Taxation of Interest Income

17 Pages Posted: 19 Feb 2003

See all articles by Roger H. Gordon

Roger H. Gordon

University of California, San Diego (UCSD) - Department of Economics; Harvard University - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: February 2003

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.

Suggested Citation

Gordon, Roger H., Taxation of Interest Income (February 2003). NBER Working Paper No. w9503. Available at SSRN: https://ssrn.com/abstract=380125

Roger H. Gordon (Contact Author)

University of California, San Diego (UCSD) - Department of Economics ( email )

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La Jolla, CA 92093-0508
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Harvard University - Department of Economics ( email )

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United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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