ch22_taxes_savings - Chapter 22- Taxes on Savings capital...

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Chapter 22- Taxes on Savings capital income taxation - the taxes levied on the returns from savings intertemporal choice model - the choice individuals make about how allocate their consumption over time While Working Retirement Consumption Stream 1 $800,000 $200,000 Consumption Stream 2 $500,000 $500,000 prefer Consumption Stream 2 because of diminishing marginal utility of consumption utility gain from income rising from $500,000 to $800,000 is less than utility loss from income falling from $500,000 to $200,000 consumption smoothing - individuals would prefer to smooth their consumption over time, consuming a constant amount rather than feasting in some periods and starving in others no savings→ forced to consume much less in retirement→ big utility loss can smooth consumption by saving savings - the excess of current income over current consumption Intertemporal Budget Constraint intertemporal budget constraint - the measure of the rate at which individuals can trade off consumption in one period for consumption in another period choose C W so as to maximize utility subject to intertemporal budget constraint period 1- working life (W) period 2- retirement (R) Y- earnings during working life C W - consumption during working life C R - consumption during retirement r = interest rate t = tax rate savings consumption during retirement no tax world S = Y - C W C R = S * (1 + r) tax world S = Y - C W C R = S * [1 + r(1-t)] EX) s = $100, r = 0.10, t = 0.25
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Draw intertemporal budget constraint choose C W so as to maximize utility subject to intertemporal budget constraint period 1- working life (W) period 2- retirement (R) Y- earnings during working life C W - consumption during working life C R - consumption during retirement r = interest rate t = tax rate savings consumption during retirement no tax world S = Y - C W C R = S * (1 + r) tax world S = Y - C W C R = S * [1 + r(1-t)] 2
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intertemporal budget constraint with IE and SE ↑t, ↓r n (after-tax, net interest rate) recall→ S = Y - C W C W = Y – S SE→ ↓ r n , ↓return to S, ↓S, ↑ C W IE→ ↓ r n , in effect poorer, must ↑ S to achieve target C R , ↑S, ↓C W 3
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Inflation and Capital Taxation nominal interest rate - the interest rate earned by a given investment real interest rate - nominal interest rate minus inflation rate (tells us about real purchasing power) real interest rate (r) = nominal interest rate (i) – inflation rate (π) problem- taxes are levied on nominal, not real, interest earnings no tax world→ percentage increase in purchasing power is the same whether or not there is inflation tax world→ percentage increase in purchasing power is bigger when there is no inflation versus when there is high inflation because taxes are levied on nominal interest rates, higher inflation lowers the after-tax real return to savings Economy A (no inflation) Economy B (inflation) Real interest rate 4% 4% Inflation rate 0 8 Nominal interest rate (real + inflation) 4 12 Reduced interest due to 25%
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ch22_taxes_savings - Chapter 22- Taxes on Savings capital...

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