Tax System with a Neutral Treatment of Life-Cycle Savings for the Vast Majority of Taxpayers - Essay Example

Evaluation of a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers of the current system The current system of household taxation hinders households from making savings, by encouraging them to consume their incomes presently. This is because, the current system subjects all households incomes to taxation when they are received, as well as the returns that such incomes earn, if the households opt to save the income for future consumption, rather than consuming it currently (Mirrlees, 2008:295). Thus, the current standard income tax treatment system of household income makes the future consumption of incomes more expensive than the current consumption. This is because, if the households receive income and consume it currently, they will only be prone to single taxation of that income, when they consume it. However, should the household hold opt to save the income and consume it in the future, the household will be prone to double taxation, considering that the income will be taxed when it is received, and the returns that such income earns when it is saved for future consumption will also be taxed (Mirrlees, 2008:295). Further, saving the households income for future consumption under the current standard income tax treatment system will make such future income consumption even more expensive. This is due to the consideration that, depending on the rates of inflations and how such inflation rates fluctuate, the incomes saved will end up being taxed not only on the real incomes, but also on the nominal income. This increases the charges on such income and makes it more expensive to consume in the future, than it is to consume the income currently (Mayshar, 1990:263). The standard income tax treatment system of household savings hinders the ability and willingness of the households to save their incomes in various ways. First, the current system of taxation applies compound rates of interest (Mirrlees, 2008:295). This means that the rate of effective returns is reduced with the increase of the duration of savings, such that the longer the period the households save their incomes, the less the interests they will earn from the savings. In this respect, the compound rate of interest applied by the current system becomes increasingly penal with the extension of the time horizon for savings, thus hindering the households from making long-term savings (Mirrlees, 2008:295). Thus, for a young person who would like to save their incomes over a long period of time, they will find that the interests attracted by their savings keep decreasing as the time they are saving progresses, meaning that the ability of such young people to create wealth out of the savings becomes increasingly difficult (Bradford, 1986:27). For example, a bank interest rate that reduces the rate of earning for the savings at a rate of 1% annually will eventually have reduced the value of the savings by 9% after duration of 10 years, and by the end of 50-year duration, the value of the savings will have been reduced by 38% (Mirrlees, 2008:295). In this respect, the application of the compound rate of interest discourages the households from making savings, and thus makes them opt to consume their incomes presently. Secondly, inflation is factor that contributes to the uncertainty of the gains that the households will make out of investing their incomes under the current standard income tax treatment system. In this case, unless there is full indexation of the rate of inflation over the full duration of savings such that it remains constant, the value of gains on the incomes that have been saved by the households will remain uncertain (Mirrlees, 2008:295). The rate of inflation keeps changing depending on various economic factors that are at play within a certain economic period (Kim, 2008:42). Therefore, where the rate of inflation increases, the value of the savings made will decrease and vice versa. However, since it is not possible to accurately determine the rate of inflation that will be experienced in the future, it becomes difficult for the households to determine the likely gains that they will make through saving their incomes, or whether they will lose the value of their incomes, in case inflation becomes high in the future. Consequently, the households opt to consume their incomes presently, thus reducing their savings (Mirrlees, 2008:295). In conclusion therefore, the current standard income tax treatment system for savings reduces the future value of the current incomes, by reducing the amount of goods and services that the savings can purchase in the future, effectively discouraging the households from saving their incomes for future consumption. Description of the proposed recommendations The proposed recommendations cover three different methods which might see the current system of taxation transformed into a savings-neutral system. The three proposed systems are based on different stages of the saving life-cycle, with the first proposed recommendation based at the early stage of the savings life-cycle which is the point at which income is received, the second stage based at the stage where the income earns returns, while the third proposal is based at the last stage of the savings-lifecycle, where the savings and the returns earned are withdrawn for consumption. The proposed methods include: Cash-flow expenditure tax approach This is a proposed recommendation for achieving a savings-neutral taxation system through the taxation of household incomes only when the income is spent (Mirrlees, 2008:299). Under this proposed recommendation, the households will earn their savings in full and preserve them for the duration they might deem necessary, without the income being taxed, until when the income will be used for consumption at the time the expenditure is made (Mirrlees, 2008:285). In so doing, this proposed recommendation ensures that the income earned by individuals is only taxed once, thus providing an incentive for the households to save their incomes, since it will not be subjected to taxation during the saving period. Labour earnings tax This is a proposed recommendation for achieving a savings-neutral taxation system where all the saving incomes are exempted from taxation, with the exception of the first time when the savings are made (Mirrlees, 2008:285). Under this proposed recommendation, the income received by the households and then deposited into savings is taxed the moment it is deposited, and then no more tax is applied to the savings afterwards. This way, all the returns that the savings earning over the duration when the income is saved will not be taxed (Mirrlees, 2008:297). This way, the households are able to create wealth through saving their incomes, since the returns earned by the incomes will not be reduced by taxes, thus, encouraging the households to save (Kahn, 1990:7). Income tax with a rate-of-return allowance This proposed recommendation to achieving a savings-neutral taxation system entails the taxation of labour incomes and the excess returns that are earned by the savings above the normal returns (Mirrlees, 2008:297). Under this proposed recommendation, the returns earned by the savings are exempted from taxation, as long as they remain within the normal rate of returns. However, if the returns exceed the normal rate and thus become supernormal returns, such returns are subjected to taxation (Mirrlees, 2008:285). While the taxation of supernormal returns ensure that the excess earnings from savings are brought into the tax bracket, the exemption of normal returns from taxation ensures that the income of households is able to generate returns without being reduced by taxation, thus making it possible for the households to create wealth through savings (Mayshar, 1990:269). Purpose of a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers First, the purpose of establishing a savings-neutral taxation system for the vast majority of taxpayers is to give the households a fair and equal choice on whether to consume the income now or save the income for future consumption, since the value of the income will remain constant under savings-neutral system (Mirrlees, 2008:292). This is achieved through ensuring that the time distortion existing in the current standard income tax treatment system is addressed. The current taxation system creates the distortion of time in savings, considering that there is a disparity created between the value of consumption presently, and the value of consumption in the future (Mirrlees, 2008:294). Under the current system, the value of income in the future is lower compared to the value of income presently, due to the operation of both inflation and compound rate of interest system, which affects the future value of income saved by the households, through reducing its purchasing power. This makes the households capable of purchasing more commodities presently with the income, as opposed to the quantity of such commodities they can purchase in the future using the same income (Kahn, 1990:12). The second purpose for establishing a savings-neutral taxation system is that, the vast majority of taxpayers will benefit from having an equal and fair choice between the types of assets they would wish to invest their savings. The savings-neutral taxation system ensures that all saving assets produce equal value for the savings invested (Mirrlees, 2008:295). Under the current standard income tax treatment system of household savings, different saving assets produce different values for individuals, where those investing in pension savings have their savings exempted from taxation, while those saving in other assets are taxed both on their savings and on the returns they earn from their savings (Mirrlees, 2008:294). This way, the application of the savings-neutral taxation system will give the vast majority of taxpayers’ equal choices on whichever assets they may opt to save their incomes in, since the savings and the returns will be equally spared from taxation (Kim, 2008:33). Opinion on the strengths and weaknesses of the proposals The proposed recommendations have two main strengths. First, the implementation of the proposals will ensure that taxpayers have equal choices between consuming the income now and saving the incomes for the future, thus eliminating the uncertainty associated with the current system of taxation (Kahn, 1990:15). Secondly, the implementation of the recommended proposals will ensure that the taxpayers have equal choices regarding the type of assets they would opt to put their savings in, considering that under all categories of saving assets, their savings will be spared from taxation (Mirrlees, 2008:292). Weaknesses There are two weaknesses associated with the proposed recommendations for the achievement of a savings-neutral taxation system. First, while some of the proposed recommendations bring the supernormal earnings under the taxation brackets, others do not provide for the taxation of the supernormal returns, thus creating inequality between taxpayers (Bradford, 1986:77). Secondly, the proposed recommendations only caters for the life-cycle savings, while leaving out other wealth creation avenues such as inheritances and bequests (Mirrlees, 2008:307). This means that the proposed recommendations for the achievement of a savings-neutral taxation system are not comprehensive. Potential winners and losers of such a move The potential winners of the implementation of a savings-neutral taxation system are the households and the taxpayers, because they will be able to have fair and equal choices regarding both the time of consuming their incomes and the type of assets they may want to invest their incomes in (Mirrlees, 2008:293). However, the potential losers are the deposit-taking institutions, since they will no longer be able to subject the savings made to any charges (Kim, 2008:56). This will effectively reduce their revenue earning capabilities. References Bradford, D. F. (1986). Untangling the Income Tax. Cambridge: Harvard University Press. Kahn, D. A. (1990).The Two Faces of Tax Neutrality: Do They Interact or are They Mutually Exclusive? Northern Kentucky Law Review18, 1-22. Kim, S. B. (2008). A value-added tax (VAT) and the federal income tax reform. Ann Arbor, Mich.: UMI. Mayshar, J. (1990). Measures of Excess Burden. Journal of Public Economics, 43, 263-289. Mirrlees, J. A. (2008). Tax by Design: The Mirrlees Review. Oxford: Oxford University Press. 283 – 317. Read More