TY  - JOUR
AU  - Gordon,Roger H.
TI  - Taxation of Interest Income
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 9503
PY  - 2003
Y2  - February 2003
UR  - http://www.nber.org/papers/w9503
L1  - http://www.nber.org/papers/w9503.pdf
N1  - Author contact info:
Roger H. Gordon
Department of Economics 0508
University of California, San Diego
9500 Gilman Drive, Dept. 0508
La Jolla, CA 92093
Tel: 858/534-4828
Fax: 858/534-7040
E-Mail: rogordon@ucsd.edu
AB  - 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.
ER  -