Saving, taxes and

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

B. Douglas Bernheim
Stanford University

John Karl Scholz
University of Wisconsin–Madison

The "right" amount of saving, the decision to allocate income to future rather than current consumption, is important to a nation’s economic growth. Tax policy can, and often does, affect the saving decision through a variety of channels.

The tax treatment of capital income is a potentially important determinant of national saving. It affects private saving by altering the economic benefits associated with thrift, and it affects public saving by altering the balance between government revenues and expenditures. Those who favor tax incentives for saving argue that these incentives would reduce the excess burden associated with the tax system, and that this would stimulate capital accumulation. Policy initiatives to encourage saving include broad-based measures (such as consumption or wage taxation), as well as more narrowly targeted measures (such as individual retirement accounts and other tax-favored vehicles for saving).

The components of national saving

National saving has two components: private saving and public saving. Private saving takes place in the personal and corporate sectors of the economy. Public saving is the sum of budget surpluses (deficits) for federal, state, and local governments. For the United States, the National Income and Product Accounts (NIPA), published by the Commerce Department, provide extensive data on each of these sectors. Net national saving fell sharply from 8.3 percent of net national product in 1980 to 1.8 percent in 2003. Net national product is equal to the more familiar concept of gross domestic product (GDP) minus depreciation on existing plant and equipment, while net national saving also measures private and public saving net of depreciation. There is some disagreement over the specific causes of this decline, but factors that play a role include reductions in the rate of private saving, large government budget deficits, and substantial increases in the value of existing housing and stock market wealth.

Some economists contend that it is meaningless to decompose national saving into public, corporate, and private components. They point out that all economic assets and liabilities ultimately belong to households. Consequently, saving is saving, regardless of where it occurs. If this is correct, then the allocation of national saving among sectors is merely an exercise in accounting and has no behavioral significance (see Ricardian equivalence).

Other economists believe that it is possible to obtain a better understanding of national saving by decomposing it into personal, corporate, and public saving. They argue that, for various reasons, households do not regard an additional dollar of corporate or public saving as equivalent to a dollar of personal saving. This is sometimes referred to as the hypothesis that households do not perfectly pierce either the "corporate veil" or the "government veil."

This issue is of great practical importance. If one accepts the premise that households regard all forms of national saving as equivalent, then it is impossible to influence the level of national saving by adjusting government budget deficits, or by influencing corporate saving, because households simply adjust their behavior to offset these effects. Conversely, if one rejects this premise, then policies that affect government budget deficits and corporate saving will-all else remaining the same-alter national saving.

How do taxes affect saving?

Tax policy can, in principle, affect saving through a variety of channels. Economists have traditionally emphasized the fact that capital income taxation reduces the after-tax rate of return available on investments, thereby diminishing the rewards associated with thrift. The interest elasticity of saving is a common quantitative measure of how saving changes in response to movements in the real after-tax rate of return (see the related discussion under elasticity, demand and supply). The real after-tax rate of return is defined as the difference between the after-tax rate of return and the rate of inflation. If the interest elasticity of saving is positive, then saving rises with the real after-tax rate of return, and falls with the rate of taxation applicable to capital income.

Many economists believe that the interest elasticity of saving is positive. They assert that households will save more when saving is more rewarding economically. As a matter of theory, this issue is far from clear. An increase in the real aftertax rate of return effectively reduces the price of future consumption, in the sense that households do not need to sacrifice as much current consumption to achieve a given level of future consumption. Therefore, even if future consumption rises in response to a higher real after-tax rate of return, saving may fall.

A simple calculation illustrates this point. Suppose that a household wishes to accumulate $100,000 over the next 10 years to send a child to college. Suppose also that this household expects to earn 8 percent on its investments, and to pay 25 percent of capital income as taxes. Finally, suppose that the household expects an annual inflation rate of 4 percent. Then the real after-tax rate of return is 2 percent (75 percent of 8 percent, minus 4 percent), and the household can achieve its target by saving roughly $7,160 a year. Now suppose that the government permits this same household to accumulate these resources in a special account, and exempts all associated capital income from taxation. Then the real after-tax rate of return is 4 percent, and the household can achieve its target by saving roughly $6,390 a year.

This example illustrates an important point: If households save for fixed targets, then saving must fall in response to an increase in the real after-tax rate of return, and must rise in response to higher capital income taxation. Of course, asset targets are not usually fixed. With higher real after-tax rates of return, households may set higher targets, particularly for objectives that do not require fixed expenditures, such as retirement. However, even if asset targets rise in response to increases in the real after-tax rate of return, saving may still fall. The interest elasticity of saving will be positive only if saving targets are sufficiently responsive to the real after-tax rate of return.

Much controversy surrounds the empirical measurement of the interest elasticity of saving. Although the evidence is mixed, most studies that have relied on macroeconomic data conclude that saving is not very responsive to the after-tax rate of return. These studies are, however, vulnerable to a variety of criticisms that call the reliability of macroeconomic estimates into serious question. Some analysts have also attempted to infer the interest elasticity of saving from simulation models. Simulation studies have identified some important factors that should make saving more sensitive to the real after-tax rate of return. For example, simulations have shown that an increase in the after-tax rate of return significantly decreases the value of "human wealth" by reducing the present discounted value of all future earnings and pension income. In response to this reduction in wealth, households should consume less and save more. Unfortunately, the simulation methodology cannot reliably establish the interest elasticity of saving. Simulated values of this parameter are highly sensitive to the assumptions on which the simulations are based.

Even if the interest elasticity of saving is small, personal saving may still be sensitive to tax policy. Psychological theories of saving suggest that certain institutional arrangements may increase thrift by promoting self-discipline. For example, an individual might choose to place funds in a tax-favored retirement account, rather than in a more flexible savings vehicle, knowing full well that early withdrawals from the retirement account will be subject to heavy penalties, in part because the existence of these penalties helps to enforce selfdiscipline. Tax-favored retirement accounts may ultimately stimulate greater total personal saving precisely because households are less likely to invade these accounts prematurely. But there is little solid empirical evidence for or against these considerations.

Tax policy can also affect corporate saving. The taxation of dividends may discourage cash distributions to shareholders, and encourage the retention of earnings (see dividends, double taxation of), thereby increasing net saving in the corporate sector. Similarly, high rates of corporate taxation can reduce corporate saving by siphoning off earnings that might otherwise have been reinvested. Of course, these are valid concerns only if households do not perfectly pierce the corporate veil.

Finally, tax policy can affect government saving. Tax reforms that increase revenues without associated increases in spending reduce deficits, or increase surpluses. While this is true of all taxes, the issue deserves special emphasis in the context of capital income taxes. Efforts to stimulate private saving through tax incentives generally require reductions in capital income tax rates, which tend to reduce revenue and increase government deficits. Thus, unless these measures significantly stimulate private saving, they may actually reduce national saving. Of course, effects on government saving are of concern only if households do not perfectly pierce the government veil.

Possible justifications for favorable tax treatment of capital income

One potential justification for reducing or eliminating capital income taxes is that this might reduce the excess burden associated with taxation (see excess burden). Capital income taxes distort households’ intertemporal choices by, in effect, raising the price of future consumption relative to current consumption. The elimination of capital income taxes would remove this source of excess burden. However, a revenueneutral reduction in capital income tax revenues would necessitate an increase in other tax rates, which would in turn create other distortions. For example, an increase in the tax burden on labor income would further distort the choice of labor versus leisure. Thus, revenue-neutral cuts in capital income tax will reduce the excess burden associated with taxation only if, on the margin, capital income taxes create more excess burden per dollar of revenue than other taxes (see optimal taxation and inverse elasticity rule).

Another potential justification for reducing or eliminating capital income taxes is that it might stimulate domestic capital formation. Capital formation is important because it fuels the growth of employment, wages, and income. Historically, domestic saving has been the most important source of funds for domestic investment, so policies that stimulated saving also promoted investment. In recent years, the progressive integration of international capital markets has permitted saving and investment to diverge. Thus, although domestic investment declined significantly during the 1980s and 1990s, it did not fall as far as national saving. The impact of lower saving on investment was cushioned to some extent by inflows of foreign capital. Conversely, if the rate of domestic saving were to increase, it is likely that a significant fraction of the incremental funds would be invested abroad, rather than domestically. Nevertheless, many economists believe that domestic saving continues to constrain domestic investment over long periods.

Finally, some economists believe that an alarming number of Americans have been doing little to prepare themselves financially for economic adversity or retirement, perhaps reflecting poor planning and limited financial sophistication on the part of low-saving households, rather than deliberate choice. This view leads to a paternalistic justification for encouraging saving by reducing or eliminating capital income taxes.

Tax provisions and saving

Tax provisions for private and public pensions attempt to increase household and national saving. The tax expenditure for employer-provided pensions is estimated by the Joint Committee on Taxation to cost $522.1 billion from 2004 to 2008 (see tax expenditures and pensions, tax treatment of). It is justified in part as a way of promoting household saving and ensuring adequate retirement income security for the elderly. Social Security, a publicly provided pension system, provides income to elderly households (see Social Security benefits, federal taxation of).

The effect of private and public pensions on national saving is the sum of their effect on public, business, and household saving. Because Social Security benefits for current retirees are largely funded by the taxes paid by today’s workers, only a small fraction of Social Security taxes go toward increasing public saving (see Social Security Trust Fund). In contrast, employer pension obligations are generally fully funded and hence increase business saving. Thus, private pensions have a larger positive effect on the sum of public and business saving than does Social Security. These programs will have an ambiguous effect on household saving. To the extent that pensions raise lifetime wealth, current consumption would be expected to increase and household saving would decline. If, however, pensions allow people to retire earlier than otherwise, private saving may increase in order to maintain living standards during a longer retirement period.

The crucial empirical issue when thinking about the effects of private and public pensions on saving is, to what extent do people "undo" the effect of pensions by altering private saving? If people reduce private nonpension wealth dollar for dollar in relation to private pension wealth, national saving will fall by roughly the amount of the tax expenditure associated with private pensions. If people respond in a similar way to Social Security wealth, national saving will fall by nearly the full amount of Social Security expenditures. These outcomes would be dramatically different from those intended by these programs.

Empirical studies of pensions are hampered by the difficult task of accurately calculating lifetime resources for households. This issue is important, because policies that increase the use of pensions would undoubtedly be accompanied by reductions in other forms of employee compensation. Thus, the effect of increased pension wealth for a household is to reallocate resources toward retirement, holding the present discounted value of lifetime resources constant. Studies that have most carefully addressed the effect of private pensions and Social Security on household saving find that for every dollar of pension and Social Security wealth, private wealth falls by 10 to 50 cents, depending on the study. These estimates suggest that Social Security may have an important depressing effect on national saving. In contrast, private pensions, because they are fully funded, increase national saving. The empirical literature on the effects of Social Security and private pensions on household and national saving is far from definitive, however.

Given the low rates of household saving in the United States and the concern that Social Security depresses national saving, the country has experimented, particularly since 1981, with narrowly targeted personal saving incentives. These voluntary accounts-individual retirement accounts (IRAs), 401(k) plans, and Keogh accounts-feature preferential tax treatment of contributions and investment earnings, annual contribution limits, and penalties for early withdrawals (see individual retirement accounts). Since 1986, contributions to IRAs, Keoghs, and defined contribution pensions have amounted to about one-half of personal saving as measured by the NIPA.

There are sound conceptual reasons to doubt the effectiveness of voluntary saving incentives. First, contributions are capped. A single taxpayer under age 50, for example, can make no more than $3,000 in tax-deductible IRA contributions in 2004. For any taxpayer in these circumstances who would have saved more than $3,000 in the absence of IRAs, the availability of an IRA does not affect the costs or benefits to be had from an additional dollar of saving and therefore provides no incentive on the margin for the taxpayer to increase saving. Yet the IRA will reduce federal tax receipts. In addition, the IRA may actually induce the taxpayer to consume more, because it increases his or her total after-tax resources. For both these reasons, the IRA would contribute to a lower rate of national saving. 401(k) and Keogh plans have higher contribution limits (the 401(k) limit was $13,000 in 2004) and hence are more likely than IRAs to provide marginal incentives.

Second, even if a taxpayer would not (in the absence of a saving incentive) have saved more than the contribution limit in a given year, he or she could take full advantage of the saving incentive deduction either by drawing down previously accumulated assets or by borrowing. Contributions funded either by shifting existing assets or by borrowing do not increase household saving. Instead, they depress national saving by reducing federal tax receipts, thereby adding to the federal budget deficit.

Determining the effectiveness of these narrowly targeted saving incentives is difficult, given currently existing data. First, saving at the household level is very difficult to measure. Second, households with similar characteristics may save vastly different amounts, which complicates estimation of empirical models. Third, households may have different motives for saving. Some may save primarily for retirement, others may save to meet unexpected expenses, and others may follow simple rules of thumb or not save at all. If underlying motives to save are not well understood, it is difficult to predict the effects of policies that alter the incentives to save. These pitfalls contribute to widely different estimates of the effects of IRAs and 401(k) plans in the empirical literature.

Because it is difficult to design narrowly targeted saving incentives that do not reward taxpayers for borrowing, reshuffling existing assets, or redirecting saving from conventional instruments into tax-favored accounts, many economists believe a consumption-based tax system would more successfully promote household saving (see consumption taxation). Under the income tax, a dollar of income saved and consumed 10 years from now yields a considerably smaller amount of after-tax consumption in constant dollars than it would if it were consumed immediately. This is because income is taxed as it is earned, and again as it is saved. With an interest rate of 5 percent and a marginal tax rate of 28 percent, for example, the tax system imposes a greater than 12 percent penalty on saving after 10 years. Because of the bias toward current consumption in the tax system, many proposals to stimulate saving are designed to make the tax system more neutral toward intertemporal consumption decisions.

The present tax system could be changed to an expenditurebased system by, among other changes, eliminating contribution limits and early withdrawal penalties on IRA-type saving plans and phasing out taxation of capital income. By removing saving from the tax base, an expenditure tax eliminates distortions in intertemporal consumption decisions. Many economists believe a switch from a progressive income tax to a progressive expenditure tax would significantly increase economic efficiency. Expenditure tax advocates also argue that the tax system would be administratively simpler. Expenditure tax critics, however, argue that income is a more appropriate basis for taxation, that the difficulties in making the transition to an expenditure tax are formidable, and that absent effective end-of-life wealth transfer taxes, an expenditure tax could lead to inappropriate concentrations of wealth.

ADDITIONAL READINGS

• Bernheim, B. Douglas. "The Economic Effects of Social Security: Towards a Reconciliation of Theory and Measurement." Journal of Public Economics 33 (1987): 273-304.
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• Bradford, David F. Untangling the Income Tax. Cambridge, MA: Harvard University Press, 1986.
• Burman, Leonard E., Richard W. Johnson, and Deborah Kobes. "Pensions, Health Insurance, and Tax Incentives." Tax Policy Center Discussion Paper no. 14. Washington, DC: Tax Policy Center, December 2003.
• Campbell, John, and N. Gregory Mankiw. "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence." NBER Macroeconomics Annual, 1989.
• Dicks-Mireaux, Louis, and Mervyn King. "Pension Wealth and Household Savings: Tests of Robustness." Journal of Public Economics 23 (1984): 115-39.
• Engen, Eric M., William G. Gale, and John Karl Scholz. "Do Saving Incentives Work?" Brookings Papers on Economic Activity 1 (1994): 85-180.
• Feldstein, Martin. "The Welfare Cost of Capital Income Taxation." Journal of Political Economy 86, no. 2 (April 1978): 29"51.
• Gale, William G. "The Effects of Pensions on Household Wealth: A Reevaluation of Theory and Evidence." Journal of Political Economy 106, no. 4 (August 1998): 706-23.
• Gale, William G., and John Karl Scholz. "IRAs and Household Saving." American Economic Review 84, no. 5 (December 1994): 1233-41.
• Gale, William G., J. Mark Iwry, and Peter Orszag. "The Saver’s Credit: Issues and Options." Tax Notes 103, no. 53 (May 3, 2004): 597-612.
• Graetz, Michael J. "Expenditure Tax Design." In What Should Be Taxed- Income or Expenditure? edited by Joseph Pechman (161-276). Washington, DC: The Brookings Institution, 1980.
• Kotlikoff, Laurence J. "Taxation and Savings: A Neoclassical Perspective." Journal of Economic Literature (22 December 1984): 1576-1629.
• Madrian, Bridget, and Dennis Shea. "The Power of Suggestion: Inertia in 401(k) Participation and Saving Behavior." Quarterly Journal of Economics 116 (November 2001): 1149-87.
• Poterba, James M., Steven F. Venti, and David A. Wise. "Do 401(k) Contributions Crowd Out Other Personal Saving?" Journal of Public Economics 58 (September 1995): 1-32.
• Scholz, John Karl, Ananth Seshadri, and Surachai Khitatrkun. "Are Americans Saving ‘Optimally’ for Retirement?" Mimeo, University of Wisconsin-Madison, 2004.
• Shefrin, Hersh, and Richard Thaler. "The Behavioral Life-Cycle Hypothesis." Economic Inquiry 26 (1988): 609-43.
• Summers, Lawrence H. "Capital Taxation and Accumulation in a Life Cycle Growth Model." American Economic Review 71, no. 4 (September 1981): 533-44.
• Venti, Steven, and David Wise. "Have IRAs Increased U.S. Saving? Evidence from Consumer Expenditure Surveys." Quarterly Journal of Economics 105 (1990): 661-98.