Taxation of Life-Cycle Savings - Essay Example

Taxation on Household Savings Inserts His/Her Inserts Inserts Introduction In modern life, the decision of how much individuals should save for the future and how much they should use for normal day to day activities can be regarded as being the most important economic decision in our society. This decision not only impacts the safety of households making this choices, but it also has a considerable impact on the rate of economic growth and investments imperative for the wellbeing of future generations. Taxation is among some of the policies that affect household savings (Boadway & Wildasin 1995). Other policies that affect savings include systems of social security, debt policies, and education and welfare services. Household savings are composed of several aspects important for tax analysis. The first vital factor is that the main purpose of savings is future consumption, which takes savings as the value and not the quantity. The worth of future consumption as expressed by present consumption is the after-tax discount offer. This means that savings can be expressed as the discounted current cost of future consumption. The second important factor is the nature of budgetary constrictions. The income of different households may at times be in terms of a stream of earnings. This means that constraints to the household budgets will involve an existing value of earnings, described as lifetime wealth. Uncertainty about future trends as well as individual characteristics about saving form other issues affecting savings. Taxation of Personal Savings in the UK Taxation of household savings plays a very important role in the development of taxation systems. First, the development of different tax depends on the taxation of savings. The manner in which taxation of savings is carried out defined the difference between the two main forms of tax base. If a tax base is expressed as being composed of labour earnings and income from savings and these two components of the tax base are equally taxed, we then have the comprehensive income tax. However, if labour earnings and the income from savings are not taxed until they are utilized for consumption, then the tax system that arises is termed as the “consumption tax” or an “expenditure tax”. Secondly, taxation of savings provides the limits through which interpersonal differences in lifetime income can be recognised from annual income by the tax system utilised (Boadway & Wildasin 1995). The design of an efficient tax system of savings is an important approach of equalizing the tax burden on citizens having comparable lifetime earnings but diverse patterns of income. Third, taxation of savings lies at the margin between taxation of the profits coming from companies and the taxation on the income of individuals. The manner in which savings are taxed has the ability to sway the behaviour of small businesses and people who are self-employed. It also has an impact on how large firms allocate capital. Fourth, taxation of savings can impact how much savings exists in the economy as well as how these savings are distributed across diverse assets. This in turn affects the total amount of invested capital and the manner in which this capital is invested. Finally, taxation on savings affect how household decide on the total amount to save, when to save, and the amount of risk they are ready to take in deciding how to distribute their savings among different assets. The way in which taxation is carried out is highly determined by household savings behaviour. Generally people with less income tend to save less but increase their savings in case of an increase in income levels. The amount of household needs also has an impact on savings such as high spending with low savings during holidays, or when there are children needing education. In the U.K., many people are able to balance their spending habits during both their working life and retirement. The tax policy utilized in the country is such that it finds a balance between providing a safety net for those unprepared of their future and avoiding biases on saving behaviour. The current taxation system takes the assumption that households make complex decisions that are dependent on beliefs and informed expectations about future economic trends. The reality however is very different as while people might consider there long term decisions, they usually act on limited information. In the U.K., the income tax and the capital gain tax forms the two most important taxation systems that affects personal savings. The income tax is payable by any tax unit of earnings from savings and is charged at a basic rate of 20% and at a higher rate of 40% (Attanasio & Wakefield 2010). The tax system in the country imposes a tax on the earnings from savings. This system taxes earnings that only compensate for what would be consumed at a later day. According to Parker and Fischhoff (2005), this system of taxation is impartial as it is lenient for current consumers and is hard for those who plan to consume in the future. Some household have an easier time with making consumption decisions especially those with access with enough credit. This however is usually common in older and richer households but not in poorer and younger households. Some households however are quite short-sighted making decisions about the current consumption without any regards about saving for the future. This causes a policy concern about the level to which individuals save enough such that they can support themselves during their retirement age. It has been noted that there is a significant drop in consumption during the time of retirement. A large percentage of this drop can be explained by the circumstances of a life cycle plan while a small percentage (33%) can be attributed to poor planning concerning savings during the working years. Concerns relating to inadequate savings for retirement led the U.K. government to propose a system that would force people to save more through an automatic registration into an employer sponsored pension (Tanzi & Zee 1998). An effective taxation system should take into account the difference in self-control, patience and ability to make long-term plans about the future. It is impossible to have a population that can make the required provisions for their future. This lack of rationality is responsible in some way on how policies about pension, savings and social security are made (Cullen & Gordon 2007). The Neutrality Principle There are two basic concepts of the neutrality principle in related to taxation on savings. The first concept involves neutrality with respect to the timing and level of savings. In this concept, a neutral tax system will not distort the choices people make on when to consume their earnings (Mirrlees Review 2013). The second concept involves neutrality in how people choose to save or their savings assets. In this concept, a neutral tax system does not affect the choice individuals make over the assets in which they save. The U.K. tax system mainly taxes the earning on savings in which the earnings are just reimbursement for the deferral in consumption. This tax system does not satisfy the first criteria of neutrality as explained above. Taxing earnings from savings mean that people who plan to consume tomorrow are more taxed than those how consume today. While taxing based on savings might seems a good way of wealth redistribution, having savings does not necessarily mean that one lives better than those without. Different groups of people work and spend at different times in their life’s, some choosing to work while young and save so that they can spend in their old age while some choose instant gratification. The total resources of individuals can be taxed at the point of entry (earning taxation) or taxing when consumed (taxing expenditure). Those who are better off can be taxed accordingly by ensuring the rate schedule in relation to expenditure or earnings is more progressive. Considering what we know of the spending behaviour of people, the decisions made about savings is not dependent on how much they earn, but on when they decide to spend. Taxing savings therefore is unable to target the rich more accurately that taxing earnings. The proposed recommendations for a neutral system must follow a three step stage that includes: Taxation of income before or at the point when it is deposited in a savings account or used to acquire an asset. Taxation as the returns accrues Taxation when an asset is sold or when one withdraws money from an account When considering development of a savings-neutral taxation, we describe the lifecycle of an invested asset by two notations, (T) for taxed and (E) for those exempt from tax. When we consider the stages above, we can propose three forms of savings-neutral taxation. The first form is the cash-flow expenditure tax. This form of taxation only taxes income used for consumption at the point of consumption and is denoted by EET. The second proposed form of taxation is the labour earnings tax. This form of taxation eliminates all savings income from taxation but offers no exemptions when the savings are first made. It is denoted by TEE. The final proposed neutral taxation system is the income tax with a rate of return allowance. In this form of taxation, labour earnings and supernormal returns from savings are taxed. It is denoted by TTE, where the lower case “t” denotes exemptions from normal returns. The three forms of saving-neutral taxation methods exempt the normal risk free return from taxation and thus do not cause any distortion on the decision of whether to spend today or tomorrow. Analysis of the Proposals The three proposals made seem to seek neutrality in taxation. The proposals come with several advantages over the normal comprehensive income tax current in use. The main advantage of these proposals is that they are able to avoid distortions on the decisions about when to spend savings and how to use these savings. This avoids the obstacle that taxing the income from savings has, where all the income is taxed similarly. Savings denote a deferment of consumption thus by taxing what people have saved, we tax more for tomorrow’s use than those consuming today. The assumption that those with large savings are better off is faulty since the level of savings might be related to the preferred time of spending. These proposals however pose several disadvantages. The labour earnings tax does not tax excess earnings. As such, there is no further taxation applied due to success of particular investments. This type of tax system is inappropriate for those savings that yield more than the normal returns. This means that the use of this tax system could result in people putting more effort to elude it such as stock-picking. For assets with extraordinary returns, the cash flow expenditure tax and the rate of return allowance tax offer a good system for taxation. The cash flow expenditure tax targets those with variable consumption more while the rate of return allowance tax mainly targets those with variable earnings. This means that the rate of return tax is less for those saving in times of low consumption and withdrawing in times of higher consumption. The cash flow expenditure tax on the other hand will tax more for those planning to spend tomorrow while having a constant income. The difference between the cash flow expenditure tax and the rate of returns tax can be resolved by giving the people a chance to choose which they would rather adopt. In both these case, someone is sure to benefit when others suffer. In the cash flow expenditure tax, those with a stable job, especially white collar workers, have a lot to gain. This is also the same to large organizations having a lot of capital. White collar workers usually do not put their money first so that they can trade however those in the blue collar sector (self-employed) may at times be needed to put something in so as to get an income. As such, they are taxed twice, that is, when they put money in order to do their job and when they buy personal items. Conclusion Taxation is among some of the policies that affect household savings. However, modern systems of taxation are not neutral and seem to distort household savings behaviour. By applying taxes on the income from savings, we assume that the amount saved corresponds to the level on income rather than how a person chooses to spend their savings and when. The three proposed taxing systems seek to develop a savings-neutral taxation system. This system thus ensure that the choice of when to consume and in what manner one’s saving take, does not affect how they are taxed. References Attanasio, O. & Wakefield, M. 2010. The effects on consumption and savings of Taxing’s Assets Returns. Mirrlees Review. Available at: http://www.ifs.org.uk/mirrleesreview/dimensions/ch7.pdf [Accessed 6 March 2014] Boadway, R. and Wildasin, D. 1995. Taxation and Savings: A Survey. Fiscal Studies, 15, pp. 19- 63 Cullen, J.B., Gordon, R.H. 2007. Taxes and entrepreneurial risk- taking: Theory and evidence for the U.S. Journal of Public Economics 91, 1479-1505. Mirrlees Review. 2013. “The Taxation of Household Savings.” Available at: ifs.org.uk › mirrleesreview. [Accessed 6 March 2014] Parker, A.M. & Fischhoff, B. 2005. Decision-making competence: External validation through An individual-differences approach. Journal of Behavioral Decision Making, 18(1), 1-27 Tanzi V. & Zee, H. 1998. Taxation and the House Saving Rate. International Monetary Fund. Available at: http://www.imf.org/external/pubs/ft/wp/wp9836.pdf [Accessed 6 March 2014] Read More