Greg Mankiw endorses the Bowles-Simpson recommendation to eliminate the mortgage interest deduction. I am not convinced. Here’s why:
I start from the position that capital income (including interest income) ought not be taxed. Unlike a tax on labor income, which (unfortunately) discourages work, a tax on capital income discourages both work and saving, and so is doubly destructive. Moreover, it effectively taxes the labor of the young (who earn, save for a while, and then spend) at a higher rate than the labor of the old (who earn, save for a shorter time, and then spend), which is both unfair and distortionary (in that in encourages young people to postpone their high-earning years).
If you discourage saving, you discourage capital formation, which means you dampen wage growth. (“Capital” here refers to factories, machines, etc., not to financial instruments.) In the long run, the one and only thing that drives wage growth is worker productivity — and the key reason workers become more productive is that they have better equipment to work with. A tailor with a sewing machine is more productive, and therefore earns higher wages, than a tailor with a needle and thread. So if you tax capital to avoid taxing labor, you’re doing labor no favor in the long run.
If you want to tax capital income because you think it accrues mainly to “the rich”, who already claim too many resources, keep in mind that capital taxation encourages the rich to save less, consume more, and therefore command even more resources. It is counterprodutive to adopt a tax policy that encourages even more consumption by the people you believe are consuming too much already.
Greg Mankiw has eloquently made some of these very arguments with regard to the estate tax (which is one form of capital taxation), but at least some of those arguments apply more generally.
So what does all this have to do with the mortgage interest deduction? Answer: Mortgage interest is (unfortunately) taxable income to the lender. And I like the mortgage interest deduction because it effectively undoes that tax.
How so? Take an example. In a world with no taxes, I lend you money to buy a house. Every month you pay me $100 in mortgage interest. Now the government starts taxing that income. As a result, fewer people are willing to lend and the interest rate rises. You’re now paying me (say) $130 a month, of which I’m keeping (say) $80 after taxes.
Now let’s throw in a mortgage interest deduction. Now more people want to borrow, and that pushes the interest rate up still further. You’re now paying me $150 a month, of which I’m keeping $100 after taxes. And that $150 a month costs you only $100 a month, because you’ve got your deduction. You and I are both right back where we were in the world without taxes. So adding the mortgage interest deduction is equaivalent to subtracting the tax on interest.
Wait a minute now. The tax on interest pushes down my after-tax return, and the mortgage interest deduction (by increasing the demand to borrow) pushes up my after-tax return. But my example claimed more than that — it claimed that the two effects are not just in opposite directions; they are equal and opposite, so that my after-tax income returns to its original $100. Where did that come from? Answer: It’s a standard exercise in economic theory, which I hope my sophomore-level theory students can all carry out. The proof fits easily on a blackboard, but not (unfortunately) in a blog post. (It also relies on certain assumptions, e.g. that the borrower and the lender are in the same tax bracket. These assumptions are probably not literally true, but close enough for practical purposes.)
So I like the mortgage interest deduction because it effectively repeals a bad tax. But a possible response to that is that not all bad taxes should be repealed. Sometimes two bad taxes are better than one. Mankiw essentially makes this argument when he says that “tax subsidies to housing, together with the high taxes on corporations, cause too much of the economy’s capital stock to be tied up in residential structures and too little in corporate capital.”
His (quite reasonable) point is that given the existing tax on corporate capital, it might be a good idea to tax residential capital, even if what we’d really prefer is a world where neither corporate nor residential capital was taxed. (Our commenter Doug raised the same point in comments last week here on The Big Questions.) To put this another way: We currently have too much consumption and too little investment. If we eliminate the mortage interest deduction, fewer resources will go into residential investment. I am pointing out that some of those resources will go to consumption, which is bad. Greg is pointing out that some of those resources will go to more productive types of investment, which is good. To this I have three responses:
- Thanks to our system of IRA’s, 403(b)’s, 401(k)’s, Keogh plans and the like, a lot of dividends and capital gains are not taxed (though they’re still usually implicitly subject to the corporate income tax). So it’s not like we’re starting from a position where all capital is taxed equally. We’ve already carved out a bunch of exemptions, and I think that’s on balance a good thing.
- Sometimes the best way out of the swamp takes you temporarily a little deeper into the mud. The ultimate goal is to eliminate all capital taxation. The mortgage interest deduction effectively eliminates some capital taxation, at the possible cost of diverting capital from more productive uses in industry to less productive uses in real estate. This could well make us worse off for the time being, but if it’s the first of many steps in the right direction, that could be a price worth paying.
- The strength of these arguments depends partly on the magnitudes of the various distortions involved and partly on your political model of whether steps in the right direction tend to be precursors to further steps in the right direction. At least regarding the former, it ought to be possible to make some useful estimates. Depending on what those estimates show, I could conceivably switch over to Greg’s side of this issue.
Saving is good because it allows investment. Yet last week Scrooge was lauded for keeping lots of money in his swimming pool and nuzzling it. Scrooge’s money cannot inrease productivity, so is his behavior a good thing or not?
This way out of the swamp has us chin-deep in mud already and getting deeper. Saving is good, but not all of its vehicles are equal.
Encouraging the populace to invest the greatest part of their worth – tying up big chunks of the financial sector in the process – in a single immobile, indivisible, physically vulnerable, and (as a lot of folks are now finding out) financially volatile asset would appear to be problematic, to put it gently. That’s before looking at the effects on labor mobility, capital allocation, and (you won’t see me invoke this often) the environment.
Harold:
Yet last week Scrooge was lauded for keeping lots of money in his swimming pool and nuzzling it. Scrooge’s money cannot inrease productivity, so is his behavior a good thing or not?
Scrooge saves, and therefore allows investment. The goods he does not consume are available for others to consume or invest.
Since I’m a bit of a Georgist, I have a question: Would there be a difference if mortgage interest were fully deductible on improvements, and removed completely from land value? The value of a home is a combination of the site value and the value of the improvements, and while tax policy can change the incentives on the labor and capital involved, nothing you do will encourage (or discourage) the formation of land.
(I just woke up and am getting ready for work, so I haven’t had a chance to work through it.)
Heh, that will teach me to write when I’m half asleep. I meant:
Would there be a different result if you could fully deduct mortgage interest from improvements but not from land?
A further question would be: Assuming the change is revenue-neutral, what would the difference be in the following:
1. Full mortgage interest deduction on land, but no deduction on improvements.
2. Full mortgage interest deduction on improvements, but not on land.
3. Mortgage interest deducted at the same rate for both.
I’m with Mankiw, I think if anything, people do need a nudge away from investing in their houses.
In my two years in the Navy, I’ve seen so much stupidity with houses. People talk about equity like it is better than money in the bank or the value in stocks. I’ve had people brag to me about making $10K on a $200K house over two years (that’s only 5%/year!).
The military is now bailing out anyone who lost money on houses they’ve moved away from that have lost value do to the collapse of the bubble. Also due to the collapse of the bubble, I’ve seen lots of guys have to leave their families behind when it is time to move since they can’t afford to sell their houses and need to move into the bachelor’s quarters at their new base.
In my recent search for a house to rent, I found landlord after landlord who refuses to acknowledge that there is a glut of empty houses in this area. They would all rather have houses go empty month after month then rent them out at a monthly loss or sell them at a loss. The neighborhood I finally moved into has about 80 homes and a dozen empty ones, down from 13 when I moved in several months ago.
Home ownership is an irrational thing for a significant minority of those who have chosen to do it. Poll anyone who has bought a house and I’m quite certain you will hear the same that I’ve heard; the tax break is among the biggest reasons and for some, the only thing that makes it possible.
@Harold
The good professor’s answer is of course correct. The equivalent macro way of thinking about the dollars in Scrooge’s vault is that by Scrooge’s withdrawal of these dollars from circulation allows the monetary authorities to create that many more dollars without zero net effect on inflation. If Scrooge ever decides to spend his dollars, the monetary authorities can again cancel the inflationary effect by destroying (or not creating) that many dollars. In order words, if you have a competent monetary authority, Scrooge’s dollars will circulate in the economy even as he keeps them in his vault.
@Prof. Landsburg
Thank you for coming out against abolition of the mortgage interest deduction. In contrast to many clever and otherwise ideologically congenial (to me) economists (like Mankiw), I’ve had doubts on the wisdom of abolition since learning the following argument from my tax law professor (the late, great Martin Ginsburg):
Consider three, otherwise equivalent individuals: Owner (O), Mortgagor (M), and Renter (R). Each of them wants to live in a house which provides the equivalent of $100,000 in “housing services” every year.
O owns such a house outright. That means that he receives the $100,000 of housing services every year tax-free. It is true that he paid for the house up-front, but if he had made the same investment, for example, in interest-bearing bonds, he would had to pay taxes on the income. By receiving the housing service in-kind, he avoids creating any tax liability.
R rents such a house. His rent will be $100,000 and all of it will be paid out of after-tax income.
M owns the house, but has a mortgage for its full value. He receives the housing-services in-kind too, so he is not taxed on them. But he has to pay the mortgage. If there is a mortgage-interest deduction, he will effectively pay for the house with untaxed dollars.
So the current law (under appropriate assumptions about interest rates and inflation), allows M and O to consume housing services untaxed, but taxes R. This seems unfair to R and it certainly distorts the choice from renting to owning (with or without a mortgage).
Abolishing the mortgage interest deduction, would tax M’s and R’s housing services, but leave O’s untaxed. That would seem to be equally unfair and distorting as the current setup.
The only way to consistently tax housing services without distorting the rent/mortgage/own decision is either to tax all which would involve not only the abolition of the mortgage interest deduction, but also taxing home owners on imputed income from their house. That would be both politically suicidal and technically quite difficult.
Alternatively, we could leave all housing services untaxed. That would involve keeping the interest deduction, but allow renters to deduct rent too. That would be technically easier, but seems almost as unlikely politically.
But playing with the deductibility of the mortgage deduction alone is not going to solve, or even necessarily move in the direction of solving, this conundrum.
“Unlike a tax on labor income, which (unfortunately) discourages work”
The substitution effect tells us this is true. What about the income effect in this scenario? We cannot conclude that a tax on labor income will discourage work, it has an ambiguous effect.
It’s not clear to me why you never want to tax capital income.
My understanding of the Chamley-Judd result is this: if consumers have homothetic utility, then we want uniform commodity taxation (and hence no capital income taxes). But homothetic utility is a wildly implausible assumption. Stiglitz constructed examples where he breaks Chamley-Judd. Are his assumptions any less plausible than homothetic utility?
“The value of a home is a combination of the site value and the value of the improvements, and while tax policy can change the incentives on the labor and capital involved, nothing you do will encourage (or discourage) the formation of land.”
False. See for example land reclamation and seasteading.
I learned this conundrum from the late great David Bradford, and it doesn’t cause me to embrace the mortgage interest deduction. To the contrary, it leads me to question Landsburg’s income-from-labor/income-from-capital distinction.
I pay Joe to work on my house. He’s taxed on the amount I pay him. I pay Bill to work on my house, but I provide him housing instead of a salary. Why should the manner in which I pay him influence the amount of tax he pays? It shouldn’t; the market value of the housing should be taxable as income (a “fringe benefit”).
Similarly, I work on my house and provide MYSELF housing. Why should the stream of benefits Bill receives be taxed differently than the stream of benefits I receive?
Yes, it’s technically difficult to set a tax rate that places a market value of a stream of benefits flowing from a capital asset. No, it’s not political suicide; it’s called a property tax.
I sense that the foundation of my confusion about these matters lies in my fundamental confusion about the distinction between consumption and investment. If I buy a washing machine, does that count as an act of consumption or an act of investment? How about a car? How about a vacation? I still derive utility from the memories of vacations I took as a child; that’s been quite a long pay-out. Is this really so different than if I’d received an annuity? Is our treatment of consumption just another example of latent Puritanism/Mercantilism in our public policy?
Whoops — Dr. Lehrer didn’t post that last comment; I did. I’m not only confused about consumption and investment, I also have some difficulty with cut-and-paste.
Why is buying a big house considered an investment rather consumption?
“if you have a competent monetary authority,” I hope some of these beneficial efects occur even withiut this caveat!.
Regarding O, R and M. I started off down a simplified world with no inflation and no interest. I then realised that with no interest there is no interest tax relief, so it didn’t help much. Does this tie in with the Aeternitatis’ comment “If there is a mortgage-interest deduction, he will effectively pay for the house with untaxed dollars.”. In fact does he pay for the house with untaxed dollars, but the interest with untaxed dollars?
If the comment that the system with tax relief puts the renter in the worst position, then this is a case for abolishing tax relief, as the poorest tend to be the renters. We do not want to single out the poorest for worst treatment.
Robert said:
““Unlike a tax on labor income, which (unfortunately) discourages work”
The substitution effect tells us this is true. What about the income effect in this scenario? We cannot conclude that a tax on labor income will discourage work, it has an ambiguous effect.”
Dang, someone beat me to it.
Too much generated income also discourages work because the opportunity cost for working that extra day, hour, effort, etc. means one must forgoe time spent with family, friends, vacation, doing hobbies, etc.
Robert: The income effect is present regardless of what you’re taxing. If you’re comparing a tax on labor to some *other* tax, it’s the substitution effect you want to focus on.
Also, because I’m studying macro this morning, I’ve had to look over the IS relation again.
I = S + (T-G)
It could be the case that, for the economy as a whole, investment would decrease if taxes (T) were to decrease. Then again, considering c1(Y-T), a decrease in T would increase consumption…again showing an ambiguity.
“The value of a home is a combination of the site value and the value of the improvements, and while tax policy can change the incentives on the labor and capital involved, nothing you do will encourage (or discourage) the formation of land.”
False. See for example land reclamation and seasteading.
I mean “land” in the economic sense of a naturally-occurring resource that is fixed in quantity (in this case, geographic location). Seasteading and land reclamation would both be classed as improvements (compare the value of a seastead off the coast of Long Island with an identical one in the middle of the Pacific).
{Please consider the unadorned block quote of Mr. Lehrer from my previous comment to be the start of this comment}
Fair enough. But for a property tax to accurately compensate for the conundrum we discuss it would (1) have to represent an equal share of the economy-wide rate of return as the income tax rate and (2) not be charged on rental property. It seems that (1) exists only rarely and purely by chance and (2) is unheard of (by me at least). (And had I realized that David Bradford taught such interesting things, I would have signed up for his class at the time).
@Harold
Actually they do, at least if prices are free to move (which is not always a valid assumption). If there was no competent monetary authority (or a monetary authority without discretion as it is tied to a gold or other commodity standard), Scrooge’s dollar hoarding would have a deflationary impact. While Scrooge withholds his dollars, all the other dollars effectively become more valuable and can purchase a greater quantity of goods and services. If, again, prices are free to move, the effect is the same.
No, because I assumed that M got a mortgage for the full price of the house. In other words, he didn’t pay any dollars, taxed or untaxed. Realistically most people have some downpayment, but that just makes the realistic M a mixture of our stylized M and our O. So it deviating from these stylized facts adds nothing to the analysis except complication.
If you want to do the math assume a real interest rate (5%, let’s say) and 0% inflation.
One amusing side-effect of the mortgage interest deduction in the presence of substantial inflation is that the government may effectively pay you to live in your home. For example, with 5% real interest and 10% inflation, you’ll $150,000 annually on a interest-only loan for the full price of a $1,000,000 house. If you live in a $1,000,000 house, you’ll probably pay about 40% in income taxes, so the mortgage interest deduction ($60,000) results in a net annual payment of $90,000. But at the same time, due to inflation, your house will have increased in value from $1,000,000 to $1,100,000. Bottom line: You live rent-free and the government threw in $10,000 for good measure.
In theory part of that gain may be lost on sale when you pay capital gains tax on illusory inflation gains in the price of the house. But (a) long-term capital gains tax rates are very low, (b) there are large loopholes often allowing you to avoid capital-gains taxes on the sale of your residence, and (c) if you die with the house, you’ll never pay capital-gains taxes and neither will your kids due to step-up basis.)
Maybe, but is poor R really going to be comforted by M joining him in misery, while O–surely the richest of them all on average–continues to escape tax?
I am skeptical about this being a way out of the mud. This deduction is functionally a “subsidy” which benefits only a slice of society. It attracts then a lobby and it becomes hard to kill. If SL gets the no capital taxes regime he wants he is likely to still have this deduction. We have now a rare opportunity to kill it. Bird in the hand.
There must be something that I’m overlooking. Perhaps somebody can help. It seems to me that the value of a house is basically comprised of two things: First, the “market price” of the land and building, and second, the NPV of the tax break for the mortgage interest rate deduction. Removing that deduction would change the NPV portion of the total home price to 0, and would almost instantly depress overall total home prices by what, 25 – 30%? We already know something of what happens when there is a nationwide depression of home prices, so why would an economist put this on the table? What am I missing?
So I guess the IRS must not make much money off of their net mortgage interest taxing activities.
I guess they make money off of those who don’t meet the threshold to deduct their interest on schedule A. And perhaps from a difference in marginal rates between corporations and the average individual, though from just guessing from what I remember about corporate rates vs individual rates that could be a negative cash flow for the IRS.
Steven,
When you are talking about not taxing capital at all, are you referring to the Chamley-Judd result?
Chamley-Judd requires quite restrictive assumptions. It can be shown that in the case of non-linear taxes, the Chamley-Judd result is not necessaryli valid anymore and pareto-optimum is achieved when the tax on capital is strictly greater than zero. How do you see this question in terms of macro models?
It is not always possible to distinguish between capital gains and earned income. This is true whenever shareholders exercise any supervisory role (or any other role) in the running of a company.
@Ben:
That is true and one reason I’m not yet signed up with the good professor’s crusade to abolish the capital gains tax. If investment income is overtaxed–and I think it very well may be–a better solution would be to abolish the corporate income tax (or, equivalently, make dividends expensable). The corporate income tax is an idiocy owing its survival exclusively to the anencephalic sloganeering against evil corporations not paying their fair share.
@DividedLine:
You are quite right–abolishing the home mortgage interest deduction would indeed severely reduce home prices.
Whether that is a good thing or a bad thing for you depends on whether you are housing long or housing short. While the former interest gets all the press, the latter may be as large and important.
Whether that is a good thing for the economy in general in the long-run depends on whether the distortions induced by the mortgage interest deductions are larger than the ones that it ameliorates. Again, the answer to that question is not obvious either.
Here’s what I understand from Mankiw’s article: removing the mortgage interest deduction will be offset by decreasing income tax rates. More of my income (as a homeowner) will be taxable, but taxed at a decreased rate.
Here’s what I understand from your article: Mankiw’s point is all fine and dandy, but it effectively makes the tax the lenders pay on interest a distortion. One the one side you have lender’s paying interest that isn’t subtracted on the other side by borrowers getting a tax deduction.
My question is this: why isn’t that distortion compensated by decreasing the income tax rate? E.g. Increased income tax on interest received by lenders is compensated by decreased income tax rates? More of the lender’s income is taxable, but they pay a lower rate on that income.
Frankly, the biggest issue I have with removing the mortgage deduction is the uncertainty it creates amongst those already in the housing market. For me, I’m not selling at the moment, so I don’t really care whether I get money back in the form of an income tax rate reduction or a deduction on interest. But for those in the buying and selling market, it strikes me as a bad idea to be changing the rules. I think it’s reasonable for people to ask whether or not their tax burden will increase or decrease if they lose a deduction but get a reduced rate – despite the fact that sophomore econ students might be able to prove it. Which means that it’ll be harder for people to switch jobs if doing so requires moving.
And this is where I start to care, because the labor market becomes less dynamic making it hard for people (including me) to move up. Which makes it hard to convince my boss that my skills are in high enough demand to justify a wage increase. No wage increase during price inflation (QE2) means I’m poorer.
… or am I missing something?
Professor Landsburg wrote, “I start from the position that capital income (including interest income) ought not be taxed. Unlike a tax on labor income, which (unfortunately) discourages work, a tax on capital income discourages both work and saving, and so is doubly destructive.” There are many problems with this starting position. Morally, it is objectionable to tax the labor incomes from ordinary hard-working citizens earning working-class and middle-class incomes, and exempt the rentier incomes of multi-millionaires and billionaires.
For Professor Landsburg’s starting position to have any economic validity, one would need statistics comparing revenue-equivalent tax regimes, showing more economic growth under tax regimes biased toward labor tax than tax regimes biased toward capital tax. Until you present and analyze the statistics, you are just making stuff up. But just anecdotally, economic growth during the Clinton administration was much better than economic growth in the George W. Bush administration, and didn’t the Bush tax cuts increase the share of taxes paid by labor?
Also, consider the impact of taxes on individual choices regarding education and training. Under a regime of high personal income taxes, people are discouraged from investing in their own education and training. So if Professor Landsburg got his way and we taxed labor income more and capital income less, perhaps fewer people would undergo income-enhancing training programs, and which could have a significant effect on the economy as a whole.
Eyesay:
In your most recent comments, as in some of your earlier ones, you are conflating the issue of progressivity with the issue of what should be taxed. If you want to argue for a far more progressive tax code, that’s fine. But it’s quite a separate issue from whether it’s a good idea to tax capital.
As for this:
Until you present and analyze the statistics, you are just making stuff up.
Actually, a good theoretical analysis is sometimes a lot more valuable than a pile of hard-to-interpret statistics.
Professor Landsburg, of course it would be nice if we could get national defense, the highway system, border protection, the federal court system, medical research, disease control and prevention, and the whole panoply of goods and services we get from the federal government without paying for them. But these things cost money and that comes from taxes. You fret over whether it’s a good idea to tax capital, without providing a scintilla of evidence that economic growth would be any higher in a high-labor-tax-low-capital-tax universe than a universe where labor income and capital income are taxed alike. You have a thin theoretical argument that is undermined by several things, including the fact that, as Ben points out here and I pointed out elsewhere, it is not always possible to distinguish between capital gains and earned income. It’s also undermined by the fact that, absent actual evidence, which you do not provide, there is no way of knowing that a dollar of taxes on labor income reduces innovation and economic growth less than a dollar of taxes on capital income. It is also undermined by the fact that during the Eisenhower administration, the United States had very high economic growth despite a top income tax rate of 91% and relatively high taxes on capital income compared to today. And aside from the morally repugnance of letting multi-millionaires and billionaires completely avoiding their share of contributing to the commonweal, it simply won’t wash with the public, as Queen Elizabeth II discovered when Brits observed that the Royal Family had been receiving taxpayer-provided fire protection without paying income taxes that supported that fire protection.
Eyesay:
of course it would be nice if we could get national defense, the highway system, border protection, the federal court system, medical research, disease control and prevention, and the whole panoply of goods and services we get from the federal government without paying for them.
…..
aside from the morally repugnance of letting multi-millionaires and billionaires completely avoiding their share of contributing to the commonweal…
I take it you’re not interested in a serious discussion. The question here isn’t whether we should have taxes, and it’s not what share should be paid by the millionaires and billionaires. It’s what form the taxes should take. You can take as much or as little as you like from the millionaires and billionaires with a pure (progressive) consumption tax, or with a pure capital tax, or with anything in between — so saying that you want to take more from the billionaires is really quite off topic when the topic is whether to tax capital.
The issue of progressivity and the issue of capital taxation are both worth discussing, but it’s quite impossible to discuss them seriously if you insist on veering back and forth between them.
Dear Professor Landsburg,
Thank you for engaging with those who disagree with you and keeping comments open.
In your original posting, you referred taxes on capital income several times and taxes on labor income several times, but you never mentioned taxes on consumption. Your original posting established that your opinion is that if we’re going to tax income, we should tax only labor income, not capital income.
I challenged that opinion on five grounds, not necessarily spelled out exactly as in these one-sentence descriptions: (a) There’s no evidence that allocating income taxes to labor income rather than a mix of labor income and capital income provides more economic growth. (b) It’s not always possible to distinguish labor income and capital income. (c) There is some historical evidence, admittedly not rigorously analyzed, that suggests that when income taxes were less tilted toward labor than they are now, economic growth was good. (d) Taxing labor income and not capital income is regressive, and extremely regressive in the tails of the income distribution, and this violates a moral sense, a general sense of fairness, and the fact that the rich in many cases benefit from government services in proportion to their wealth and income. (e) Voters would never accept this level of regressivity.
Now you suggest that I don’t want to have a serious discussion, saying all of a sudden that the problem of regressivity of taxing labor income and not capital income can be solved by taxing consumption instead of income. I believe it is you and not I who has avoided serious discussion, for two reasons. (a) I provided five reasons challenging your idea of taxing labor income and not capital income, and rather than address these reasons, all of a sudden you bring up taxing consumption. B. You suggest that the issue of regressivity is extra-topical when it is inherent to the issue that was on the table, taxing labor income vs. capital income. (For that matter, regressivity is never extra-topical in a discussion about what kind of taxes should be imposed. Your posting was never only about economic growth. You said: “capital income (including interest income) ought not be taxed.” That is a normative statement, so it can’t be extra-topical to bring up moral considerations such as regressivity.
One could have a serious discussion about allocating revenue within and among income taxes, estate taxes, property taxes, consumption taxes, pollution taxes, user fees, and import duties. But you started this discussion with a piece that discussed labor income vs. capital income, and I stayed on that topic. If you want to discuss consumption taxes vs. income taxes, why not start a new posting on that topic, instead of blaming me for allegedly changing the subject?
Sincerely,
eyesay
Eyesay: What you are missing is that a labor income tax and a consumption tax are equivalent. I apologize for assuming you knew this. All economists know it, but of course there’s no reason to assume anyone else does.
To see this equivalence (and to understand what I mean by it) consider the menu of choices you’ve got left after each of several taxes, in a stylized example where the interest rate is 50%. (If you don’t like that number, change it to anything you like and adjust the example accordingly).
Case I: No taxes. You earn a dollar. You can spend a dollar today or you can spend $1.50 tomorrow, or anything in between (e.g. half of each — half a dollar today and 75 cents tomorrow, etc.)
Case II: 50 percent tax on labor income. You earn a dollar, and pay 50 cents in tax. You can spend 50 cents today, or 75 cents tomorrow, or anything in between.
Case III: 100 percent consumption tax. You earn a dollar, and can spend either 50 cents today (paying the other 50 cents in tax) or 75 cents tomorrow (paying the other 75 cents in tax), or anything in between. Note that the consumption tax leaves you with exactly the same menu of options as the labor income tax. That’s the (important) sense in which they are equivalent.
Case IV: An 40% tax on all income, including interest. You earn a dollar and pay 40 cents tax. You can now either spend 60 cents today, or save your 60 cents, earning 30 cents interest, on which you pay 15 cents tax, leaving you with 75 cents. So you can spend either 60 cents today or 75 cents tomorrow. An income tax at a different rate will leave you with some other options, but they will *never* be the same as the options you had in Cases II and III.
So when I say “a tax on labor income”, I mean a “a tax on labor income, or consumption — it’s all the same thing”. A tax on all income, including capital income, is genuinely different.
Now whatever you’re taxing, there’s a separate issue of how progressive you want to make the tax. That discussion can (and for most purposes should) be largely separate from whether you’re taxing income or consumption.
My case for a pure consumption (or pure labor) tax does not rest primarily on historical experience; it rests on an understanding of the secondary and tertiary effects of different kinds of taxes. 1) There is a quite general result (which I’ve blogged about before, with drawings of indifference curve diagrams, etc) that says that for a given tax bill, people prefer to have all their activities taxed at the same rate. When you apply this to the case where the activities are current and future consumption, you can see from the above examples that a labor/consumption tax taxes both current and future consumption at the same rate, while an income tax effectively taxes future consumption at a higher rate than current consumption — that is, a 40% income tax reduces your potential current consumption by 40% but your potentital future consumption by more than that. 2) An income tax distorts savings decisions and effectively encourages people to delay their most productive working years. 3) There are many results in the economic literature (beginning with the Chalmley/Judd paper) showing that at least under certain ideal conditions, the world is much better off without a capital tax, largely because of the effects of points 1) and 2) above. 4) A tax on *your* capital affects *my* wages; the less you save, the fewer machines there will be for me to work with, and therefore the less productive I will be. It is a silly mistake to think that the taxes you collect from Mr. Rich have no effect on Mr. Poor.
None of this has anything to do with the question of how progressive the tax system should be. You and I might have an interesting debate about that some day, but it is largely a separate topic.
If changes to the mortgage interest deduction are on the table, why don’t we simply make interest income untaxed instead?
Prof. Landsburg is right as an academic matter that the mortgage interest deduction and the tax on interest income net out in theory. But the transaction costs of making both parties deal with the IRS must be higher than they would be otherwise. Instead of a tax to one party and a deduction to another, it has to be cheaper to have no tax at all (or a tax/deduction granted to the same party).
TSW:
If changes to the mortgage interest deduction are on the table, why don’t we simply make interest income untaxed instead?
Yes, this would certainly be my preference.
Actually, that might not work very well administratively.
Currently, many types of interest payments (such as almost all made by businesses) are already tax deductible. Some types are not (such as personal credit card interest payments). But whether any particular interest payment is tax deductible or not universally depends on information within the knowledge of the interest *payer*, not the *recipient*.
Unless you want to create a situation in which an interest payment is tax deductible to the payer *and* not taxable to the recipient, you’d need a system in which the interest recipient receives some sort of auditable certification from the interest payer that this particular payment was not deductible to the payer, before the recipient could exempt it from income.
On the whole, making interest income non-taxable may create greater administrative burdens than the current system.
Professor Landsburg: All economists do not know that a labor income tax and a consumption tax are equivalent, because it isn’t true. In fact, it’s not even a well-formed statement, because the meanings of “a labor income tax” and “a consumption tax” are not well-defined. This might mean, for example, that one particular labor income tax and one particular consumption tax can be shown to be equivalent. I think you want it to mean that a generic labor income tax and a generic consumption tax are equivalent, but there’s no way of knowing that that would mean.
There are huge problems in defining a consumption tax. Presumably, VATs and sales taxes are examples of consumption taxes. But sales taxes are imposed on durable goods, which are consumed over the course of many years. Sales taxes usually cover used items, but private sales à la Craigslist are generally exempt, either de facto or de jure. For a given labor income tax, how would you construct an equivalent consumption tax for real estate, and how would it be made equitable between those who owned real estate before the tax was imposed and those who purchased it after the tax was imposed? These are non-trivial issues, and they illustrate that the notion “a labor income tax and a consumption tax are equivalent” doesn’t even have a well-defined meaning.
If, somehow, a labor income tax and a consumption tax could somehow be constructed as equivalent for in-country income and in-country consumption, there’s immediately the question of how to preserve the equivalence covering foreign income and foreign consumption. As a simple example, suppose the labor income tax is based on the U.S. federal income tax, but investment income, however that is defined, is not taxed. How would you construct the equivalent consumption tax to deal with the money I spend in restaurants and hotels while traveling abroad?
And you’ve also failed to define “equivalent.” You probably mean something like “having the same impact on individual choices of consumption, savings, and investment.” But even if two tax regimes are equivalent in that sense, they may differ greatly in when the government gets the money, and this is no small consideration.
There is considerable literature on the Chamley-Judd result, much of it exploring cases where the Chamley-Judd result does not apply. For example, “Optimal Capital Income Taxation” by Andrew B. Abel says, “The finding that a capital income tax with immediate expensing can collect a nontrivial amount of revenue in a non-distortionary manner turns the Chamley-Judd result on its head. Instead of setting the capital income tax rate equal to zero and using a distortionary labor income tax to collect revenue as in Chamley-Judd, the results in this paper indicate that the optimal configuration of taxes is to set the labor income tax rate equal to zero and to use a constant tax rate on capital income, combined with immediate expensing, to collect revenue. The optimal capital income tax scheme I present here leads to a higher level of utility of the representative household than does the Chamley-Judd prescription because the tax system presented here is non-distortionary, while Chamley-Judd requires the use of distortionary taxes.”
Sorry, in my previous post, where I said “but there’s no way of knowing that that would mean,” of course I meant “but there’s no way of knowing what that would mean.”
Eyesay:
For the second time, I apologize for guessing wrong about how much economics you know; obviously you’re far better educated than I’d assumed. You surely didn’t need the elementary examples I constructed. I hope someone else will find them useful though.
Of course when I say that two taxes are “equivalent” I mean exactly what you guessed in your penultimate paragraph; more precisely I mean that the Euler equations are the same under both tax schemes. Yes, they may differ in when the government gets the money; contrary to your assessment, I would call this quite a small consideration.
The case against taxing capital cannot, I think, be based on Chamley-Judd or any other particular stylized model, but rather on the intuitions gleaned from understanding what’s going on in those models. Abel’s paper seems to me not to overturn those intuitions, since his proposed scheme still taxes capital at an effective rate of zero. But it’s possible there’s more to be learned from this paper than I’m aware of, and I’ll plan to reread it carefully before the end of the year.
Enjoy your holiday.
Prof. Landsburg:
I don’t believe Mr. Mankiw’s argument that tax subsidies to housing tie up too little in corporate capital applies here.
This isn’t a housing subsidy, it an interest subsidy.
Apparently on average, houses are sold every 7 years. If I take out a $ 250,000 30-year mortgage with a 6% interest rate and sell it in 7 years, I’ve paid:
$ 36,164 (27%) toward my principle (tied up in real estate).
$ 99,114 (73%) has gone to the bank and back into the corporate capital generating machine.
That said, given that this is so clear to me, I’m probably missing something very important. Unlike eyesay, you can accuse me of not knowing a lot about economics.
A purely anecdotal argument in favor of keeping the mortgage deduction stems from a talk I had with a friend who came into some inheritance. I asked if he was going to pay down his house. He said that he talked to his financial planner who said that he would loose the mortgage deduction and recommended investing the money instead.
It seems pretty easy to see how removing the mortgage deduction will encourage people to take out smaller loans and put their extra income toward their houses. Thereby increasing the $’s that are tied up in real estate.
If I wasn’t so lazy, I would probably research the percentage of Americans who paid off their credit cards before and after 1986 when credit card interest couldn’t be written off.
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tax on capital income discourages both work and saving, and so is doubly destructive. Moreover,
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Is it worthwhile to target taxes? Are taxes fungible? Does Exxon-Mobile pass corporate taxes on to gasoline customers? Does the landlord pass property tax on to the tenant? Who knows? One thing for sure — much less overhead per tax dollar collected from XOM than per tax dollar collected from millions of fuel customers. General Accounting Office equates the GDP of Kansas to the resources burnt up each year on 1040 forms. Would a big savings for America the Beautiful be forthcoming with a change to a feudal-like-system of taxation trickle-up? The IRS taxes each of the 50 states. Each state taxes its 99 counties, the corporate headquarters chartered by the state, the local labor unions, and the landlords. The landlords pass tax on to the tenants by raising rent. The tenant skimps on cat food. No! Not for his mother, but for the cat.
The cat eats more rats
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