Econ 208

Marek KapickaLecture 14

Capital TaxationFinancial Intermediation

Next Week

No class next Monday (Memorial day)

No class next Wednesday as well

PS5 will be posted on Wednesday

Ramsey TaxationImplications for Government Debt

Example:

Hence W = G = 1 The optimal tax rate

0 ,1

0 ,0 ,0 ,1

tY

tGtG

t

tt

r*

Ramsey TaxationImplications for Government Debt

Tax collection each period: r / (1+r) Core Deficit

Government Debt:

0 ,1

1

100

tr

rTG

rTG

tt

0 ,1

1

t

rB g

t

Ramsey TaxationWWII vs. Korean War

WWII financed differently than Korean War

Marginal Taxes

% OF EXPENDITURES FINANCED BY

Direct Taxes Debt and seignorage

World War II 41% 59%

Korean War 100% 0%

% TAX RATES BEFORE/DURING THE WAR

Labor Capital

World War II 9/18 44/60

Korean War 16/20 52/63

Ramsey TaxationWWII vs. Korean War

What if WWII were financed like Korean War (taxes only)? Labor taxes would be 64% rather than

18% Capital taxes would be 100% rather than

60% Welfare costs are 3% of consumption

Ramsey TaxationWWII vs. Korean War

What if Korean War was financed like WWII (both taxes and debt)? Labor taxes would be 23% rather than

20% Capital taxes would be 50% rather than

62% Welfare gains are 0.4% of consumption

Source: Lee Ohanian, “The Macroeconomic Effects of War Finance in the United States: World War II and the Korean War”, American Economic Review, vol. 87, (1), 1997, pp. 23 - 40

Where are we? Introduction: A model with no Government The Effects of Government Spending Government Taxation and Government Debt

Labor Taxation Taxation and Redistribution Government Debt Capital Taxation

Financial Intermediation

Capital Taxation

What does it mean to tax capital? Tax on the stock of capital (wealth

tax, property taxes) Tax on the income from savings (tax

on interest or dividends, tax on capital gains)

Capital Taxation

The effect of capital taxation: It taxes future consumption more heavily than current consumption

Example: You have income $2 An apple costs $1 The interest rate between today and

tomorrow is 100%

Capital Taxation

1. Scenario 1: no tax Can buy either 2 apples today or 4

apples tomorrow

2. Scenario 2: 50% tax on wages Can buy either 1 apple today or 2

apples tomorrow Both current and future consumption

cut in half ( and )

Capital Taxation

1. Scenario 3: 50% tax on wages and interest

Can buy either 1 apple today or 1.5 apples tomorrow

Current consumption cut in half () Future consumption cut by 62.5% () Tax on interest taxes future

consumption more!

Capital Taxation

Why is it bad to tax interest? Uniform Commodity Taxation:

taxes should be spread evenly across goods

Tax on capital violates this principle.

Capital Taxation What could be the reasons for capital

taxation?1. Capital returns are risky. Taxing capital

provides social insurance.2. (tax on dividends/profits): If investment is

financed by retained earnings then (under certain conditions) a tax on profits/dividends have no effect on investment levels

Where are we? Introduction: A model with no Government The Effects of Government Spending Government Taxation and Government Debt

Labor Taxation Taxation and Redistribution Government Debt Capital Taxation

Financial Intermediation

Financial crises Economic crisis in 2007-2008: The

largest recession since the Great Depression

Associated with banking crisis The first banking crisis in the US since

the Great Depression However, banking crises are

recurrent Before 1913 In other countries Banking crises are nothing new!

Recent Crises Scandinavian Crisis 1990-1991

Increase in asset and housing prices before the crisis 1990-1991: increase in oil prices and collapse of

trade with Soviet Union triggered a crisis Sweden: took over major banks, recapitalized them

and sold them later

Japan 1990’s The Argentina Crisis 2001-2002 The Russian Crisis, 1998

A. History of banking crises: U.S.

1863-1913: Crises were a frequent phenomenon in the U.S.

They have occurred at about 10 year intervals

A Banking Panic

Bank Runs

U.S. National Banking Era Panics

Why Financial Crises?

Key insight: Banks are here to transform illiquid assets to liquid liabilities Depositors prefer to withdraw deposits

easily (preference for liquidity) Borrowers need time to repay the loans

Tension between both sides of the balance sheet: If everyone wants to withdraw deposits,

there is not enough resources

A Liquidity Problem How to choose between liquid and

illiquid assets? Liquid assets: can be converted into

immediate consumption without any costs

Illiquid assets: it is costly to convert them into immediate consumption

People have preference for liquidity: they are unsure when they need to consume

A Liquidity Problem

1. Autarchic Solution2. Market Solution3. Efficient Solution4. Banking Solution

A Liquidity ProblemTiming

Time Two assets:

Liquid, short-term (short) asset unit of consumption in period t can be converted

to unit of consumption in period Illiquid, long-term (long) asset

unit of consumption in period can be converted into units of consumption in period

Long asset yields more in the long run, but nothing in the short run!

A Liquidity ProblemPreferences

Liquidity preference: Two types of consumers: Early consumers: only want to

consume in period 1 Late consumers: are indifferent about

the timing of consumption The consumer learns about his

type at the beginning of period

An Example of Early Consumers

A Liquidity ProblemPreferences

Probability of being early: Preferences of a consumer:

expected utility

Trade-off: investing in long asset yield higher return but does not insure against the risk of being an early consumer

𝜃𝑈 (𝐶1)+(1−𝜃 )𝑈 (𝐶1+𝐶2)

1. Autarchic Solution

The consumer has initial wealth Invests fraction in the short asset

Chooses to maximize

𝜃𝑈 (𝜆 )+ (1−𝜃 )𝑈 (𝜆+(1 −𝜆 ) 𝐹 )

1. Autarchic SolutionThe Budget Constraint

1

1

𝐶1

𝐶2

𝐹

1. Autarchic Solution

If the utility is logarithmic, the solution is

If increases, increases If increases, decreases

𝜆=min [𝜃

1−1𝐹

¿,1]¿