Martin Feldstein on capital taxation

Follow these numbers, and the bold face is mine:

An example will illustrate the harmful effect of high taxes on the income from savings and show how the tax reform could make taxpayers unambiguously better off. Think about someone -- call him Joe -- who earns an additional $1,000. If Joe's marginal tax rate is 35%, he gets to keep $650. Joe saves $100 of this for his retirement and spends the rest. If Joe invests these savings in corporate bonds, he receives a return of 6% before tax and 3.9% after tax. With inflation of 2%, the 3.9% after-tax return is reduced to a real after-tax return of only 1.9%. If Joe is now 40 years old, this 1.9% real rate of return implies that the $100 of savings will be worth $193 in today's prices when Joe is 75. So Joe's reward for the extra work is $550 of extra consumption now and $193 of extra consumption at age 75.

But if the tax rate on the income from saving is reduced to 15% as the tax panel recommends, the 6% interest rate would yield 5.1% after tax and 3.1% after both tax and inflation. And with a 3.1% real return, Joe's $100 of extra saving would grow to $291 in today's prices instead of just $193.

There are two lessons in this example, each of which identifies a tax distortion that wastes potential output and therefore unnecessarily lowers levels of real well-being. The first is that a tax on interest income is effectively also a tax on the reward for extra work, cutting the additional consumption at age 75 from $291 to just $193. Because the high tax rate on interest income reduces the reward for work (as well as the reward for saving), Joe makes choices that lower his pretax earnings -- fewer hours of work, less work effort, less investment in skills, etc.

The second lesson that follows from the example is that the tax on interest income substantially distorts the level of future consumption even if Joe does not make any change in the amount that he saves. With the same $100 of additional saving, the higher tax rate reduces his additional retirement consumption from $291 to $193, a one-third reduction. If Joe responds to the lower real rate of return that results from the higher tax rate on interest by saving less, the distortion of consumption is even greater. For example, if Joe would save $150 out of the extra $1,000 of earnings when his real net return is 3.1% (instead of saving $100 when the real net return is 1.9%), his extra consumption at age 75 would be $436, more than twice as much as with the 35% tax rate. But the key point is that Joe's future consumption would be substantially reduced by the higher tax rate even if he does not change his savings.

Taken together, these two lessons imply that a lower tax rate on interest income, combined with a small increase in the tax on other earnings, could make Joe unambiguously better off while also increasing government revenue. More specifically, if reducing the tax on interest income from 35% to 15% had no effect on Joe's earnings or on his initial consumption spending, the government could collect the same present value of tax revenue from Joe by raising the tax on his $1,000 of extra earnings from $350 to $385. Although this would cut Joe's saving from $100 to $65 (if he keeps his initial consumption spending unchanged), the higher net return on that saving would give Joe the same consumption at age 75. In this way, Joe would be neither better off nor worse off.

But experience shows that Joe would alter his behavior in response to the lower tax rate. He would earn more at age 40 and would save more for retirement. This change of behavior makes Joe better off (or he wouldn't do it) and the extra earnings and interest income would raise government revenue above what it would be with a 35% tax rate. So Joe would be unambiguously better off with the lower tax rate on interest income and the government would collect more tax revenue.

Here is the link.  Elsewhere from The Wall Street Journal, here is a piece on bargaining theory, thanks to Chris Masse for the pointer.