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Università Bocconi A.A. 2005-2006
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Transcript of Università Bocconi A.A. 2005-2006
Università Bocconi, A.A: 2005-2006 1Mec – Comparative public economics 1
Università Bocconi A.A. 2005-2006
Comparative public economics
Giampaolo Arachi
Università Bocconi, A.A: 2005-2006 2Mec – Comparative public economics 2
Alternative savings vehiclesAlternative savings vehicles
Intertemporally constant rates
Changes in tax rates over time
Assets with differentially taxed components
References:
M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 3
Università Bocconi, A.A: 2005-2006 3Mec – Comparative public economics 3
Alternative savings vehiclesAlternative savings vehicles
Intertemporally constant rates
Changes in tax rates over time
Assets with differentially taxed components
References:
M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 3
Università Bocconi, A.A: 2005-2006 4Mec – Comparative public economics 4
Different Legal Organizational FormsDifferent Legal Organizational Forms
There are different legal organizational forms (Alternative Savings Vehicles) through which individuals save for the future– Different needs: insurance policies v. bank deposits– Different regulations or policy aims: short and long period
Differences may be leveled out through new contractual arrangements or financial innovation
Università Bocconi, A.A: 2005-2006 5Mec – Comparative public economics 5
Four main tax attributesFour main tax attributes
Is the deposit into a savings account tax deductible?–Immediately–Through time (depreciation allowances)
Frequency that earnings are taxed–On accrual–Annually–On realization–Never
Tax base –Selling or purchasing price–Difference between selling and purchasing price–Other
Tax rate–Ordinary income PIT rate–Capital Gains tax–Schedular or exempt
Università Bocconi, A.A: 2005-2006 6Mec – Comparative public economics 6
Alternative savings vehicles U.S.Alternative savings vehicles U.S.
Savings vehicle
(example)
Is the investment tax deductible?
Frequency that earnings are tax
Tax rate
Money market fund No Annually Ordinary
Single premium deferred annuity
No Deferred Ordinary
Mutual fund No Annually Capital Gains
Foreing corporation No Deferred Capital Gains
Insurance policy No Never Exempt
Pension Yes Deferred Ordinary
Università Bocconi, A.A: 2005-2006 7Mec – Comparative public economics 7
Alternative savings vehicles U.K.Alternative savings vehicles U.K.
Savings vehicle
(example)
Is the investment tax deductible?
Frequency that earnings are tax
Tax rate
Money market fund No Annually Ordinary
Single premium deferred annuity
No Deferred Ordinary
Mutual fund No Annually Capital Gains
Foreing corporation No Deferred/
Annually
Capital Gains/
Ordinary
Insurance policy No Never Exempt
Pension Yes Deferred Ordinary
Università Bocconi, A.A: 2005-2006 8Mec – Comparative public economics 8
Alternative savings vehicles ItalyAlternative savings vehicles Italy
Savings vehicle
(example)
Is the investment tax deductible?
Frequency that earnings are tax
Tax rate
Money market fund No Annually 27%
Single premium deferred annuity
No Deferred 12.5% / Ordinary
Mutual fund No On accrual 12.5%
Foreing corporation No Deferred Capital Gains
Insurance policy
Pension Yes Annually 11%
Università Bocconi, A.A: 2005-2006 9Mec – Comparative public economics 9
ComparisonsComparisons
The same underlying investment will be held in each of the savings vehicles. As a result the before tax rates of return will be identical in each case
The after-tax rates of return will differ widely as the investment returns will be taxed differently across the alternatives
Simplifying assumptions: - Intertemporally constant tax rates- No non-tax costs
Notation:- R denotes the pretax rate of return- r denotes the after-tax rate of return- for a one-year investment in a simple interest-bearing savings account, the after-tax rate of return is r=R(1-t)
Università Bocconi, A.A: 2005-2006 10Mec – Comparative public economics 10
Vehicle IVehicle INot tax deductible; Taxed annually; Ordinary incomeNot tax deductible; Taxed annually; Ordinary income
Examples: Corporate bonds, money market accounts offered by banks
Returns
After 1 year: $K (1+R) - $K(1+R-1) t = $K + $K R – $KRt
= $K [1+R(1-t)]
After 2 years = [1 + R (1-t)] [1 + R (1-t)]
After n years = [1 + R (1-t)]n
Università Bocconi, A.A: 2005-2006 11Mec – Comparative public economics 11
Vehicle IIVehicle II Not tax deductible; Deferred taxation; Ordinary incomeNot tax deductible; Deferred taxation; Ordinary income
Examples: Single premium deferred annuity (US)
After one year: $K (1+R) - (1+R-1) t = 1 + R (1-t)
After 2 years: $K (1+R) (1+R) - $K [(1+R) (1+R) -1] t
= $K (1+R)2 - $K (1+R)2 t + $K t
= $K (1+R)2 (1-t) + $K t
After n years: $K (1+R) n - $K [(1+R) n -1] t
= $K (1+R)n (1-t) + $K t
Università Bocconi, A.A: 2005-2006 12Mec – Comparative public economics 12
After-tax accumulations to savings vehicles I and II: R = 7%, t=30%
0
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ac
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lati
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SV I SV II
Università Bocconi, A.A: 2005-2006 13Mec – Comparative public economics 13
After-tax accumulations to savings vehicles I and II: R = 15%, t=30%
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40
60
80
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120
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160
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0 10 20 30 40
Years
MMA
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tax
ac
cu
mu
lati
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SV I SV II
Università Bocconi, A.A: 2005-2006 14Mec – Comparative public economics 14
Savings Vehicle IIISavings Vehicle III Not tax deductible; Taxed annually; Capital gainsNot tax deductible; Taxed annually; Capital gains
Examples: mutual funds
After n years = $K [1+ R(1-tg)] n
Università Bocconi, A.A: 2005-2006 15Mec – Comparative public economics 15
Savings Vehicle IVSavings Vehicle IV Not tax deductible; Deferred taxation; Capital gainsNot tax deductible; Deferred taxation; Capital gains
Examples: shares in corporations located in tax haven;
After n years = $K (1+R) n - $K [(1+R) n -1]tg
= $K (1+R)n (1-tg) + $K tg
Università Bocconi, A.A: 2005-2006 16Mec – Comparative public economics 16
Savings Vehicle VISavings Vehicle VITTax deductible; Deferred taxation; Ordinary incomeax deductible; Deferred taxation; Ordinary income
The government act as a partner in the investment
Partners Investment AccumulationTaxpayer 1-t (1-t) (1+R)n
Government t t (1+R)n
Each dollar invested in the pension fund costs only (1-t) dollars after tax
After tax accumulation per after tax dollar invested = $ K (l + R) n (l - t) = (l + R) n
(l - t)
Università Bocconi, A.A: 2005-2006 17Mec – Comparative public economics 17
Summing upSumming up
Savings vehicle
Is the investment tax
deductible?
Frequency that
earnings are tax
Tax rate After tax accumulation per after tax dollar $ I
Invested
I No Annually Ordinary $K [1 + R (1-t)]n
II No Deferred Ordinary $K (1+R)n (1-t) + $K t
III No Annually Capital Gains
$K [1+ R(1-tg)] n
IV No Deferred Capital Gains
$K (1+R)n (1-tg) + $K tg
V No Never Exempt $K (1 + R) n
VI Yes Deferred Ordinary $K (1 + R) n
Università Bocconi, A.A: 2005-2006 18Mec – Comparative public economics 18
OutlineOutline
Intertemporally constant rates
Changes in tax rates over time
Assets with differentially taxed components
Università Bocconi, A.A: 2005-2006 19Mec – Comparative public economics 19
Changes in tax rates over timeChanges in tax rates over time
Simplifying assumption: future tax rates are known
• Returns depends on realization strategy: realize profit when taxes are low and losses when taxes are high
• Simple dominance relations no longer hold
Università Bocconi, A.A: 2005-2006 20Mec – Comparative public economics 20
Vehicle VI (Pension plans)Vehicle VI (Pension plans)
t0 relevant tax rate when contributions are made
tn relevant tax rate when withdrawals are made
Partners Investment Accumulation
Taxpayer 1-t0 (1-tn) (1+R)n
Government t0 tn (1+R)n
Università Bocconi, A.A: 2005-2006 21Mec – Comparative public economics 21
Vehicle VI (Pension plans) vs Vehicle V (Insurance Vehicle VI (Pension plans) vs Vehicle V (Insurance policy)policy)
After tax accumulation per after tax dollar invested
If tax rates are falling, (t0 > tn) Vehicle VI is superior
If tax rates are increasing, (t0 > tn) Vehicle V is superior
Insurance
n
Pension
nn
o
R)(1t-1R)(1t-1
1
Università Bocconi, A.A: 2005-2006 22Mec – Comparative public economics 22
Rollover into a different vehicleRollover into a different vehicle
Traditional deductible IRA
An eligible taxpayer may contribute up to $2000 per year. Contributions are tax deductible and earnings in the pension account are tax deferred until the taxpayer makes withdrawals in retirement.
Savings Vehicle VI
Università Bocconi, A.A: 2005-2006 23Mec – Comparative public economics 23
Rollover into a different vehicleRollover into a different vehicle
Roth IRA
An eligible taxpayer may contribute up to $2000 per year. Contributions are NOT tax deductible and withdrawals are tax free.
Savings Vehicle V
Università Bocconi, A.A: 2005-2006 24Mec – Comparative public economics 24
Rollover into a different vehicleRollover into a different vehicle
Since 1998 taxpayers with balances in deductible IRAs can rollover the balance into a Roth IRA.
The amount rolled over is included in the taxapayer taxable income in the year of the rollover
Is it the rollover profitable?
Deductible IRA accumulation = V (1+R)n (1-tn)
Rollover Roth accumulation = V (1+R)n - taxes paid at rollover - returns lost on taxes paid
Università Bocconi, A.A: 2005-2006 25Mec – Comparative public economics 25
Rollover into a different vehicleRollover into a different vehicle
Taxes due on rollover paid out of funds invested in Vehicle II
taxes paid at rollover + returns lost on taxes paid
V t0 [(1+R)n (1-tn) + tn]
Rollover Roth accumulation =
V (1+R)n – V t0 [(1+R)n (1-tn) + tn]
Università Bocconi, A.A: 2005-2006 26Mec – Comparative public economics 26
Rollover into a different vehicleRollover into a different vehicle
Rollover Roth accumulation – Deductible IRA =
V (1+R)n tn – V t0 [(1+R)n (1-tn) + tn]
Greater than zero if t0 = tn
t0 < tn
Università Bocconi, A.A: 2005-2006 27Mec – Comparative public economics 27
OutlineOutline
Intertemporally constant rates
Changes in tax rates over time
Assets with differentially taxed components
Università Bocconi, A.A: 2005-2006 28Mec – Comparative public economics 28
Assets with differentially taxed componentsAssets with differentially taxed components
Shares pay dividend and deferred capital gains
Two additional issuesTwo different tax ratesBy reinvesting there is a change in the value of the stock
Simplifying assumptionsDividend rate is constant and equal to dtdiv tax rate on dividendsReturn thruogh capital gains constant and equal to RC
Capital Gains are tax when share are sold at rate tgAfter-tax dividends are invested in sharesDividend are paid at the end of the year
Università Bocconi, A.A: 2005-2006 29Mec – Comparative public economics 29
Assets with differentially taxed componentsAssets with differentially taxed components
Accumulation with no taxes
(1+d+RC)n
Accumulation after dividend tax:
(1+d(1-t)+RC)n
Accumulation after dividend and capital gains tax
(1+d(1-t)+RC)n – tg[(1+d(1-t)+RC)n – Base) or
(1+d(1-t)+RC)n (1-tg) + tg Base
Which is the Base?
Università Bocconi, A.A: 2005-2006 30Mec – Comparative public economics 30
Assets with differentially taxed componentsAssets with differentially taxed components
The Base to calculate the capital gains tax
First year: d(1-t)
Second year: d(1-t) (1+d(1-t)+RC)
Third year: d(1-t) (1+d(1-t)+RC)2
Base after n years:
1yearn
1yearcRt)d(11t)d(11