Tax Progressivity and the Design of Tax Incentives for Investment

Abstract

This article uses marginal tax rate analysis to simulate the effect of our complex system of capital income taxation on of tertax returns by asset type and on tax progressivity. Preferential taxation is found to favor higher income individuals, causing returns to decline less steeply across the rate brackets, For any level of subsidy, the benefits to higher income investors are less pronounced when credits rather than deductions are used, suggesting that tax subsidies can be designed to reallocate investment without heavily favoring wealthy individuals. With leveraging, aftertax returns rise across the tax brackets for preferentially treated assets, suggesting the current tax rules produce regressive rather than progressive tax rates on capital income. The tax advantages of leveraging to high-bracket taxpayers persist when risk is introduced, as yield rises proportionally more than risk at high tax rates. Allowing for risk aversion also indicates that the timing of tax benefits affects an asset's riskiness, suggesting that tax subsidies can be designed both to achieve distributional objectives and to minimize private riskiness.