In an earlier post I argued for expanding tax-deferred retirement accounts because they eliminate the double tax on saving that exists under the current tax system. Here is the basic idea. People earn income and pay income tax on that income. If they save it and then earn interest (or dividends, or capital gains, etc.), they will be charged income tax on income that has already been taxed, amounting to a double tax.
To see that this is the case, consider this simple example (numbers chosen to make the example easy to follow).
Assume that with no income taxes, you decide to buy a new computer which costs $1000. Further assume the interest rate is 5%. Instead of buying the computer, you could put the money in the bank and earn 5% interest, or $50 a year. With no taxes, it costs the same amount to buy a $1000 computer as to receive $50 a year in interest.
Now, assume that there is a 50% income tax. (California’s highest income tax bracket is 13.3%, so combined with the highest federal rate of 39.6%, a high-income Californian could be paying a 52.9% rate.)
With a 50% income tax rate, you would have to earn $2000 to buy the $1000 computer. Half of your income would be taxed away, leaving you with $1000 to buy the computer.
To receive $50 a year in interest at a 5% interest rate, you would have to earn $100 in interest; half would be taxed away, leaving you with $50. To earn $100 in interest at a 5% rate you would have to save $2000, and to save $2000 you would have to earn $4000, half of which would be taxed away before you can put $2000 in the bank.
With a 50% income tax you would have to earn $2000 to buy the computer but $4000 to receive $50 a year in interest, after taxes.
With no income taxes, receiving $50 in interest costs you the same amount as buying a $1000 computer. With a 50% tax rate, it costs you twice as much to receive $50 in interest, after taxes, than to buy the $1000 computer.
This example shows why when income is earned as a return on after-tax income, taxing the earnings amounts to a double tax on saving.