Welfare Implications of the Taxation of Savings

Historically, the welfare aspects of the taxation of savings have mainly been discussed in the context of the relative merits of income and consumption (expenditure) taxation. These have long been the subject of debate, with the book by Kaldor (I955) being probably the best known contribution. In the present paper, we examine the role of the two types of taxation in the context of a model that draws both on modern analysis of optimal taxation and on the theory of economic growth. In so doing, we feel that the issues involved can be discussed in greater depth, but the cost is that some important matters have to be left out. Thus, we do not discuss the implications of alternative tax structures for short-run stabilisation policy, nor do we consider the costs of tax administration.' Moreover, we neglect problems of distributive justice within a given generation of individuals. Instead, we concentrate on the implications of taxation for the efficiency of resource utilisation and for the intertemporal allocation of consumption. In popular expositions one often encounters the following efficiency argument in favour of expenditure taxation. An income tax applies to both labour earnings and interest on savings. The imposition of such a tax introduces (into an otherwise first-best world) distortions in both the labour market and the capital market. By comparison, the expenditure tax, while affecting the labour-leisure choice, is 'neutral' with respect to savings decisions, and thus appears to dominate the income tax in terms of efficiency considerations. Although still current,2 this view is not very convincing. The theory of the second-best has taught us that one cannot evaluate alternative tax systems by simply comparing the number of distortions involved; it is essential to consider the magnitude of the various distortions as well as their interaction. Among other aspects, the conventional argument ignores the possibility that a tax on interest income might be desirable in order to offset the distortions introduced by a tax on labour earnings. A more sophisticated argument, taking account of this objection, is that * Previous versions of this paper were presented to the Franco-Swedish seminar in public economics at Sarlat, France, in March 1976, and to the University of Aarhus conference on public economics at Sandbjerg, Denmark, in April 1978. These, versions, the latter of which was also circulated as a discussion paper, were entitled 'The Welfare Implications of Personal Income and Consumption Taxes'. We are indebted to many seminar participants, to John Kay, Mervyn King, Joe Stiglitz, the Editor and a referee for a number of helpful comments and suggestions. 1 For a good discussion of these and other matters with a view to practical implementation, see Andrews (I974) and Kay and King (1978).

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