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Chapter 22

Taxes on Savings
Jonathan Gruber
Public Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 Worth

Introduction
Does the existing structure of income

taxation in the United States reduce the


amount of savings done by individuals?
This is an important policy question
because making more capital available
to business can be a key determinant of
economic growth.
What is the appropriate role of capital
income taxation the taxes levied on
the returns from savings?

Introduction
This lesson proceeds as follows:

Basic theoretical model with two-period


consumption
Empirical evidence
Precautionary savings models
Self-control models
Retirement accounts

TAXATION AND SAVINGS


THEORY AND EVIDENCE
Traditional theory
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.

Taxation and savings Theory and


evidence
Traditional theory
We define savings as the excess of

current income over current


consumption.

It earns a real rate of return, r, that


buys consumption in future periods.

Figure 1 illustrates the basic model.

Figure 1
C2
Y(1+r)

Y(1+r(1-))
C2

slo

pe

slop

=-

e=

Initially savings is S, and


consumption is C1.

( 1+
r)

-(1+
r(1-

))

Taxing savings rotates the


budget constraint, and creates
income and substitution effects.

S(1+r)
BC2
C1

BC1
Y

C1

Taxation and savings Theory and


evidence
Traditional theory
The initial blue line represents the budget

constraint, given income Y in period 1, BC1.

The intertemporal budget constraint is


the measure of the rate at which individuals
can trade off consumption in one period for
consumption in another period.

Jack has preferences over consumption

goods today and consumption in the future.

He initially chooses bundle A.

Taxation and savings Theory and


evidence
Traditional theory
The slope of the intertemporal budget

constraint is (1+r), meaning that the


opportunity cost of first-period consumption
is the interest income not earned on savings
for second period consumption.
Savings (as with hours of work in the labor
supply model), is measured going toward
the origin on the x-axis.

It is the difference between income and


consumption.

The model assumes the person can freely

borrow, if his preferences dictate.

Taxation and savings Theory and


evidence
Traditional theory
If the government taxes all income,

including interest income, then the rate


of return falls from r to (1-)r, because
the government collects r.
The slope therefore changes from (1+r)
to (1+((1-)r), shifting the intertemporal
budget constraint to red budget
constraint, BC2.
Figure 2 shows possible responses to the

taxation of savings.

Figure 2
C2

C2
Substitution effect
is larger

Income effect
is larger

Savings can fall.

Or rise.

C2

C2
C2*

C2*
BC2

BC1

BC2
C1

C1 C1 *
S

BC1

C1 * C1
S

C1

Taxation and savings Theory and


evidence
Traditional 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.

Taxation and savings Theory and


evidence
Traditional theory
One way to think about the income

effect from a fall in the after-tax rate of


return is to think about a target level
of consumption in retirement.
As the interest rate falls, Jack has to
save more to meet this target level.

Taxation and savings Theory and


evidence
How 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.

Taxation and savings Theory and


evidence
Inflation and the taxation of
In the late 1970s,savings
the U.S. experienced
double-digit inflation rates. At that time,
neither the income tax brackets nor the
treatment of capital income was indexed for
inflation.

This led to bracket creep whereby individuals


would see an increase in their tax rate despite
no real increase in their real income.

Although the treatment of income tax brackets

changed in 1981 by becoming indexed to


inflation, the rules about capital income
taxation have remained the same.

Taxation and savings Theory and


evidence
Inflation and the taxation of
savings
The nominal interest
rate (i) is the interest
rate earned by a given investment.
The real interest rate (r) is the nominal
interest rate minus the inflation rate.

This measures an individuals actual improvement


in purchasing power due to savings.

These are related by r=i+, where is the

inflation rate. The tax system taxes nominal


returns, not real returns.
Table 1 illustrates the impact of capital
taxation in an inflationary environment.

Table 1

Capital taxation in an inflationary


environment
Case
No inflation

Inflation
Constant real
rate

Tax rate
Inflatio
on
Saving
The
nominal
rate
n
interest
s

will
0%

likely
0%adjust for
100
inflation,
however.
0%
50%
100

With
taxes
on
With
10%
inflation
Interes
After-tax
nominal
returns,
and
at 10%
return,
Nominal earning resource
the real
returns is
rate
s
negative!
zero.

Price
of
skittle
s

Bags
of
skittle
s

10%

$10

$110

$1.00

110

10%

$10

$105

$1.00

105

10%

0%

100

10%

$10

$110

$1.10

100

10%

50%

100

10%

$10

$105

$1.10

95.5

10%

0%

100

21%

$21

$121

$1.10

110

10%

50%

100

21%

$21

$110.5

$1.10

100.5

Taxation and savings Theory and


evidence
Inflation and the taxation of
savings
In the first panel, there
is no inflation.

With no taxes, the number of skittles that can be


bought is 110.
With a 50% tax rate, only 105 bags can be bought.

In the second panel, imagine that inflation equals

the nominal rate of return. Thus, the real rate of


return is 0%.

With inflation but no taxes, 100 bags can be bought.


With inflation and taxes, even though real purchasing
power is unchanged, the taxation of nominal returns
means only 95.5 bags can be bought.

In the third panel, if the nominal rate adjusts for

inflation (to 21%), then in the absence of taxation


inflation will not erode the purchasing power of
savings.

Taxation and savings Theory and


evidence
Inflation and the taxation of
savings
The problem in the
second and third panels,
with taxation, is that taxes are levied on
nominal, not real earnings. Individuals,
when making savings decisions, care about
the real interest rates.
Because taxes are levied on nominal
returns, the impacts of inflation on the tax
code remain important.
Higher inflation lowers the after-tax real
return to savings.

ALTERNATIVE MODELS OF
SAVINGS
Precautionary 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.

l
Social
insurance
and
a
c
i
r
i
ce
p
n
Em vide
personal savings
E
There are a number of studies in support of
the precautionary model. They show that
greater uncertainty leads to higher savings,
and that social insurance programs that lower
income uncertainty lead to lower savings.
Chou, et al. (2003) find that the introduction
of National Health Insurance in Taiwan led to
a decrease in savings among affected workers.
Gruber and Yelowitz (1999) find that Medicaid
expansions in the U.S. lowered the need for
precautionary savings.

Alternative models of savings


Self-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.

Alternative models of savings


Self-control models
Investment devices such as Christmas

club bank accounts or tax-preferred


retirement accounts are consistent with
self-control problems.
Self-control problems also 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.

Alternative models of savings


Self-control models
A final piece of evidence for self-control problems is

from an innovative experiment run by Thaler and


Benartzi (2004), called Save More Tomorrow.
Employees committed a portion of future pay
increases to their retirement savings. By arranging
the decision this way, the decision seemed less
difficult.
Although this should not have any attractiveness
to a rational saver, 78% of the employees offered
the plan decided to join it, and 80% of those
employees stuck with it through four pay raises.
The bottom line is that Save More Tomorrow
raised savings for employees.

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
401(k) accounts
Individual Retirement Accounts
Keogh Accounts

Tax incentives for retirement


savings
Available tax subsidies for
retirement
savings
A pension plan
is an employer-sponsored
plan through

which employer and employees save on a (generally) tax-free


basis for the employees retirement.
A defined benefit pension plan is one in which worker
accrue pension rights during their tenure at the firm, and
when they retire the firm pays them a benefit that is a
function of the workers tenure at the firm and their
earnings.
A defined contribution pension plan is one in which
employers set aside a certain proportion of a workers
earnings in an investment account, and the worker
receives this savings and any accumulated investment
earnings when he or she retires.

The percentage of earnings varies, but 5% is not uncommon.

The contributions that employers make to pension plans are

not taxed until the money is withdrawn at retirement.

Tax incentives for retirement


savings
Available tax subsidies for
savings
A 401(k)retirement
account is a tax-preferred

retirement savings vehicle offered by


employers, to which employers will often
match employees contributions.
The analog in the non-profit sector is
403(b).
Many firms offer an employer match on
contributions made to such a plan to
encourage participation.

The contribution limit for 2005 is $14,000,

schedule to rise to $15,000 in 2006, and


indexed for inflation thereafter.

Tax incentives for retirement


savings
Available tax subsidies for
retirement
savings
An Individual
Retirement Account
(IRA) is a tax-favored retirement
savings vehicle primarily for lowincome and middle-income taxpayers,
who make pretax contributions and are
then taxed on future withdrawals.
The contribution limit is currently
$3,000 per person.

Tax incentives for retirement


savings
Available tax subsidies for
retirement
savings
A Keogh
account is a retirement
savings account specifically for the selfemployed, under which up to $40,000
per year can be saved on a tax-free
basis.
They function much the same as 401(k)
accounts, except they are not run
through an employer.

Tax incentives for retirement savings


Why 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.

Tax incentives for retirement savings


Why 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.

Tax incentives for retirement savings


Why do tax subsidies raise the return
to savings?
Table 2 illustrates the difference

between a regular, taxed investment


and a deductible IRA.
We assume in this table that the
earnings accumulations are taxed as
ordinary income, not as capital gains.

Table 2

The tax advantage of IRA savings


Accoun
t type

Earning
Tax on
Initial
s With an
earning
IRA (ordeposi
t
401k),sthe

Regula
r

( =25%)
investment
accrues
$100
$25
$75
at the before-tax
rate of return.

IRA

$100

$100

Interest

Taxes paid

Total amount
withdrawn

$7.50

$1.88
=0.25x($7.5
0)

$80.62
=$75+$7.50-$1.88

$10

$27.50
=0.25x($11
0)

$82.50
=$100+$10$27.50

This
tax subsidy
earned
upon
leads to greater
withdrawal
(r=10%)
overall wealth.

Tax incentives for retirement savings


Theoretical effects of tax-subsidized
retirement savings
These tax subsidies to retirement

savings rotate the intertemporal budget


constraint in an opposite way to the
taxation.
This is illustrated in Figure 3.
3

IRAs increase the


after-tax rate of
return, and rotate
the budget
constraint.

Figure 3
C2
Y(1+r(1-))

Y(1+r(1-))

C2

slo

pe

slop

=( 1+
r(1
-
))

e=

-(1+
r(1

B
C

))

S(1+r(1-))
The

effect of IRAs on savings


is ambiguous, however.

BC2

C1

BC3 = BC1
Y

C1

Tax incentives for retirement savings


Theoretical effects of tax-subsidized
retirement savings
Initially the after-tax rate of return is r(1-).
With the tax-subsidy, however, the delay in tax

payments reduces the tax burden by , so the


effective tax rate on retirement savings is only .
Thus, the rate of return rises to r(1-).
The substitution effect leads to more savings,
while the income effect leads to less savings.
Thus, the change in total savings is ambiguous.
Moving from point A to B results in an increase in
savings (where the substitution effect dominates),
while moving from A to C results in a decrease in
savings (where the income effect dominates).

Tax incentives for retirement savings


Theoretical 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 taxadvantaged rate of return from saving
below the cap is higher than taxed rate
of return above the cap.
Figure 4 illustrates this situation.

Figure 4
C2
D

slope = -(1+r(1-))

Y(1+r(1-))

With a cap, savings


slope =
is-(1+r(1-))
subsidized, but
only up to a point.

Y
$3,000

C1

Tax incentives for retirement savings


Theoretical effects of tax-subsidized
retirement savings
The slope on segment BE is -(1+r(1-)),

while the slope on segment DE is (1+r(1-)).


This kinked budget constraint has
potentially different effects on different
types of savers.
Consider an initially low saver in
Figure 5a.
5a

Figure 5a Low saver


C2

Y(1+r(1-))
B
?
For athe
lownet
saver,
theis
Thus,
effect
income and
ambiguous
for low
substitution
effects go
savers.
in opposite directions.

A
C1 g

Y
1,000

C1

Tax incentives for retirement savings


Theoretical effects of tax-subsidized
retirement savings
On the marginal $1 of savings, this

individual now gets a higher rate of


return.
Thus, he faces both the income and
substitution effects discussed before, so
savings could increase (to point B) or
decrease (to point C).

Tax incentives for retirement savings


Theoretical effects of tax-subsidized
retirement savings
On the other hand, consider an initially

high saver in Figure 5b.


5b

Figure 5b High saver


C2

Y(1+r(1-))

For high-savers, IRAs


represent an income
effect only and therefore
lower savings.

C1W C2W
$4,000
$5,000

C1

Tax incentives for retirement savings


Theoretical effects of tax-subsidized
retirement savings
On the marginal $1 of savings, this individual

receives the same rate of return as before.


He faces only an income effect, but not a
substitution effect, so savings decreases (to point
B).
The income effect for high savers such as the
person in panel (b) arises as they reshuffle
their existing assets into an IRA; they take
$3,000 of savings they were already putting
aside and label it as tax-preferred IRA savings.
It is possible that IRAs actually lower overall
private savings through this income effect.

n
o
i
t
a
c
pli
p
A

The Roth IRA

A Roth IRA is a variation on normal IRAs to

which taxpayers make after-tax contributions


but may then make tax-free withdrawals later in
life.

Unlike traditional IRAs, individuals are never


required to make withdrawals from Roth IRAs, so
the earnings on assets can build up indefinitely.

Why was the Roth IRA created? Budget politics

clearly came into play: traditional IRAs entail


immediate loss in tax revenue, while Roth IRAs
entail loss of future tax revenue.

Tax incentives for retirement


savings
Implications of alternative
The retirement taxmodels
incentives may have stronger
positive effects on savings than implied by the
traditional theory and intertemporal budget
constraint analysis.
Consider, first, the precautionary savings motive.
Imagine a person who had more than $3,000 in
savings, but was using it for precaution against
job loss. The illiquid IRA would not be viewed as
a good substitute, so contributions to the IRA are
not simply reshuffling. Thus, there may be
more savings due to retirement incentives than is
suggested by traditional models.

Tax incentives for retirement


savings
Implications of alternative
models
Second, the hallmark
of self-control
models is the search for commitment
devices to provide self-control.
401(k) accounts, taken directly out of the
paycheck, provide such a commitment
device, because the money cannot be
easily accessed until retirement.
Beyond the demand for these accounts
due to tax incentives will be demand that
arises because of commitment.

Tax incentives for retirement


savings
Private 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
30 of tax revenue (43%x 70 of existing
savings) is forgone, and there is no new
national savings.

Tax incentives for retirement


savings
Private versus national savings

This example illustrates the notion of

marginal impacts versus inframarginal


impacts.
The marginal impact is the 30 of new
private saving.
The inframarginal impact is the 70 of
existing saving that was going to
happen even in the absence of a tax
subsidy.

l
The impact of tax incentives
a
c
i
ir nce
p
Em vide for savings on savings behavior
E
Empirical work examining the impact of IRAs and

401(k)s has proven difficult.


Those who contribute to IRAs also save more in
every form than non-savers who dont contribute
to IRAs. Thus, non-contributors do not form a
good control group.
The same kinds of comparisons have been made
for workers in firms that offer a 401(k) to workers
in firms that do not offer a 401(k). The workers in
these different firms appear to be different in
observable ways, and therefore are likely to be
different in unobservable ways as well.

l
The impact of tax incentives
a
c
i
ir nce
p
Em vide for savings on savings behavior
E
Engelhardt (1996) studies the Canadian
Registered Home Ownership Savings Plan.
Unlike the programs in the U.S., this created
quasi-experimental variation because:

It was available to renters but not owners.


It was in effect from 1974 to 1985, but not
afterwards.
The benefit varied by marginal tax rate, which
varied widely across Canadian provinces.

The results indicated that each $1 contributed to

the program resulted in up to 93 in new private


savings, and up to 57 of new national savings.

Recap of Taxes on Savings


Taxation and Savings Theory and

Evidence
Alternative Models of Savings
Tax Incentives for Retirement Savings