When The Market Defeats The Government

May 11, 2010

When The Market Defeats The Government
Income tax currently taxes the interest you earn on your savings, which should deter you from saving. Then the tax code gives me an exemption for interest I pay, which should encourage me to borrow and spend. In a sense they’re trying to transfer some of the tax burden from me, the borrower, to you, the saver. What happens is that the market shifts the tax burden right back to the borrower.
This tax policy is the result of a current Keynesian economic fallacy that spending is the road to prosperity and saving brings stagnation to the economy.
But it doesn’t work out that way. Any change in government policy to influence our economic motivations will cause unintended side effects in the market. You and I and others will adjust our actions to maximize our satisfaction under the changed circumstances. (That’s the market in action). Here’s a thought experiment to show what will happen:
Our situation is this: You have loaned me some money for which I’m paying you 4% interest. Suppose there is no tax break for interest paid, no income tax on interest income, and the tax rate on all other income is 20%, and the market rate of interest is 4%. (Nice convenient round numbers.)
Now, the government decides to tax you, as a saver, on your interest income, also at 20%, but give me, as a borrower, a tax exemption on interest paid, which is equivalent to a 20% refund on the interest I pay you.
With your reduced return from the loan, you might decide to demand full payment of the loan. However, with the tax break from Uncle Sam, I’d be willing to pay more interest on the loan. I offer to pay 5% if you’ll renew the loan.
You’d still be getting a 4% return on your savings, after tax, and I’d still (after tax “refund”) be paying 4% interest.
So nothing has really changed. The government tries to take something from you and give it to me, and I voluntarily give it back to you.
The new system, with tax on your interest income and tax relief on my interest paid has had no effect and is therefore equivalent to a system without tax on Interest income and no tax relief on interest paid. The market (that’s you and I) has shifted the tax burden back to the borrower. In fact, it seems that the market shifts all taxes back to the consumer. The only consequence is that you, I, and the IRS all have more bookkeeping to do.
All this illustrates the lack of economic understanding in our legislators.
Or does it? There is always some political advantage to making it appear that they are punishing the “rich” moneylender (that’s you), and giving some relief to the poor, exploited borrower (that’s me). That’s politics.

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