Econ 208
Marek Kapicka
Lecture 14
Capital Taxation
Financial Intermediation
Next Week

No class next Monday (Memorial day)
No class next Wednesday as well

PS5 will be posted on Wednesday
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Ramsey Taxation
Implications for Government Debt

Example:
Gt  1, t  0, Gt  0, t  0
Yt  1, t  0


Hence W = G = 1
The optimal tax rate
 r
*
Ramsey Taxation
Implications for Government Debt



Tax collection each period: r / (1+r)
Core Deficit
1
G0  T0 
1 r
r
Gt  Tt  
,t  0
1 r
Government Debt:
1
B 
,t  0
1 r
g
t
Ramsey Taxation
WWII vs. Korean War

WWII financed differently than Korean War
% OF EXPENDITURES FINANCED BY

Direct Taxes
Debt and seignorage
World War II
41%
59%
Korean War
100%
0%
Marginal Taxes
% TAX RATES BEFORE/DURING THE WAR
Labor
Capital
World War II
9/18
44/60
Korean War
16/20
52/63
Ramsey Taxation
WWII vs. Korean War

What if WWII were financed like Korean
War (taxes only)?



Labor taxes would be 64% rather than 18%
Capital taxes would be 100% rather than 60%
Welfare costs are 3% of consumption
Ramsey Taxation
WWII vs. Korean War

What if Korean War was financed like
WWII (both taxes and debt)?




Labor taxes would be 23% rather than 20%
Capital taxes would be 50% rather than 62%
Welfare gains are 0.4% of consumption
Source: Lee Ohanian, “The Macroeconomic Effects of War Finance in the
United States: World War II and the Korean War”, American Economic
Review, vol. 87, (1), 1997, pp. 23 - 40
Where are we?

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Introduction: A model with no Government
The Effects of Government Spending
Government Taxation and Government Debt

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Labor Taxation
Taxation and Redistribution
Government Debt
Capital Taxation
Financial Intermediation
Capital Taxation

What does it mean to tax capital?


Tax on the stock of capital (wealth tax,
property taxes)
Tax on the income from savings (tax on
interest or dividends, tax on capital gains)
Capital Taxation


The effect of capital taxation: It taxes
future consumption more heavily than
current consumption
Example:



You have income $2
An apple costs $1
The interest rate between today and
tomorrow is 100%
Capital Taxation
1.
Scenario 1: no tax

2.
Can buy either 2 apples today or 4 apples
tomorrow
Scenario 2: 50% tax on wages


Can buy either 1 apple today or 2 apples
tomorrow
Both current and future consumption cut
in half (2 → 1 and 4 → 2)
Capital Taxation
1.
Scenario 3: 50% tax on wages and
interest




Can buy either 1 apple today or 1.5
apples tomorrow
Current consumption cut in half (2 → 1)
Future consumption cut by 62.5% (4 →
1.5)
Tax on interest taxes future consumption
more!
Capital Taxation



Why is it bad to tax interest?
Uniform Commodity Taxation: taxes
should be spread evenly across goods
Tax on capital violates this principle.
Capital Taxation

1.
2.
What could be the reasons for capital taxation?
Capital returns are risky. Taxing capital provides
social insurance.
(tax on dividends/profits): If investment is financed
by retained earnings then (under certain conditions) a
tax on profits/dividends have no effect on investment
levels
Where are we?



Introduction: A model with no Government
The Effects of Government Spending
Government Taxation and Government Debt





Labor Taxation
Taxation and Redistribution
Government Debt
Capital Taxation
Financial Intermediation
Financial crises


Economic crisis in 2007-2008: The
largest recession since the Great
Depression
Associated with banking crisis


The first banking crisis in the US since the
Great Depression
However, banking crises are recurrent
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Before 1913
In other countries
Banking crises are nothing new!
Recent Crises
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Scandinavian Crisis 1990-1991
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Increase in asset and housing prices before the crisis
1990-1991: increase in oil prices and collapse of trade with
Soviet Union triggered a crisis
Sweden: took over major banks, recapitalized them and sold
them later
Japan 1990’s
The Argentina Crisis 2001-2002
The Russian Crisis, 1998
A. History of banking crises: U.S.


1863-1913: Crises were a frequent
phenomenon in the U.S.
They have occurred at about 10 year
intervals
A Banking Panic
Bank Runs
U.S. National Banking Era Panics
Why Financial Crises?

Key insight: Banks are here to transform
illiquid assets to liquid liabilities


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Depositors prefer to withdraw deposits easily
(preference for liquidity)
Borrowers need time to repay the loans
Tension between both sides of the
balance sheet:

If everyone wants to withdraw deposits,
there is not enough resources
A Liquidity Problem


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How to choose between liquid and illiquid
assets?
Liquid assets: can be converted into
immediate consumption without any costs
Illiquid assets: it is costly to convert them
into immediate consumption
People have preference for liquidity: they
are unsure when they need to consume
A Liquidity Problem
1.
2.
3.
4.
Autarchic Solution
Market Solution
Efficient Solution
Banking Solution
A Liquidity Problem
Timing


Time 𝑡 = 0,1,2
Two assets:

Liquid, short-term (short) asset

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Illiquid, long-term (long) asset

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1 unit of consumption in period t can be converted to 1
unit of consumption in period 𝑡 + 1, 𝑡 = 0,1
1 unit of consumption in period 0 can be converted into
𝐹 > 1 units of consumption in period 2
Long asset yields more in the long run, but
nothing in the short run!
A Liquidity Problem
Preferences

Liquidity preference: Two types of
consumers:



Early consumers: only want to consume in
period 1
Late consumers: are indifferent about the
timing of consumption
The consumer learns about his type at
the beginning of period 1
An Example of Early Consumers
A Liquidity Problem
Preferences


Probability of being early: 𝜃
Preferences of a consumer: expected
utility
𝜃𝑈 𝐶1 + 1 − 𝜃 𝑈(𝐶1 + 𝐶2 )

Trade-off: investing in long asset yield
higher return but does not insure
against the risk of being an early
consumer
1. Autarchic Solution


The consumer has initial wealth 𝑊 = 1
Invests fraction 𝜆 in the short asset
𝐶1 = 𝜆
C2 = 𝜆 + 1 − 𝜆 𝐹

Chooses 𝜆 to maximize
𝜃𝑈 𝜆 + 1 − 𝜃 𝑈(𝜆 + 1 − 𝜆 𝐹)
1. Autarchic Solution
The Budget Constraint
𝐶2
𝐹
1
1
𝐶1
1. Autarchic Solution

If the utility is logarithmic, the solution
is
𝜃
𝜆 = min [
1−1


, 1]
𝐹
If 𝜃 increases, 𝜆 increases
If 𝐹 increases, 𝜆 decreases