Taxation of Interest Income

Gordon, Roger

Taxation of Interest Income

No 9503, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Why is interest income taxed more heavily than other forms of capital income? This differential tax treatment has generated substantial tax arbitrage, resulting in lower tax revenue, efficiency costs, and apparently net gains to rich borrowers and net losses to poor lenders, together suggesting that this tax treatment makes no sense on welfare grounds. In examining this argument more formally, this paper reveals two omitted considerations that can help explain the existing tax treatment. First, the forecasted increase in the market interest rate results in a redistribution from rich borrowers to poor lenders. Yet this redistribution comes at no marginal efficiency cost, starting from a situation with no distortions to portfolio choice, so at the margin dominates further redistribution through the income tax. In addition, information about an individual's portfolio choice reveals information about her earnings ability, even controlling for observed labor income, if those who are more able tend to be less risk averse. By making use of this extra information about earnings ability, the tax system can be better tailored to redistribute from able to less able, for any given efficiency cost.

JEL-codes: H21 (search for similar items in EconPapers)
Date: 2003-02
New Economics Papers: this item is included in nep-pub
Note: PE
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Citations: View citations in EconPapers (3)

Published as Gordon, Roger H. "Taxation Of Interest Income," International Tax and Public Finance, 2004, v11(1,Jan), 5-15.

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