Measuring the welfare loss of the Finnish proposal for interest income taxation

A welfare loss of about 5 to 6 per cent of the capital stock is estimated to result from the introduction of a tax on real domestic interest receipts in the 1983 Finnish economy. Firstly. a review of the history of the tax treatment of interest income and of the proposal to change it are presented. It is pointed out that prior to the year of 1983 the Finnish economy operated approximately so that no tax wedge was included in the domestic average lending rates. Secondly, the effects of the imposition ofa tax in such circumstances on domestic interest rates is analysed graphically in the presence of international capital flows. It is observed that if the domestic (foreign) investors determine solely the domestic tax-free interest rates, the tax will shift 100 per cent forward (backward). Hence. a welfare loss results in the form of reduced domestic investment (saving). Thirdly, limitations and crucial parameter values of the applied three-sector general equilibrium model are explained. and there is also a description of how the proposed reform is tackled in the model. Finally, the consumer's equivalent variation is calculated for each successive year by comparing the new utility level to the one along the reference path. The present value of those un weighted losses in relation to the capital stock gives the welfare loss.