• In 1986, a capital gains tax increase was announced, to
go into effect in 1987.
• Capital gains spiked in 1986…
• …But didn’t fall below their 1985 levels in 1987.
• The tax hike had no long-run effect on capital gains.
23.2
Evidence on Taxation and Capital Gains
23.2
What Are the Arguments against Tax Preferences for
Capital Gains?
1. Capital gains taxes are very progressive.

o 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.
o 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.
23.2
APPLICATION: Capital Gains Taxation of “Carried
Interest”
• Republican presidential candidate Mitt Romney paid

an average tax rate of 14% on $42 million of income in
2010 and 2011.
• His income was taxed as “carried interest” earned on
the assets he managed at Bain Capital.
• Preferential treatment of “carried interest” intended
to compensate for high risk that asset managers face.
• But it is a violation of the Haig-Simons principle, and
many economists oppose it.
23.3
Transfer Taxation
• Transfer taxes are an important capital tax in the

United States.
o Transfer tax: A tax levied on the transfer of assets
from one individual to another.
o Gift tax: A tax levied on assets that one individual
gives to another in the form of a gift.
o Estate tax: A tax levied on the assets of the
deceased that are bequeathed to others.
23.3
Transfer and Wealth Taxes (% of Government
Revenue)
Transfer Wealth Transfer and

Taxes Taxes Wealth Taxes
Australia 0% 0% 0%
United Kingdom 0.62 0 0.62
United States 0.89 0 0.89
Spain 0.63 0.44 1.07
France 1.07 0.34 1.41
Switzerland 0.73 4.6 5.33
OECD Average 0.47 0.49 0.96
23.3
Why Tax Wealth? Arguments for the Estate Tax
Why tax wealth rather than income?

• Extremely progressive means of raising revenue.
• Necessary to avoid the excessive concentration of
wealth and power in 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.
23.3
Arguments against the Estate Tax
Why not tax wealth?

• A “Death Tax” Is Cruel: It is morally inappropriate to
tax individuals upon their death.
• The Estate Tax Amounts to Double Taxation: 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.
23.4
Property Taxation
• Property taxation is the major source of revenue for

local governments.
o Property tax: A tax levied on the value of real
estate, including the value of the land and any
structures built on the land.
• Tax burden based on the assessed property value, but
homeowners only pay taxes on the assessed ratio.
• Assessment ratios vary widely across the United States,
from 4% in Columbia, South Carolina, to 100% in
Providence, Rhode Island.
23.4
Who Bears the Property Tax?
Three views on the incidence of the property tax:

1. Traditional (partial equilibrium): Property tax falls on
landowners and on structures’ owners and users,
according to elasticities.
2. “Capital tax” (general equilibrium): Tax reduces return
to capital, drives capital out of localities. Falls on
capital owners.
3. “Benefits tax:” Property tax finances local
government spending, benefitting local homeowners.
In Tiebout equilibrium, no burden of taxation.
23.4
Types of Property Taxation
Two important distinctions in levying property taxes:

1. Residential Homes versus Businesses
o Some argue that to encourage economic
development, business property taxes should be
lower than residential.
2. Land versus Improvements
o Land is inelastic supply, so it should be taxed.
o Hard to separate land value from structure value,
so structures and land are both taxed in practice.
23.4
APPLICATION: Property Tax Breaks to Businesses
• Property tax breaks for businesses are ubiquitous.

o Cincinnati gave $52.2 million to a company to keep
its 1,700 jobs from moving to low-tax Kentucky.
o St. Louis County, Missouri, offered a company $2.5
million in tax breaks to settle in the county.
o New York City granted Bank of America $42 million
to build its 51-story office tower in Manhattan.
• Wages and property values rise faster in cities that
successfully attract industrial plants, suggesting these
property tax breaks may be valuable.
23.5
Conclusion
• Treatment of Savings is a central part of the tax code.

• Taxation can increase or decrease risk taking.
• Cutting capital gains taxes wouldn’t reduce lock-in, and
it is unclear if it would encourage entrepreneurship.
• Capital gains tax cuts provide large subsidies to
previous investments.
• The estate tax is a very progressive source of revenue,
but it raises horizontal equity concerns.
• Local governments rely on property taxes, which have
an uncertain incidence.

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Public Finance and Public Policy Jonathan

• Warren Buffett plans to give away 85% of his wealth to

How do takes on risk-taking affect behavior?

• Consider a $100 investment opportunity that pays out

No Tax Tax Loss No Loss Progressive

• Education is a risky investment.

• Taxes apply to capital gains as well as earned income.

Two large preferences for capital gains:

Capital gains taxed at a lower rate than earned income:

• Protection against Inflation

• Encouraging Entrepreneurial Activity

1. Capital gains taxes are very progressive.

• Republican presidential candidate Mitt Romney paid

• Transfer taxes are an important capital tax in the

Transfer Wealth Transfer and

Why tax wealth rather than income?

Why not tax wealth?

• Property taxation is the major source of revenue for

Three views on the incidence of the property tax:

Two important distinctions in levying property taxes:

• Property tax breaks for businesses are ubiquitous.

• Treatment of Savings is a central part of the tax code.

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