Fundamentals of Finance – Lecture 10

Outline
1. Income Taxes a) Personal b) Corporate
2. Consumption and Sales Taxes
3. Taxes on Wealth and Property
4. Fiscal Policy a) The Keynesian View b) The New Classical View c) Fiscal Policy Changes and Problems of Timing d) Supply-Side Effects of Fiscal Policy

Comprehensive Income:
The Haig-Simons Definition
It is “the exercise of control over the use of society’s scarce resources.”
Algebraically it is defined as
I = C +

NW
Where
I = Income
C = Consumption

NW = The Change in Net Worth

Implications of the Haig-Simons Definition
• If a person borrows to consume, there is no increase in income because the change in net worth is negative.
• If a person sells an asset so as to consume, there is no increase in income.

Capital Gains
• Capital gains are the increased value of assets that a person holds.
• If a person owns a stock that has gone up in value, their net worth increases and therefore they have an increase in income by this definition.
• This is true whether or not they actually sell the asset and see the money in their bank accounts.

Realized and Unrealized Capital Gains
• Realized Capital Gains are those gains that a person has received by selling an asset.
• Unrealized Capital Gains are those gains that a person has not yet received by selling an asset but exist only on paper as the market price of the asset they hold has increased.

An Income Statement
• Sources of Funds:
– Earnings from Sale of Productive Services
– Transfer Payments Received
– Capital Gains (or Losses)
• Uses of Funds:
– Consumption
– Taxes
– Donations
– Gifts
– Saving (Increases in Net Worth)
Sources = Uses
So
• Earnings + Transfer Payments + Net Capital Gains =
Consumption + Taxes + Donations + Gifts + Saving

Modifications to the Income Definition
• The cost of acquiring income needs to be accounted for in the definition.
• Earnings + Transfer Payments + Net Capital Gains –
Cost of Acquiring Income
=
Consumption + Taxes + Donations + Gifts + Saving –
Cost of Acquiring Income

Problems with Measuring Income using the Haig-Simons Definition
• How do you measure unrealized capital gains on an asset that is not regularly traded?
• Is the cost of an automobile used to drive to and from work a “cost of acquiring income?” Are child care expenses? Union Dues? Education expenses?
• How do you distinguish what part of an expense is a cost of acquiring income and what part is merely consumption?

Forms of Business
• Sole Proprietorships
• Partnerships
• Corporations
– Corporations are granted the legal status of people.
– This means that they can own property and borrow money

Corporate Taxes
• Corporations are subject to a corporate income tax;
• Since the corporation is not really a person, the people who bear the burden of this tax depend on the shifting of the tax;
• The tax could be shifted backwards to employees, shifted forward to consumers or borne by the shareholders.

The Tax Base: Measuring Business Income
• Using the comprehensive definition of income, business income is receipts + net capital gains income – labor, interest, material, and other business costs.
• Only realized capital gains are included in net taxable income for corporations.

Taxation of Owner-Supplied Inputs
• In a small business setting, the owner works for him or herself. The profit from the business is what this owner is “paid.”
• Some of this is normal profit, some economic profit.
• When there is a corporation there is no ownersupplied input so all profit, normal and economic, is taxed.

Corporate Profits and Where They Go
• Corporate Profits = Corporate Taxes + Retained
Earnings + Dividends
• Retained Earnings are the portion of after-tax corporate profits that a company keeps to invest in the business.
• Dividends are the portion of after-tax corporate profits that are distributed to households.

Economic Depreciation
• Economic Depreciation is the amount that an asset devalues over time.
• When a business buys an expensive capital asset, it cannot deduct from corporate profits the entirety of the value of the asset.
• Because the asset will be productive for a substantial period of time, companies can only deduct a portion of the value of the asset.

Accelerated Depreciation
• Accelerated depreciation allows businesses to deduct the loss in the value of an asset before it occurs.
• The ultimate in accelerated depreciation is the allowance for expensing an asset in the year it is purchased.
• Typically assets are allowed to be depreciated on a straight-line basis, which means in equal increments for the life of an asset.

Double Taxation of Corporate Income
• Corporate Income is considered to be double-taxed because it faces taxes on the same income twice.
• The Corporation must pay taxes on the profits then the shareholders must pay taxes on the amount they receive in either dividends or capital gains.
• Under a comprehensive income tax this would not happen. Corporate profits, either retained or paid in dividends, would enter individual income tax structures according to the percentage of the corporation owned by each shareholder.

Arguments in Favor of Double Taxing
Corporate Income
• Unrealized Capital Gains and the Stepped-Up Basis:
– A major source of unrealized capital gains for individuals is corporate stocks. If the business profit were not taxed at the corporate level, it may never be taxed.
• Compensation for Bankruptcy Protection:
– Individuals are not liable for the bankruptcy of assets they hold in corporations whereas they are in cases of proprietorships and partnerships.

The Consequence of Double Taxation:
A Bias Toward Debt Finance
• A corporation can raise money by borrowing or it can raise money by selling stock.
• The corporation can deduct from its profits the amount it pays in interest to its bondholders.
• It cannot deduct the dividends it pays to its stockholders. This encourages debt finance over equity finance.

Demonstrating the Bias toward Debt Finance
Assumptions :
10% interest;
34 % tax rate
Conclusion :
The taxation of corporate profits combined with the deductibility of interest raises the after-tax return on equity to firms in greater debt thereby motivating firms to increase their debt burdens to an inefficiently high level.
Item
Balance Sheet
Total Assets
Debt
Shareholder’s Equity
All-Equity
$1,000,000
0
$1,000,000
50% Debt –
50% Equity
$1,000,000
$500,000
$500,000
Income Statement
Operating Income
Interest Expense
Taxable Income
Income Tax
Income after
Corporate Tax
Return on Equity
$150,000
0
$150,000
$51,000
$99,000
9.9%
$150,000
$50,000
$100,000
$34,000
$66,000
13.2%

Consumption as a Tax Base
• Consumption can be an alternative to income as a measure of ability to pay.
• Comprehensive consumption:
Income-Savings
Note that capital gains would not be taxed if it were not spent.

Comparing a Tax on Income to a Tax on Consumption
Assumptions
• Two equally situated persons with no physical capital
• Wages = $30,000 per year
• Interest rates = 10%
• Flat rate tax for either consumption or income of 20%.
• Two earning periods.
They have equal ability to pay taxes over their lifetime so they should pay equal taxes over their lifetime.

Comparing a Tax on Income to a Tax on
Consumption: Step 1 An Income Tax
• I
A
• S
A
= I
B
= 0
= $30,000
• S
B
= $5,000
• T
A
• T
B
= $6,000 + $6,000/(1+.1)
= $6,000 + $5,455 = $11,455
= $6,000 + $6,100/(1+.1)/(1+.1)
= $6,000 + $5,545 = $11,545

Comparing a Tax on Income to a Tax on Consumption:
Step 2 A Consumption Tax for the Non-Saver
Income = Consumption + Consumption Tax +Savings
First and Second Year
• I
A
= C
A
+ T
A
+ S
• $30,000 = C
A
A
+ .2C
A
• C
A
• T
A
• S
A
= $25,000
= $5,000
= 0
+ 0
Present Value of All Taxes
• T
A
= $5,000 + $5,000/(1+.1)
= $5,000 + $4,545.45 = $9,545.45

Comparing a Tax on Income to a Tax on Consumption:
Step 2 B Consumption Tax for the Saver
First Year Second Year
 I
B
= C
B
+ T
B
+ S
B
 $30,000 = C
B
+.2C
B
+ $5,000
 C
A
= $20,583.33
 T
A
= $4,166.66
 S
A
= $5,000
 I
B
= C

 C
 T
A
A
+ Proceeds from Saving
B
+ T
B
$35,500 = C
B
+ .2C
= $29,583.33
= $5,916.67
Present Value of All Taxes
T
B
= $4,166.66 + $5,916.67/(1+.1)
= $4,166.66 + $5,378.79 = $9,545.45
B

Comparing a Tax on Income to a Tax on Consumption
• Under an Income tax, savers pay more in tax than non-savers.
• Under a consumption tax, they pay the same present value of taxes.

Impact of a Sales Tax on the Efficiency in Labor Markets
• A substitution of a consumption tax for an income tax (with equal yields) would require a higher tax rate because of savings.
• The net efficiency change depends on whether the gain in the investment market is greater than the loss in the labor market.
• Estimates suggest such a change would have a positive impact on GDP.

A Sales Tax
• A retail sales tax is typically a fixed percentage on the dollar value of retail purchases.
• Sales taxes are a major source of tax revenue for state and local governments. Some state rates are as high as 7% with local governments adding an additional 3% on top of that.
• Often food and medicine are exempt.

An Excise Tax
• An excise tax is a selective tax on particular goods.
• In Bulgaria excise taxes exist on alcohol, tobacco and tobacco products, and energy resources (petrol, natural gas, oil, electricity).

The Incidence of Sales and Excise Taxes
• Generally, sales taxes are regressive when food and medicine are not exempt.
• A national sales tax would be borne by labor income and would lack the progressive rate structure of the personal income tax.

Turnover Taxes
• Turnover taxes are multistage taxes that are levied at some fixed rate on transactions at all levels of production.
• The effective rate of tax depends on the number of times the good is sold during the production process.
• This creates a significant bias toward vertical integration (where all production stays within the same firm).

A Value-Added Tax
A value-added tax (VAT) is a consumption-based tax levied at each stage of production.
Value Added = Total Transactions – Intermediate Transactions
= Final Sales
= GDP
= Wages + Interest + profits + Rents + Depreciation
Tax Liability = Tax on Payable Sales – Tax Paid on Intermediate Purchases
= t(sales) – t(purchases)
= t(sales – purchases)
= t(value added)

The VAT in Europe
• The VAT accounts for about 20% of EU member nation revenue.
• The average rates within the EU are between 15 and
20%.
• Different rates apply to different types of goods with luxury items facing the highest rate and necessities facing the lowest.
• The tax applies to services as well as goods.
• Economists find the VAT a good alternative to an income tax because it does less to discourage savings and investment.

A Comprehensive Wealth Tax Base
• Real Property is property such as land and the structures on the land.
• Intangible Property is wealth that is held as paper or financial assets.
• Personal Property is wealth that is held in the form of cars, furniture, clothing, jewelry, etc.

Measuring Wealth
• Market value can be used to establish the value of most real property and intangible property but personal property has no acceptable resale market.
• Serious inequities can arise from mismeasurement of wealth and serious shifting can take place when one form of wealth is taxed while another is not.

Assessment of Property Value
• For the property tax, the assessed value of a home and the land upon which it sits is quite subjective. Real-estate markets exists for many homes but not others.

Budget Deficits and Surpluses
• Budget deficit:
Present when total government spending exceeds total revenue from all sources.
• When the money supply is constant, deficits must be covered with borrowing.
• Governments borrow by issuing bonds.
• Budget surplus:
Present when total government spending is greater than total revenue.
• Surpluses reduce the magnitude of the government’s outstanding debt.

Budget Deficits and Surpluses
• Changes in the size of the deficit or surplus are often used to gauge whether fiscal policy is stimulating or restraining demand.
• Changes in the size of the budget deficit or surplus may arise from either:
• A change in the state of the economy, or,
• A change in discretionary fiscal policy.
• The budget is the primary tool of fiscal policy.
• Discretionary changes in fiscal policy:
Deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.

The Keynesian View of Fiscal Policy
• Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in aggregate demand.
• Following the Great Depression, Keynesians challenged the view that governments should always balance their budget.
• Rather than balancing their budget annually,
Keynesians argue that counter-cyclical policy should be used to offset fluctuations in aggregate demand.
• This implies that the government should plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.

• When an economy is operating below its potential output, the
Keynesian model suggests that the government should institute
expansionary fiscal policy, by:
• increasing the government’s purchases of goods & services, and/or,
• cutting taxes.

Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process.
Expansionary Fiscal Policy
Price
Level
LRAS
SRAS
1
SRAS
2
P
2
P
1
P
3 e
1
E
2
E
3
Expansionary fiscal policy stimulates demand and directs the economy to full-employment
AD
1
AD
2
Goods & Services
(real GDP)
Y
1
Y
F
• At e
1
( Y
1
), the economy is below its potential capacity Y
F
.
There are 2 routes to long-run full-employment equilibrium:
• Wait for lower wages and resource prices to reduce costs, increase supply to SRAS
AD (shift to AD
2
2 and restore equilibrium to E
) and guide the economy back to E
2
3
, at
• Alternatively, expansionary fiscal policy could stimulate
, at Y
F
.
Y
F.

Keynesian Policy
To Combat Inflation
• When inflation is a potential problem,
Keynesian analysis suggests a shift toward a more restrictive fiscal policy by:
• reducing government spending, and/or,
• raising taxes.

Price
Level
Restrictive Fiscal Policy
LRAS
SRAS
2
SRAS
1
P
3
P
1
P
2
E
3
E
2 e
1
Restrictive fiscal policy restrains demand and helps control inflation.
AD
2
AD
1
Goods & Services
(real GDP)
Y
F
Y
1
• Strong demand such as AD
1 will temporarily lead to an output rate beyond the economy’s long-run potential Y
• If maintained, the strong demand will lead to the long-run equilibrium E
3
F at a higher price level (SRAS shifts to SRAS
.
2
).
• Restrictive fiscal policy could reduce demand to AD
AD from shifting to AD
1
2
(or keep initially) and lead to equilibrium E
2
.

The Crowding-out Effect
• The Crowding-out effect
– indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy.
• The implications of the crowding-out analysis are symmetrical.
• Restrictive fiscal policy will reduce real interest rates and "crowd in" private spending.
• Crowding-out effect in an open economy:
Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

Increase in budget deficit
Crowding-Out in an Open Economy
Decline in private investment
Higher real interest rates
Inflow of financial capital from abroad
Appreciation of the dollar
Decline in net exports
• An increase in government borrowing to finance an enlarged budget deficit places upward pressure on real interest rates.
• This retards private investment and Aggregate Demand.
• In an open economy, high interest rates attract foreign capital.
• As foreigners buy more domestic currency to buy domestic bonds and other financial assets, the domestic currency appreciates.
• The appreciation of the domestic currency causes net exports to fall.
• Thus, the larger deficits and higher interest rates trigger reductions in both private investment and net exports, which limit the expansionary impact of a budget deficit.

The New Classical View of Fiscal Policy
• The New Classical view stresses that:
• debt financing merely substitutes higher future taxes for lower current taxes, and thus,
• budget deficits affect the timing of taxes, but not their magnitude.
• New Classical economists argue that when debt is substituted for taxes:
• people save the increased income so they will be able to pay the higher future taxes, thus,
• the budget deficit does not stimulate aggregate demand.

The New Classical View of Fiscal Policy
• Similarly, New Classical economists believe that the real interest rate is unaffected by deficits as people save more in order to pay the higher future taxes.
• Further, they believe fiscal policy is completely impotent – that it does not affect output, employment, or real interest rates.

Expansionary Fiscal Policy
Price
Level
SRAS
1
P
1
AD
2
AD
1
Y
1
Goods & Services
(real GDP)
• New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes.
• If households did not anticipate the higher future taxes, aggregate demand would increase (from AD
1 to AD
2
).
• However, when households fully anticipate the future taxes and save for them, demand remains unchanged at AD
1
.

Expansionary Fiscal Policy
Real interest rate S
1
Loanable Funds
Market
S
2 e
1 e
2 r
1
Here, fiscal policy exerts no effect on the interest rate, real GDP, or unemployment.
D
1
D
2
Quantity of loanable funds
Q
1
Q
2
• To finance the budget deficit, the government borrows from the loanable funds market, increasing the demand (to D
2
).
• Under the new classical view, people save to pay expected higher future taxes (raising the supply of loanable funds to S
• This permits the government to borrow the funds to finance the deficit without pushing up the interest rate.
2
.)

Problems with Proper Timing
• There are three major reasons why it is difficult to time fiscal
policy changes in a manner that produces stability:
• It takes time to institute a legislative change.
• There is a time lag between when a change is instituted & when it exerts significant impact.
• These time lags imply that sound policy requires knowledge of economic conditions 9 to 18 months in the future. But our ability to forecast future conditions is limited.
• Discretionary fiscal policy is like a two-edged sword; it can both harm and help:
• If timed correctly, it may reduce economic instability.
• If timed incorrectly, however, it may increase economic instability.

Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS
1
P
0
P
1 e
1
E
0
Y
0
AD
1
AD
0
Goods & Services
(real GDP)
Y
1
• Consider a market at long-run equilibrium E
0 the natural rate of unemployment is present.
where only
• An investment slump and business pessimism result in an unanticipated decline in AD (to AD
1
) and unemployment increases.
1
). Output falls (to Y

Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS
1
Suppose that shifts in AD are difficult to forecast.
P
0
P
1 e
1
E
0
Y
0
AD
1
AD
0
Goods & Services
(real GDP)
Y
1
• After a time, policymakers consider and implement expansionary fiscal policy seeking to shift AD
1 back to AD
0
.
• But it will take time to institute changes in taxes and expenditures. Political forces will slow this process.

Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS
1
P
0
P
1
E
0
Y
1 e
1
Y
0
AD
1
AD
0
AD
2
Goods & Services
(real GDP)
• By the time a more expansionary fiscal policy is instituted and begins to exert its primary effect, private investment may have recovered and decision makers may therefore be increasingly optimistic about the future.
• Hence, the more expansionary fiscal policy may over-shift
AD to AD
2
.

Timing of Fiscal Policy is Difficult
Price
Level
LRAS SRAS
2
SRAS
1
P
3
E
3
P
2 e
2
P
0
E
0
P
1 e
1
Y
2
AD
0
AD
1
AD
2
Goods & Services
(real GDP)
Y
1
Y
0
• The price level in the economy rises (from P to inflation.
1 to P
2
) as the economy is now overheating. Thus, incorrect timing leads
• Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS
2
(driving the price level up to P
3
).

Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS
1
P
2
P
0
E
0 e
2
AD
0
AD
2
Y
0
Y
2
Goods & Services
(real GDP)
• Alternatively, suppose an investment boom disrupts the initial equilibrium shifting AD out to AD
2
, and prices upward to P
2 in taxes and a cut in government expenditures.

Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS
1
P
2 e
2
Suppose that shifts in AD are difficult to forecast.
P
0
E
0
P
1 e
1
Y
2
AD
0
AD
1
AD
2
Goods & Services
(real GDP)
Y
1
Y
0
• By the time the more restrictive fiscal policy takes affect, investment may have returned to its normal rate (shifting
AD
2 back to AD
0
).
• In this case, the incorrect timing of the shift to the more restrictive fiscal policy to deal with potential inflation throws the economy into a recession (by over shifting AD to AD
1
).

Why Timing of Fiscal Policy
Changes Are Difficult: A Summary
• Because fiscal policy does not work instantaneously, and since dynamic forces are constantly influencing private demand, proper timing of fiscal policy is not an easy task.
• Further, political incentives also influence fiscal policy.
Public choice analysis indicates that legislators are delighted to spend money on programs that directly benefit their own constituents but are reluctant to raise taxes because they impose a visible cost on voters.
• There is a political bias towards spending and budget deficits. Predictably, deficits will be far more common than surpluses.
• Incorrectly timed policy changes may, them-selves, be a source of economic instability.

Automatic Stabilizers
• Automatic Stabilizers
:
Without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom.
• The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action
.
• Examples of automatic stabilizers
:
 Unemployment compensation
 Corporate profit tax
 A progressive income tax

Supply-side Effects of Fiscal Policy
• From a supply-side viewpoint, the marginal tax rate is of crucial importance:
 A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less heavily taxed.
• High marginal tax rates will tend to retard total output because they will:
 discourage work effort and reduce the productive efficiency of labor,
 adversely affect the rate of capital formation and the efficiency of its use, and,
 encourage individuals to substitute less desired taxdeductible goods for more desired non-deductible goods.

Supply-side Effects of Fiscal Policy
• So, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate
supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance.
• Impact of supply-side effects:
 Usually take place over a lengthy time period.
 There is some evidence that countries with high taxes grow more slowly—France and Germany versus United
Kingdom.
 While the significance of supply-side effects are controversial, there is evidence they are important for taxpayers facing extremely high tax rates – say rates of 40 percent or above.

Supply Side Economics and Tax Rates
Price
Level
LRAS
1
LRAS
2
SRAS
1
SRAS
2
P
0
E
1
E
2
With time, lower tax rates promote more rapid growth
(shifting LRAS and SRAS out to LRAS
2 and SRAS
2
).
AD
1
AD
2
Y
F1
Y
F2
Goods & Services
(real GDP)
• What are the supply-side effects of a cut in marginal tax rates?
• Lower marginal tax rates increase the incentive to earn and use resources efficiently. AD
1
, and SRAS & LRAS shift to the right.
shifts out to AD
2
• If the tax cuts are financed by budget deficits, AD may expand by more than supply, bringing an increase in the price level.

Have Supply-siders Found a Way to Soak the Rich?
• Since 1986 the top marginal personal income tax rate in the United States has been less than 40% compared to
70% or more prior to that time.
• Nonetheless, the top one-half percent of earners have paid more than 25% of the personal income tax every year since 1997.
• This is well above the 14% to 19% collected from these taxpayers in the 1960s and 1970s when much higher marginal personal income tax rates were imposed on the rich.