The Taxation of Household Savings - Potential Winners and Losers of Such a Move - Literature review Example

The Taxation of Household Savings A of the current system (taxation of household savings in general) The current system of taxation of household savings is the standard income tax treatment of savings, which entails the taxation of the household savings as well as the returns on the savings. This current system is characterized by deterring saving, because it makes the future consumption more expensive, compared to the current consumption, effectively making many households opt to consume now their income, rather than save for the future (Mirrlees, 2008:295). The current standard income tax treatment of savings treats the incomes as they are received as taxable, and then goes further to treat the returns on the savings as taxable (Greenstein, 2013:n.p.). Consequently, the received earnings will have been subjected to double taxation on the event that households decide to make some savings (Mirrlees, 2008:295). Further, the reason that makes the current standard income tax treatment of savings hinder savings by households is that; the present value of the savings as consumed now is higher, compared to the value of the savings in the future, which will have been reduced by the taxation on the returns that such savings will have earned (Form, Smith & Thistle, 2014:27). This is because; inflation is an economic factor that plays in the savings and consumption markets. Consequently, the rate of inflation presently may differ with the rate of inflation in the future, which then means that the savings will have a higher present value currently, than when they are consumed in the future, when the inflation is much higher (Mirrlees, 2008:295). As a result, the households are discouraged from saving, since the rates of inflation keeps fluctuating, and consequently it may not be possible to index the future rate of inflation and to determine whether the current savings will have a higher or a lower value in the future. Additionally, the other factor that makes the current standard income tax treatment of savings unsuitable as a taxation system for household savings is the compound rate of interest phenomena. The compound interest system applied in the current taxation of household savings is progressively punishing, considering that it reduces the overall wealth generated from the savings, as the time saving horizon extends (Mirrlees, 2008:295). Therefore, for an individual seeking to make savings for a longer period of time, the concept of the compound interest system will make a noticeably great difference in wealth created. This is because; a compound rate of interest that affects the savings of an individual by 1% will have affected their savings by 9% after a saving period of 10 years. The difference will be much higher for an individual who will have saved for more years, considering that the compound rate of interest will have affected an individual’s savings by 38%, after a saving period of 50 years (Mirrlees, 2008:295). Therefore, the combination of the inflation factor and the compound rate of interest, means that the value of the savings made currently by the household will be reduced substantially when consumption is done in the future, than it would become apparent for an individual looking at the statutory schedule of taxation rates. A description of the proposed recommendations The proposed three approaches to arriving at a savings-neutral system are equivalent in respect to normal returns, and can only differ where the returns are supernormal. The proposed recommendations are: Cash-flow expenditure tax approach (EET) This is a proposed approach to taxation of the household savings, based on taxing only incomes used for consumption, at the time that such income is spent (Mirrlees, 2008:297). This approach amounts to saving the household incomes in a tax deferred account, where the incomes can be received presently and saved without being taxed. In this approach, the savings are secured from being taxed for the whole duration that they will be saved, and the taxation will only occur when the savings have been withdrawn and then spent (Entin, 2014:n.p.). This approach to achieving a savings-neutral system applies the pensions schemes saving model, where all the savings are done over the whole life time of an individual’s work, and only taxed after the pensions have are withdrawn, during the expending of the savings (Mirrlees, 2008:297). The advantage associated with this proposed approach to taxation is that; it eliminates the distortions associated with the current comprehensive income tax treatment of savings, while ensuring to bring on board the excess returns earned from supernormal returns into the tax base, so that they are equally taxed (Mirrlees, 2008:298). Labour earnings tax approach (TEE) This is a proposed approach to the taxation of household savings, geared towards achieving savings-neutral, through excluding all households saving incomes from taxation, with an exemption of when the savings are made for the first time (Mirrlees, 2008:297). This approach seeks to ensure a fair and equitable taxation of household savings without the limiting distortions. This serves to ensure that the only tax applicable on the household savings is on the principle sum that is saved. The rest of the returns that is generated from the earnings on the savings are then shielded from taxation, to ensure that the household savings create wealth that is not reduced over the period of saving (Hassett & Hubbard, 2002:45). However, the limitation associated with this proposed approach to the taxation of the household savings is that; while it achieves savings-neutrality for the normal returns, the method leaves the excess returns in the form of supernormal returns untouched (Mirrlees, 2008:298). To this effect then, it does not matter how better the investments will perform; the excessive gains will still remain out of the tax bracket. The other difficulty associated with the Labour earnings tax approach is that; it requires a very sharp scrutiny and differentiation o f the income and the investment savings, considering that the income savings are taxed under the approach, while the investment incomes are spared the taxation (Mirrlees, 2008:299). Income tax with a rate-of-return allowance (TtE) This is another proposed approach to realizing savings-neutral taxation of the household savings, through the taxation of the labour earnings and the supernormal earnings from the excess returns on savings (Mirrlees, 2008:298). Thus, under this approach, the normal earnings from the savings are spared from taxation, with taxation only being applied after the returns have surpassed the normal earnings rate. The benefits associated with this proposed approach to achieving savings-neutral taxation system is that, it helps to eliminate the distortions associated with the current comprehensive income tax treatment of savings, while ensuring that the excessive earnings from the savings in terms of supernormal returns are brought into the tax bracket (Mirrlees, 2008:298). Further, the approach offers a wider benefit than the traditional consumption tax system, since it presents minimal disruptions in its implementation (Mirrlees, 2008:299). The purpose for providing a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers The neutrality of a taxation system is a principle based on the concept of time and type of assets. The purpose for providing a tax system with a neutral treatment of savings during the entire life-cycle when the savings are made is therefore divided into two: First, the major purpose for providing a tax system with a neutral treatment of savings during the life-cycle is that, neutrality enhances the choice of the consumers on the most appropriate time that they should make such savings (Mirrlees, 2008:292). This is because, a taxation system that does not offer the neutrality treatment of savings serves to distort the choices for tax payers, considering that they are not sure of the benefits or the loss they will derive from their savings. This is because, the concept of compound interest that is applied to compute returns on savings, coupled with the economic factor of inflation fluctuation, creates uncertainty for the households on whether they should save their incomes or consume them presently (Mirrlees, 2008:293). Thus, the purpose of providing a tax system with a neutral treatment of savings during the life-cycle is to remove the hindrances brought by the comprehensive tax system currently operating, and thus allow more taxpayers to engage in savings. Secondly, the purpose for providing a tax system with a neutral treatment of savings during the life-cycle for the vast majority of taxpayers is that; it will help to realize the equality of earnings from different assets, such that those investing in pensions, housing or financial assets will benefit equally from their savings (Mirrlees, 2008:294). The concept of neutrality serves to establish a system whereby, the vast majority of taxpayers have equal choices in regard to the form of assets that they should place their savings. This is because, with the current comprehensive income tax treatment of savings, some taxpayers are benefitting more than others, since those involved in pension schemes are saved from taxation in the course of the saving life-cycle, while the other categories of investors are being taxed on their earnings throughout the saving life-cycle (Mirrlees, 2008:294). For this reason, the establishment of neutral treatment of savings during the life-cycle will ensure that the vast majority of tax payers are not taxed on their earnings, and thus will only pay taxes on their earnings at one point. This way, the neutral system will create equality and enhance diverse choices of the assets to save in, for the vast majority of taxpayers. Opinion on the strengths and weaknesses of the proposals Strengths The proposal has several strengths, compared to the current comprehensive income tax treatment of savings in that; The proposals offer a wider choice for the vast majority of the taxpayers, considering that the implementation of the proposals will ensure that the issues that hinder the tax payers from engaging in savings, especially due to the uncertainty of the future value of their investment will be eliminated (Mirrlees, 2008:292). Another strength associated with the proposals is that, they offer the taxpayers a variety of choice on the type of assets that they can put their saving in, considering that whole benefits of deferred taxation is offered equally by all asset types as proposed by the recommended proposals, thus it will be possible for taxpayers to invest in the asset type of their choice (Bradford, 1986:39). Weaknesses The weakness associated with the proposals is that, some of the recommended approaches have the risk of leaving out the excessive earners obtainable from the supernormal returns on investment out of the tax bracket, making it difficult to achieve the desired equitable taxation for all (Mirrlees, 2008:294). The other weakness is that, the implementation of some of the recommended proposals, for example the consumption tax approach, will create a wide array of disruptions in the tax system during their implementation, making the proposals unfavorable for immediate implementation (Mirrlees, 2008:299). Explanation of the type of potential winners and losers of such a move There are potential gainers and losers from the move to implement the recommended savings-neutral approaches to the taxation of households. The likely gainers are the taxpayers, who will gain through having an equal choice to make between consuming their incomes presently or saving them for the future, since the savings present value will be maintained (Mirrlees, 2008:293). Secondly, the taxpayers will gain through having equal opportunities to select on the type of asset they wish to invest in (Mirrlees, 2008:294). The losers in this move will be the financial institutions, considering that they are entities involved in receiving savings deposits from the customers, and then charging interests on such savings. The move to establish a savings-neutral taxation system will reduce their interests chargeable on the savings, considering that they will be required to impose interest charges only once; the first time the savings are made (Form, Smith & Thistle, 2014:32). The other losers will be the mortgage, building and housing corporations, since they are the institutions mostly engaged in receiving investment from the taxpayers. The introduction of a savings-neutral taxation system will serve to mean that such entities will no longer be able to charge interests on the savings made by the customers, thus reducing their revenue margins. References Bradford, D. F. (1986). Untangling the income tax. Cambridge, Mass: Harvard University Press. Entin, J. S. (February 24, 2014). Keys to Avoiding the Economic Pitfalls of Revenue Neutral Tax Reform. Tax Foundation. Retrieved March 6, 2014 from http://taxfoundation.org/article/keys-avoiding-economic-pitfalls-revenue-neutral-tax-reform Form, J.P., Smith, J. W. & Thistle, D. (March 2014). On the Definition of Tax Neutrality: Distributional and Welfare Implications of Policy Alternatives. Public Finance Review Journal 42 (2), 13-23. Greenstein, R. (April 30, 2013).Revenue-Neutral Tax Reform: The Road to Nowhere on Deficit Reduction. Center on Budget and Policy Priorities. Retrieved March 6, 2014 from http://www.offthechartsblog.org/revenue-neutral-tax-reform-the-road-to-nowhere-on-deficit-reduction/ Hassett, K., and Hubbard, R. (2002), ‘Tax Policy and Business Investment’, Amsterdam: Elsevier. Mirrlees, J. A. (2008). Tax by design: The Mirrlees review. Oxford: Oxford University Press. 283 – 317. Read More