Taxing Interest on Deposits: Theoretical and Empirical Analysis for the Case of Lebanon

In most countries, taxes on interest income are subsumed under the general income tax structure. In Lebanon, there is a departure from such a policy, and these taxes are not imposed as part of taxable income but are levied at source on interest from deposits at commercial banks. As a result, this necessitates the derivation of a theoretical model on the subject of this tax that must be applicable to Lebanon. This is the first intent of this paper. As such, the paper develops a model that attempts to maximize the tax revenue from a given tax rate and to minimize the deadweight loss from this tax. From this theory, the relevant parameters that affect the optimal tax rate are found to be the interest rate elasticities of deposit supply and demand. Assuming, as the case for Lebanon indicates, that the interest elasticity of demand for deposits is infinite, and conditioning on other exogenous variables, the own and cross interest elasticities of deposit supply are estimated by advanced econometric techniques. The results show that the optimal tax rates differ markedly for the two denominations of deposits, the one in Lebanese pounds and the one in foreign currency. The optimal tax rate is higher for the latter, and both rates are much higher than the actual rate, or even the proposed rate. The paper concludes that, although tax authorities in Lebanon can theoretically raise substantially the tax rate in order to increase tax revenues, other economic and political considerations limit to a large degree the liberty of implementing such a raise.