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Taxation of Interest Income

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  • Roger H. Gordon

Abstract

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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9503.

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Date of creation: Feb 2003
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Publication status: published as Gordon, Roger H. "Taxation Of Interest Income," International Tax and Public Finance, 2004, v11(1,Jan), 5-15.
Handle: RePEc:nbr:nberwo:9503

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  1. Naito, Hisahiro, 1999. "Re-examination of uniform commodity taxes under a non-linear income tax system and its implication for production efficiency," Journal of Public Economics, Elsevier, Elsevier, vol. 71(2), pages 165-188, February.
  2. Atkinson, A. B. & Stiglitz, J. E., 1976. "The design of tax structure: Direct versus indirect taxation," Journal of Public Economics, Elsevier, Elsevier, vol. 6(1-2), pages 55-75.
  3. Saez, Emmanuel, 2002. "The desirability of commodity taxation under non-linear income taxation and heterogeneous tastes," Journal of Public Economics, Elsevier, Elsevier, vol. 83(2), pages 217-230, February.
  4. Gordon, Roger H, 1985. "Taxation of Corporate Capital Income: Tax Revenues versus Tax Distortions," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 100(1), pages 1-27, February.
  5. Mirrlees, James A, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 38(114), pages 175-208, April.
  6. Roger H. Gordon & Joel Slemrod, 1988. "Do We Collect Any Revenue from Taxing Capital Income?," NBER Chapters, National Bureau of Economic Research, Inc, in: Tax Policy and the Economy: Volume 2, pages 89-130 National Bureau of Economic Research, Inc.
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Cited by:
  1. Albanesi, Stefania, 2006. "Optimal Taxation of Entrepreneurial Capital with Private Information," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5647, C.E.P.R. Discussion Papers.
  2. Peter A. Diamond & Johannes Spinnewijn, 2009. "Capital Income Taxes with Heterogeneous Discount Rates," NBER Working Papers 15115, National Bureau of Economic Research, Inc.
  3. David Hargreaves, 2008. "The tax system and housing demand in New Zealand," Reserve Bank of New Zealand Discussion Paper Series DP2008/06, Reserve Bank of New Zealand.

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