Lecture10b.ppt

Lecture10b.ppt - Lecture10:Taxeson Savings Outlineoflecture...

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    Lecture 10:  Taxes on  Savings
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    Outline of lecture Today discuss effects of a uniform tax on income from savings, while next class discuss portfolio choice given actual law. Taxes and savings in a lifecycle model: Income vs. substitution effects Alternative models of savings: Precautionary motives for savings Behavioral models Distortions to short-term vs. long-term savings Special tax provisions for long-term savings Balanced budget changes in tax rates
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    Lifecycle Model of Savings The traditional theory of savings is to smooth consumption across periods. This is an implication of diminishing marginal utility of income. Intertemporal choice is the choice individuals make about how to allocate their consumption over time. Savings is not valued directly, but is rather a means to an end . People give up consumption now to get “future consumption.”
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    Lifecycle Model of Savings Savings equals the excess of current income over current consumption, so the addition to assets made during the year. It earns a real rate of return, r , that buys consumption in future periods.
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C 1 C 2 C 1 Y S BC 1 BC 2 Y (1+ r ) Y (1+ r (1- τ )) C 2 S (1+ r ) slope = -(1+ r ) (1- t )) A Initially savings is S , and consumption is C 1 . Taxing savings rotates the budget constraint, and creates income and substitution effects. Saving for Retirement
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    Lifecycle Model of Savings The initial intertemporal budget constraint is the blue line BC 1 . Its slope is –(1+ r ), meaning that giving up a dollar of consumption now finances (1+ r ) extra dollars of consumption tomorrow Income ( Y ) = Consumption ( C ) + Savings ( S ) Without taxes, point A provides the highest utility, implying savings of S
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    Lifecycle Model of Savings If the government taxes interest income, then the rate of return falls from r to (1- t ) r, because the government collects tr . The slope therefore changes from –(1+ r ) to –(1+(1- t ) r ), shifting the intertemporal budget constraint to the red budget constraint, BC 2 .
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    C 2 C 2 C 1 BC 1 BC 2 BC 1 BC 2 C 1 C 1 C 1 * C 1 * C 2 C 2 * C 2 C 2 * C 1 S S Substitution effect is larger Income effect is larger Savings can fall. Or rise.
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    Lifecycle Model of Savings The lower after-tax rate of return will cause an increase in first period consumption through the substitution effect. But the income effect, arising from being on a worse indifference curve, reduces first-period consumption (and increases savings). The first panel shows that when the substitution effect dominates, savings falls. The second panel shows that when the income effect dominates, savings increases.
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    Lifecycle Model of Savings What happens, though, to C 2 ?
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This note was uploaded on 11/03/2009 for the course ACCT 130 taught by Professor Huxhold during the Spring '09 term at UCSD.

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Lecture10b.ppt - Lecture10:Taxeson Savings Outlineoflecture...

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