Working Paper: NBER ID: w9503
Authors: Roger H. Gordon
Abstract: 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.
Keywords: No keywords provided
JEL Codes: H21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| current tax treatment of interest income (H20) | substantial tax arbitrage (H20) |
| current tax treatment of interest income (H20) | significant welfare implications (I30) |
| forecasted increase in market interest rates (E43) | redistribution from rich borrowers to poor lenders (G51) |
| current tax treatment of interest income (H20) | higher effective tax rate on bonds compared to other assets (E43) |
| higher effective tax rate on bonds compared to other assets (E43) | significant tax arbitrage (H29) |
| current tax treatment of interest income (H20) | perverse distributional effects (D39) |
| including net interest income in the tax base (H24) | rise in market interest rate (E43) |
| rise in market interest rate (E43) | net transfer from rich to poor (F24) |
| portfolio choices as a proxy for ability (G11) | better approximate ability-based taxation (H21) |