Chapter 22: TAXATION AND SAVINGS

1
Chapter 22 TAXATION AND SAVINGS THEORY AND
EVIDENCE

• The traditional theory of savings is to smooth
  consumption across periods.
• This is an implication of diminishing marginal
  utility of income.
• Intertemporal choice is the choice individuals
  make about how to allocate their consumption over
  time.
• As with hours of work in the labor supply model,
  savings is not valued directly, but is rather a
  means to an end. It can be thought of as a bad
  where the complementary good is future
  consumption.

2
The 2-period Intertemporal Consumption Model
C2
Y(1r)
Initially savings is S, and consumption is C1.
slope -(1r)
Y(1r(1-t))
Taxing savings rotates the budget constraint, and
creates income and substitution effects.
A
slope -(1r(1-t))
C2
S(1r)
BC1
BC2
C1
C1
Y
S
3
Responses to the Taxation of Saving
C2
C2
Substitution effect is larger
Income effect is larger
Savings can fall.
Or rise.
C2
C2
C2
C2
BC1
BC2
BC1
BC2
C1
C1
C1
C1
C1
C1
S
S
4
Taxation and savings Theory and
evidenceTraditional theory

• The lower after-tax rate of return will cause an
  increase in first period consumption through the
  substitution effect.
• But the fall in the after-tax return makes Jack
  feel poorer, which reduces his consumption in the
  first period (and increases savings).
• The first panel shows that when the substitution
  effect dominates, savings falls.
• The second panel shows that when the income
  effect dominates, savings increases.

5
Taxation and savings Theory and evidenceHow
does the after-tax interest rate affect savings?

• Unlike the empirical literature on labor supply,
  the empirical work on after-tax interest rates
  and savings has not reached a clear consensus.
• The elasticity of savings with respect to
  interest rates varies from 0 to 0.67.
• It is more difficult to compute the appropriate
  interest rate.
• In addition, it is more difficult to find
  appropriate treatment and control groups.

6
ALTERNATIVE MODELS OF SAVINGSPrecautionary
saving models

• The precautionary saving model is a model of
  savings that accounts for the fact that
  individual savings serve at least partly to
  smooth consumption over future uncertainties.
• One of the most commonly given reasons for saving
  is for emergencies.
• This is a form of self-insurance.
• The intuition for precautionary savings are
  barriers to borrowing during an emergency.
  Liquidity constraints are barriers that limit the
  ability of individuals to borrow.

7
Alternative models of savingsSelf-control models

• An alternative formulation of the savings
  decision comes from behavioral economics models.
• Individuals have a long-run preference to ensure
  enough savings for smooth consumption throughout
  their lives, but their impatient short-run
  preferences may cause them to consume all their
  income and not save for future periods.
• These self control problems require commitment
  devices.
• Self-control problems may explain why individuals
  have substantial savings in illiquid forms
  (housing, retirement accounts), while at the same
  time carrying credit card balances at high
  interest rates.

8
TAX INCENTIVES FOR RETIREMENT SAVINGS

• Because of concern about workers under-saving for
  retirement, the U.S. government has introduced a
  series of tax subsidies for retirement savings.
• There are four major incentives
• Tax subsidy to employer-provided pensions
• DC and BD plans
• 401(k) accounts
• Individual Retirement Accounts
• Keogh Accounts

9
Tax incentives for retirement savingsWhy do tax
subsidies raise the return to savings?

• All of the tax subsidies have the following
  characteristics
• Individuals avoid paying income tax on their
  contributions.
• Earnings accumulate at the before-tax rate of
  return.
• Withdrawals are taxed as ordinary income, not the
  lower capital gains tax rate.

10
Tax incentives for retirement savingsWhy do tax
subsidies raise the return to savings?

• Since taxes are paid at retirement, how are these
  accounts tax subsidized?
• The key ingredient is that you get to earn the
  interest on the money that would have otherwise
  been paid in taxes. This is composed of three
  important parts
• The initial deductibility of the contributions
• Having earnings accumulate at the before-tax rate
  of return
• Having the potential to withdraw the money when a
  person is in a lower tax bracket.
• These tax subsidies can dramatically increase the
  rate of return to retirement savings.

11
Tax incentives for retirement savingsTheoretical
effects of tax-subsidized retirement savings

• One key institutional feature of 401(k) accounts,
  IRAs, and so forth is that the annual
  contributions are capped.
• This creates a non-linearity in the budget
  constraint, where the tax-advantaged rate of
  return from saving below the cap is higher than
  taxed rate of return above the cap.
• Figure 4 illustrates this situation.

12
C2
D
slope -(1r(1-t))
Y(1r(1-t))
A
E
With a cap, savings is subsidized, but only up to
a point.
slope -(1r(1-t?))
B
C1
Y
3,000
13
C2
Y(1r(1-t))
B
C
?
A
For a low saver, the income and substitution
effects go in opposite directions.
Thus, the net effect is ambiguous for low savers.
C1
Y
C1g
1,000
14
C2
B
Y(1r(1-t))
A
For high-savers, IRAs represent an income effect
only and therefore lower savings.
C1
Y
C1W
C2W
4,000
5,000
15
Tax incentives for retirement savingsPrivate
versus national savings

• The discussion so far has focused on private
  savings, but what matters for investment and
  growth is national savings.
• Retirement tax incentives have an offsetting
  effect on national savings because they are
  financed by a tax break.
• For example, imagine that 401(k)s raised private
  savings by 30 per 1 of contribution. If the
  tax rate were 43, then 43 of tax revenue is
  forgone.
• Since tax revenue reflects public saving, 401(k)s
  actually reduce national savings, even though it
  increased private saving.