Paul L. Caron
Dean




Wednesday, October 27, 2021

Tax Policy Design With Low Interest Rates

Alan J. Auerbach (UC-Berkeley; Google Scholar) & William G. Gale (Tax Policy Center; Google Scholar), Tax Policy Design with Low Interest Rates, Tax Policy and the Economy (University of Chicago Press): 

Interest rates on government debt have fallen in many countries over the last several decades, with markets indicating that rates may stay low well into the future. It is by now well understood that sustained low interest rates can change the nature of long-run fiscal policy choices. In this paper, we examine a related issue: the implications of sustained low interest rates for the structure of tax policy. We show that low interest rates (a) reduce the differences between consumption and income taxes; (b) make wealth taxes less efficient relative to capital income taxes, at given rates of tax; (c) reduce the value of firm-level investment incentives, and (d) substantially raise the valuation of benefits of carbon abatement policies relative to their costs.

Conclusion
It is by now generally recognized that the presence of low interest rates – sustained over time and across countries – has important implications for the fiscal stance of the federal government. In this paper, we argue that if low interest rates are expected to persist, there are important implications for the design of tax policy as well. 

In general, our results reflect three main themes: in the presence of low interest rates, subsidies to saving and investment are less potent; the wealth tax is bigger and more distortionary relative to an income tax, for given tax rates; and investments with back-loaded benefits (most prominently carbon taxes) are more valuable. This last implication is likely important in other cases we have not yet considered, particularly human capital investment, where expenditures of money and time when young provide benefits possibly decades later. However, another factor to consider in this case, and perhaps others as well, is that lower interest rates may also be associated with lower rates of productivity growth, which might also reduce the future returns to investment. In addition, the implications of low interest rates for government discounting could be affected by the irreversibility of certain policy decisions, which could provide an option value to waiting for the resolution of uncertainty and effectively increase the appropriate discount rate (Dixit and Pindyck 1994). If, as discussed above, lower market interest rates may be due in part to higher uncertainty, this could partially offset the impact of lower interest rates through an increase in option value.

Of course, the future path of interest rates is unknown, so it is not at all certain that rates will remain low. But to the extent that beliefs run toward continued low interest rates, the implications for tax policy design are significant.

https://taxprof.typepad.com/taxprof_blog/2021/10/tax-policy-design-with-low-interest-rates.html

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