US tax breaks for thrifty may hurt Treasury

Economists argue plans to use tax incentives to boost consumer savings are misconceived

Author: Christopher Swann

Published: December 18, 2004

When a member of President George W. Bush's economic team announced at a recent meeting in Washington that he had come to unveil the administration's eagerly awaited plan to reform the tax system, there was a sharp intake of breath from the audience.

The excitement subsided when it became apparent that Gregory Jenner, assistant Treasury secretary for tax policy, was ribbing those who had speculated about the content of such a plan.

However, one thing the administration has said clearly is that it believes savings are overtaxed. The Bush administration was good to the thrifty in its first term, cutting capital gains and dividends tax, extending tax-free savings accounts and proposing new ones.

But sceptics fear that exempting more savings from tax will not encourage Americans to set more money aside, and will simply reduce government tax revenues. They also wonder if it is possible to increase savings incentives and maintain the progressive nature of the US tax system, given that wealthy people do the lion's share of the saving.

Over the past 30 years US governments have created vehicles to shield savings from tax, such as 401(k)s and Individual Retirement Accounts. About 35 per cent of household financial assets are held in these vehicles.

But economists remain divided over whether these measures merely encourage households to shift money already set aside for saving, into tax-free accounts. That would deprive the Treasury of tax revenues and reduce overall national savings - increasing US dependence on foreign capital.

Studies of 401(k)s - accounts that allow Americans to invest part of their salaries in their employers' investment schemes - have compared the savings rates of those who had access to them and those who did not. It appears that those able to invest in 401(k)s amassed more financial assets.

"Roughly speaking, for every dollar invested in the schemes, about 33 cents was net additional national saving," says Jim Poterba, professor of economics at the Massachusetts Institute of Technology. But he says some of the extra savings may have been offset by reduced investment in other assets, such as real estate.

But, even if these accounts increase national savings, there is likely to be a diminishing return from exempting further savings from tax. The investment limits on most existing accounts are already high enough to absorb as much saving as most households can afford.

Just 5.6 per cent of those investing in 401(k)s, for example, put in the maximum investment of Dollars 13,000 a year, according to the Employee Benefits Research Institute in Washington.

"Adding extra tax-free accounts would simply allow the wealthy to shelter (more) of their wealth from the taxman, while doing little to raise savings or help the average American," says Bill Gale, a senior fellow at the Brookings Institution.

If anything, the savings plans of the Bush administration's first term may have lowered lifetime savings for lower income groups, some critics argue. Whereas 401(k)s and IRAs impose heavy penalties if funds are withdrawn before retirement, Mr Bush's proposed Lifetime Savings Accounts would have no restrictions on withdrawing the money and would allow annual contributions of up to Dollars 7,500 a year.

The liquidity would enable households to plunder their savings on a whim.

Critics argue that the administration's goals of maintaining the progressive nature of the tax system and offering additional breaks for savers are incompatible.

A recent paper published by leading economists in the Journal of Political Economy suggested the median savings rate for households in the bottom 20 per cent of earners was just 1 per cent of after-tax income.

The administration has promised to ensure reforms would not undermine the progressive nature of the tax system, but many Democrats will claim that any further tax breaks on savings would do just that.