December 8, 2005
By Martin Feldstein
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.
Keeping the low rates on the income from savings should now be the highest priority of tax reform. Eliminating the tax on such income would be even better.
Here's why. A tax on interest, dividends and capital gains creates a major distortion in the timing of consumption, and also exacerbates the adverse effects of the income tax on all aspects of work effort and personal productivity. Such distortions create unnecessary economic waste that lowers our standard of living. The combination of a lower tax rate on the income from savings and a revenue-neutral rise in the tax on earnings can produce a higher net reward for additional work and productivity, as well as a reduction in the distortion between consuming now and in the future. That would reduce the economic damage caused by the tax system while collecting the same total revenue with the same distribution of the tax burden.
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.
The second lesson that follows from the example is that the tax on interest income substantially distorts the level of future consumption even if Joe does not make any change in the amount that he saves. With the same $100 of additional saving, the higher tax rate reduces his additional retirement consumption from $291 to $193, a one-third reduction. If Joe responds to the lower real rate of return that results from the higher tax rate on interest by saving less, the distortion of consumption is even greater. For example, if Joe would save $150 out of the extra $1,000 of earnings when his real net return is 3.1% (instead of saving $100 when the real net return is 1.9%), his extra consumption at age 75 would be $436, more than twice as much as with the 35% tax rate. But the key point is that Joe's future consumption would be substantially reduced by the higher tax rate even if he does not change his savings.
Taken together, these two lessons imply that a lower tax rate on interest income, combined with a small increase in the tax on other earnings, could make Joe unambiguously better off while also increasing government revenue. More specifically, if reducing the tax on interest income from 35% to 15% had no effect on Joe's earnings or on his initial consumption spending, the government could collect the same present value of tax revenue from Joe by raising the tax on his $1,000 of extra earnings from $350 to $385. Although this would cut Joe's saving from $100 to $65 (if he keeps his initial consumption spending unchanged), the higher net return on that saving would give Joe the same consumption at age 75. In this way, Joe would be neither better off nor worse off.
But experience shows that Joe would alter his behavior in response to the lower tax rate. He would earn more at age 40 and would save more for retirement. This change of behavior makes Joe better off (or he wouldn't do it) and the extra earnings and interest income would raise government revenue above what it would be with a 35% tax rate. So Joe would be unambiguously better off with the lower tax rate on interest income and the government would collect more tax revenue.
A tax on the income from saving is not only wasteful but also a very unfair form of double taxation. Income is taxed when it is earned and then taxed again if the individual decides to postpone consumption. When Joe earns an extra $1,000 and saves $100 of it, he pays $350 in tax immediately and then an additional $157 in tax on his extra interest income until he reaches age 75. Why should Joe pay more tax on his $1,000 of earnings than a spendthrift who consumes all of his extra income at age 40?
Although the example assumed Joe invested his savings in bonds, the case is even stronger for investment in stocks. The higher historic yield on stocks than on bonds reflects a reward for greater risk-taking. Taxing that higher pretax yield on stocks implies a greater loss of return and therefore a greater economic waste than the tax on bond interest. Taxing that reward for risk-taking also drives individuals away from stocks and into bonds and bank deposits, thereby depriving the economy of the equity investments needed for new ventures and business expansion.
Any tax on capital gains is unjustified because it is a combination of three separate unfair taxes. One part of the capital gains tax is a tax on the rise of a company's value that reflects the retained earnings that have already been subject to a corporate income tax and should not be taxed again. A second part of the capital gains tax reflects the rise in the nominal value of the company due to the rise in the general price level since the stock was purchased, a rise in nominal value that does not make the shareholder better off in real terms. The remaining part of the capital gains reflects the unpredictable variation in share prices that averages out to zero in an efficient capital market. If the tax law allowed full loss offsets when share prices fell, the government would collect no revenue from these variations; any net revenue reflects only the unfair limits on loss offsets.
Whatever else the administration and Congress do as part of the current tax reforms, cutting the tax on the return to savings should be at the top of the list.
Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.