Chapter 23 Taxes on Risk Taking and Wealth

Taxation and Risk Taking (Basic Model)

• When the government taxes investment gains and allows full deductions for investment losses (a full tax offset), it can actually increase risk taking.

• This is because the investor can undo the tax by simply increasing the size of their investment to achieve the same after-tax return as they had before the tax.

Expected Return

• The return to a successful investment multiplied by the odds of success, added to the return to an unsuccessful investment multiplied by the odds of failure. (The PDF does not define realized return, but uses it to mean the actual payout ).

Tax Loss Offset

The extent to which taxpayers are allowed to deduct net losses on investments from their taxable income.

Less-Than-Full Tax Offset

• A real-world complication where investment losses are not fully deductible. In the U.S., individuals can only deduct $3,000 of net investment losses from other income in a year.

• This prevents investors from simply "undoing" the tax by taking more risk

Redistributive Taxation (and Risk)

• Refers to progressive tax systems where marginal tax rates rise with income.

• This can reduce risk taking, because if an investor wins a large gamble, they move into a higher tax bracket (taxed at a high rate) , but if they lose, they move into a lower bracket (losses deducted at a lower rate).

Capital Gains

The earnings realized on the sale of capital assets.

Taxed on Realization (vs. Accrual)

• Realization (How it works): Capital gains are taxed only when the asset is sold (i.e., the gain is "realized").

• Accrual (Not how it works): An accrual system would tax the asset's increase in value each year, whether it was sold or not. The PDF implies the U.S. system is one of realization, not accrual.

Arguments FOR Tax Preferences for Capital Gains (List)

• Protection Against Inflation: Taxing nominal gains overstates the real value of the gain.

• Improved Efficiency (Avoiding Lock-in): Lower rates might make people more willing to sell assets.

• Encouraging Entrepreneurial Activity: The return to starting a company often comes as a capital gain.

Arguments AGAINST Tax Preferences for Capital Gains (List)

• Progressivity: Capital gains income goes overwhelmingly to the richest taxpayers.

• Haig-Simons Principle: Taxing capital gains at a lower rate violates the principle that all income should be taxed equally, which can lead to inefficient investment choices.

Protection Against Inflation (Capital Gains Argument)

An argument for lower capital gains taxes, stating that current policy overstates the real value of capital gains because it does not account for inflation. The PDF notes, however, that it would be better to just index the basis for inflation.

Lock-in Effect Definition/Explanation

The tendency for individuals to delay selling their capital assets in order to minimize the present discounted value of their tax payments. This "locks in" their assets, reducing the fluidity of the capital market.

Encouraging Entrepreneurial Activity (Capital Gains)

An argument for low capital gains taxes, based on the idea that an entrepreneur's primary return is the capital gain from their company's increased value. The PDF calls this a "blunt instrument" for achieving this goal

Step-up of Basis at Death

A tax preference where the basis (the purchase price used to determine capital gains) of an asset passed to an heir is "stepped up" to its market value at the time of the owner's death. This means the capital gains tax burden is based only on the appreciation since the time of death, not the original purchase price

Transfer Tax

A tax levied on the transfer of assets from one individual to another.

Estate Tax

A tax levied on the assets of a deceased person that are bequeathed (left) to other

Gift Tax

A tax levied on assets that one individual gives to another in the form of a gift.

Arguments FOR the Estate Tax (Pros)

• It is an extremely progressive way to raise revenue.

• It is needed to avoid an excessive concentration of wealth and power in a few dynasties.

• It may motivate the children of wealthy families to work hard and achieve their own success.

Arguments AGAINST the Estate Tax (Cons)

• "Is the Death Tax Cruel?": The argument that it is morally inappropriate to tax individuals upon their death. (The PDF counters this by noting 98% of people who die pay no estate tax ).

• Double Taxation Argument: The claim that the estate tax amounts to double taxation, as the income was already taxed when it was earned. (The PDF counters that this is common, citing sales tax as another example ).

Property Tax

A tax levied on the value of real estate, which includes both the value of the land and any structures (improvements) built on it. It is the major source of revenue for local governments.

Property Tax Incidence (Who bears the tax?)

• Traditional View: The tax falls on landowners and on the owners/users of structures, depending on elasticities.

• "Capital Tax" View: The tax reduces the return to capital, driving it out of the locality. The tax falls on all owners of capital.

• "Benefit Tax" View: The tax is the "price" paid for local public goods (like schools). If this is true, the tax has no negative efficiency implications.

Property Tax (Land vs. Improvements)

The property tax is levied on both the value of the land and the value of structures (improvements) built on the land.

Property Tax (Residential vs. Commercial)

, but notes that local governments often give property tax breaks to businesses (commercial property) to attract or keep them in the area.