Raise Taxes on Savings? Tell Joe It Ain't So!

http://online.wsj.com/article/SB113400654429916967.html?mod=opinion_main_commentaries

Thanks to the tax legislation enacted in 2003, dividends and capital gains are now taxed at a maximum rate of 15%. The President's Advisory Panel on Tax Reform recently proposed that the 15% rate be made permanent and extended to interest income as well. If Congress does not act, the 2003 rule will expire and the rate will rise to 35% in 2008 and even higher in 2010.

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An example will illustrate the harmful effect of high taxes on the income from savings and show how the tax reform could make taxpayers unambiguously better off. Think about someone -- call him Joe -- who earns an additional $1,000. If Joe's marginal tax rate is 35%, he gets to keep $650. Joe saves $100 of this for his retirement and spends the rest. If Joe invests these savings in corporate bonds, he receives a return of 6% before tax and 3.9% after tax. With inflation of 2%, the 3.9% after-tax return is reduced to a real after-tax return of only 1.9%. If Joe is now 40 years old, this 1.9% real rate of return implies that the $100 of savings will be worth $193 in today's prices when Joe is 75. So Joe's reward for the extra work is $550 of extra consumption now and $193 of extra consumption at age 75.

But if the tax rate on the income from saving is reduced to 15% as the tax panel recommends, the 6% interest rate would yield 5.1% after tax and 3.1% after both tax and inflation. And with a 3.1% real return, Joe's $100 of extra saving would grow to $291 in today's prices instead of just $193.

There are two lessons in this example, each of which identifies a tax distortion that wastes potential output and therefore unnecessarily lowers levels of real well-being. The first is that a tax on interest income is effectively also a tax on the reward for extra work, cutting the additional consumption at age 75 from $291 to just $193. Because the high tax rate on interest income reduces the reward for work (as well as the reward for saving), Joe makes choices that lower his pretax earnings -- fewer hours of work, less work effort, less investment in skills, etc.

except for the fact that most individuals would try and invest the money in a 401(k) or other tax deferred account; resulting in a pretax gain of 6% and an after tax gain of 6%+ (the plus being a possible reduction in the marginal tax rate). Any withdrawls from the account would be made during retirement when their income would be about 75% or less of what it currently is.

Corp bonds HAVE to have a higher interest rate over tax-free (local mainly) bonds because of taxes. If you lower the tax rate on Corp bonds, you would force local govt to raise the interest rate near the Corp rate OR people would not buy local tax-free bond...

economic theory does say that the if the payoff is less, people will invest less. so from a theoretical standpoint, yes, the higher the tax on savings, the less likely you are to save, and the argument would be that you're less likely to work to produce income in the first place because the reward of income is reduced by a higher tax on savings.

true is theory, and maybe true in practice at the extremes (imagine a 95% tax on savings) but in normal, everyday practice, it doesn't work that way.

would you seriously work less overtime or take a pay cut or refuse to get the training needed for that next promotion just because the tax on the interest you would earn from the savings from your marginal earnings was taxed at 25% instead of 15%?

real people don't think that way. they work hard, then pay an extra $100 in taxes come april 15, or they get $100 refund, whichever. they don't plan their income strategy on such minor matters.

and even those who DO might do the OPPOSITE! that's right, if the taxman takes more of your money, you might just work HARDER to maintain your standard of living. the value of an hour of labor goes down, so you work more hours. you're not happy about it, but that's what you do. economists call this a 'geffen good'. it's not the usual pattern, but labor is not your typical widget.