Question

4. Suppose that in a small country interest income is taxed at rate 20%. Consider two citizens:

• a low-income one with annual income of $40,000,

• a high-income citizen with annual income of $100,000,

each of them saves 10% of his or her income for retirement. The government is proposing to allow citizens to put money into an individual retirement account, where the contributions would be tax deductible and interest would accumulate tax free. Withdrawals would be taxed as income. The government wants to set a $5,000 annual limit on the accounts. Use graphs to discuss the effect of this policy on the saving choices of both the low-income and high-income citizens in terms of both income and substitution effects as well as the overall effect.

Answer 1

Category Low income person high income person

Income before contribution 40000 100000

Less: Contribution in retirement account

(40000 x 10%), 5000 4000 5000

Taxable income 36000 95000

Income tax rate 20% 20%

Income tax on taxable income 7200 19000

(36000 x 20%), (95000 x 20%)

Category Low income person high income person

Income before contribution 40000 100000

Taxable income 40000 100000

Income tax rate 20% 20%

Income tax without contribution in retirement account 8000 20000

(40000 x 20%), (100000 x 20%)

Low income person high income person

Income tax without contribution in retirement account 8000 20000

Income tax after contribution in retirement account 7200 19000

Note: It has been assumed that the contributions made in other retirement accounts before the introduction of the new retirement account by the Govt. were not allowed as deduction.

The effect of the retirement account on tax liabilities of both low and high income individuals will be positive as their net tax liability has reduced to $7200 and $19000 respectively as can be seen. It is also to be noted that though savings of low income individual will not be affected but the total savings of high income individual will be reduced by $5000 as the earlier he used to invest (100000 x 10%) = $10000 whereas the contribution limit in retirement account of the government is only $5000.

The effects on income tax liabilities are enumerated in the graph below.