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Public Finance and Public Policy Jonathan

CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers

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Taxes on Savings

22

22.1 Taxation and SavingsTheory and


Evidence
22.2 Alternative Models of Savings
22.3 Tax Incentives for Retirement Savings
22.4 Conclusion

P R E PAR E D B Y

Dan Sacks
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22

C HAP TE R 2 2 TAX E S O N S AV I N G S

Taxes on Savings

Capital income taxation: The taxes


levied on the returns from savings.
This chapter explores:
o How capital income taxation affects
behavior in theory and in practice.
o How capital income taxation works in the
United States.

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22.1

C HAP TE R 2 2 TAX E S O N S AV I N G S

Taxation and Savings: Traditional Theory

The intertemporal choice model is the main


model for understanding how taxes affect
savings.
o Intertemporal choice model: The
choice individuals make about how to
allocate their consumption over time.
o Savings: The excess of current income
over current consumption.
The model focuses on tradeoff between
consumption today and consumption
tomorrow.
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22.1

C HAP TE R 2 2 TAX E S O N S AV I N G S

Jacks Two-Period Savings Problem

Jack has income from working.


Jack chooses how much to consume while
working () and while retired ().
Savingsis the difference between income
and first-period consumption,
Savings earns interest, and Jack consumes
net savings:
)

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22.1

C HAP TE R 2 2 TAX E S O N S AV I N G S

Jacks Two-Period Savings Problem

Intertemporal budget constraint: The


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

The opportunity cost of one dollar of first


period consumption is (1 + r) dollars of
second period consumption.
Taxes on savings affect behavior by
changing the effective interest rate, shifting
the budget constraint.
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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.1

A Simplified Model

Consumptio
n
while
retired
in period 2,
C RY x (1 Slop
e=
+ r)S
(
lop
1+
(1 e =
r)
Y x (1 + r x [1 + r x
[1

])
])

S x (1
+ r)
0

Indifference
curve, IC1
Budget
constraint,
BC2
BC1
Y Consumpti
on
while
S
working

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22.1

C HAP TE R 2 2 TAX E S O N S AV I N G S

Substitution and Income Effects of Taxes on Savings

Taxes and other price changes affect savings


in two ways:
o Substitution effect: Lower after-tax
interest rates cause first-period
consumption to rise, reducing savings.
o Income effect: Lower after-tax interest
rates reduce the lifetime value of income,
reducing first-period consumption and
increasing savings.
o Substitution effects may seem more
natural, but a target savings model
generates complete income effects.
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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.1

Effect of Taxes on Savings: Substitution Effect Is


Larger
CR

Slo
pe
=
(
Slo
1
p
e
+
(1
=
r)
+r
Y x (1 + r x [1
x[
1
])
])

Y x (1
+ r)

S1 x (1 +
r)
S2 x (1 + r x [1
])

IC
1

IC
2

BC2
0

BC
1

CW

S1
S2
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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.1

Effect of Taxes on Savings: Income Effect Is Larger


CR

Slo
pe
Y x (1
=
+ r)
(
Slo
1
pe
+
(1
=
r)
+r
Y x (1 + r x [1
x[
1
])
])

S1 x (1 +
r)
S3 x (1 + r x [1
])

A
C

IC

IC

BC2
0

BC
1

CW

S1
S3
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22.1

C HAP TE R 2 2 TAX E S O N S AV I N G S

Evidence: How Does the After-Tax Interest Rate


Affect Savings?
Evidence is ambiguous: either no impact or
positive.
Studying the connections between after-tax
interest rates and savings is a difficult
problem:
o Hard to measure the relevant interest
rate.
o Interest on any type of savings typically
changes over time in the same way for
all individuals, making it hard to find
appropriate treatment and control
groups for studying how savings respond
to interest rate changes.
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22.1

C HAP TE R 2 2 TAX E S O N S AV I N G S

Inflation and Capital Taxation

The United States taxes nominal, not real,


interest income.
o Nominal interest rate: The interest
rate earned by a given investment.
o Real interest rate: The nominal
interest rate minus the inflation rate; this
measures an individuals actual
improvement in purchasing power due to
savings.

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22.1

C HAP TE R 2 2 TAX E S O N S AV I N G S

Inflation and Capital Taxation

The relationship between real and nominal


interest rates is:

Inflation increases the nominal but not the


real interest rate, but taxes are levied on
nominal interest rates.
Inflation reduces the real after-tax return on
savings.

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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.1

Inflation Exacerbates Capital Taxation

No
Inflation
Inflatio (Constant Real
n
Rate)
Inflation

0%

10%

Nominal interest
rate

10

21

Interest earnings
After-tax
resources

$10
105

$21
110.5

Price
of $100,
Skittles
Save
10% real 1
interest rate, 1.1
50% tax
on interest.
Bags
of Skittles
105
100.5
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22.2

C HAP TE R 2 2 TAX E S O N S AV I N G S

Precautionary Savings Models

The traditional model assumes that people


only save to smooth consumption, not to
self-insure.
Precautionary savings model: A model
of savings in which individuals save, at
least partly, to smooth consumption over
future uncertainties.
Liquidity constraints make it harder to
borrow in tight times, so people develop a
buffer stock.
Liquidity constraints: Barriers to credit
availability that limit the ability of
individuals to borrow.
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22.2

C HAP TE R 2 2 TAX E S O N S AV I N G S

EVIDENCE: Social Insurance and Personal Savings

Theory predicts that social insurance


reduces precautionary savings.
Chou et al. (2003) study the introduction of
National Health Insurance (NHI) in Taiwan in
1995.
o After NHI, savings fell among the
public
o But rose among people unaffected by
NHI.
In the United States, Medicaid expansions
significantly reduced the savings of lowincome groups.
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22.2

C HAP TE R 2 2 TAX E S O N S AV I N G S

Self-Control Models

Individuals may not be able to save as


much as they would like because of selfcontrol problems.
Use of commitment devices is evidence for
this model:
o Christmas clubs, other traditional
devices, save more tomorrow plans.
o Keep money away from impatient shortrun self. Rising credit card debt, rising
housing wealth.

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Tax Subsidy to Employer-Provided Pensions

Employer contributions to pensions are taxdeductible.


Pension plan: An employer sponsored plan
through which employers and employees
save on a (generally) tax-free basis for the
employees retirement.
Defined benefit pension plans: Upon
retirement, the workers benefit depends on
tenure and earnings.
Defined contribution pension plan:
Employers set aside a certain proportion of
a workers earnings in an investment
account, and upon retirement, the worker
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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Available Tax Subsidies for Retirement Savings

401(k) accounts and IRAs also subsidize


savings.
401(k) accounts: Tax-preferred retirement
savings vehicles offered by employers, to
which employers will often match
employees contributions.
Individual Retirement Account (IRA): A
tax-favored retirement savings vehicle
primarily for low- and middle-income
taxpayers, who make pre-tax contributions
and are then taxed on future withdrawals.

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Individual Retirement Accounts

For moderate income households, IRAs work


as follows:
Almost any form of asset can be put in an
IRA (from stocks to bonds to holdings of
gold).
Individuals can contribute up to $5,000 taxfree each year (deducted from their taxable
income).
Interest on IRA contributions accumulates
tax-free.
IRA balances cant be withdrawn until age
59-12, and withdrawals have to start at age
70.
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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Keogh Accounts

Keogh accounts provide a savings subsidy


for the self-employed.
Keogh accounts: Retirement savings
accounts specifically for the self-employed,
under which up to $44,000 per year can be
saved on a tax-free basis.

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Why Do Tax Subsidies Raise the Return to Savings?

With tax-preferred retirement savings, you


get to hold on to any taxes you would have
paid on both your initial contribution and
any interest earnings,
And you get to earn the interest on the
money that would have otherwise been
paid in taxes.

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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.3

Why Do Tax Subsidies Raise the Return to Savings?

Account
Type:

Regular

IRA

Earnings
Tax on
earnings
Initial deposit
Interest
earned

Taxes at
withdrawal
Net amount
withdrawn
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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Theoretical Effects of Tax-Subsidized Retirement


Savings

Tax subsidies for retirement savings


increase the after tax return to savings by
reducing the tax rate from to .
This can encourage savings through the
substitution effect, or discourage it through
the income effect.
But IRA contributions are capped, so there
is only an income effect for high savers.
o High savers will just reshuffle their
assets from non-IRA to IRA accounts.

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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.3

Theoretical Effects of Tax-Subsidized Retirement


Savings
CR
Slo
( pe
1+ =
Y x (1 + r[1r[1
])
-
Slo
pe
])
(1
=
Y x (1 + r x [1
+rx
])
])

[1

B
C

S2 x (1 + r x [1
])

BC2

BC
3

CW

S4
S2
S3
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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Limitations on Tax-Subsidized Retirement Savings

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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.3

Effect of Tax-Subsidized Retirement Savings for Low


Savers
CR

BC2
Y x (1 + r x [1
])

slope =
(1 + r x [1 ])

slope =
(1 + r x [1 ])

BC1

CW

S3 = $500

Public Finance and Public Policy Jonathan Gruber Fourth Edition

S1 =
$1,000
S2 =
$1,500
Copyright
2012 Worth Publishers

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C HAP TE R 2 2 TAX E S O N S AV I N G S

22.3

Effect of Tax-Subsidized Retirement Savings on High


Savers
CR

BC2
Y x (1 + r x [1
])

B
slope =
(1 + r x [1 ])

BC1

slope =
(1 + r x [1 ])

CW

S2 =
$5,000
S1 =
$6,000
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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

APPLICATION: The Roth IRA

Congress introduced the Roth IRA in 1997.


Roth IRA: A variation on normal IRAs to
which taxpayers make after-tax
contributions but may then make tax-free
withdrawals later in life.
Similar to a regular IRA, but with two key
differences:
o Individuals contribute after-tax dollars to
a Roth IRA, but make tax free
withdrawals.
o Individuals are never required to
withdraw, so earnings on assets can build
up tax-free indefinitely.
Provides more generous tax subsidy than

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

APPLICATION: The Roth IRA

Why did policy makers introduce this new


option?
o The government collects tax revenues
today and loses them in the distant
future (since we dont tax interest
earnings on the account or withdrawals
from it).
o But budget implications of laws are only
evaluated over a 10-year horizon.
o The plan allowed politicians to pay for a
tax break with a tax break!

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Implications of Alternative Models

Precautionary Savings:
o No effect for high-savers.
o Low savers may not want their savings
locked up until age 59.
Self-Control Models:
o Retirement accounts are appealing.
o Excellent commitment devices:
Contributions are taken directly out of
the paycheck and individuals cant
access their money until retirement.

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Private vs. National Savings

Impact of tax subsidies for savings on


national savings depends on the marginal
and inframarginal responses.
The size of the marginal and inframarginal
response to tax incentives for savings will
depend on two factors:
o The size of the income and substitution
effects for retirement savers below the
savings limit.
o The share of retirement savers who are
above the savings limit, for whom there
is only an inframarginal response.

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

EVIDENCE: Estimating the Impact of Tax Incentives


for Savings on Savings Behavior
How do tax subsidies affect savings in
practice?
Engelhardt (1996) studied a Canadian
program (RHOSP) subsidizing savings for
home down payments.
o Ended in 1985, available only to renters,
with bigger benefits to people with
higher marginal tax breaks.
o RHOSP increased savings: Each dollar
contributed represented 56 to 93 of
new private savings, and 20 to 57 of
new national savings.
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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

EVIDENCE: Estimating the Impact of Tax Incentives


for Savings on Savings Behavior
Duflo et al. (2005) randomly assigned
people to different employer match rates.
o Random assignment eliminates all bias.
o People who received a 20% match
contributed four times as much to their
IRA accounts, relative to the control
group.
o People who received a 50% match
contributed seven times as much,
relative to the control group.

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22.3

C HAP TE R 2 2 TAX E S O N S AV I N G S

Evidence on Tax Incentives and Savings

Evidence from recent studies suggests that


individuals do respond to these savings
incentives by saving moreand might even
respond enough to raise not only private
but national savings.
Several studies suggest that opt-out
policies of enrollment have an even larger
impact on savings than do tax subsidies.
These types of findings have motivated
President Barack Obamas recent plans to
reform our retirement savings system.

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22.4

C HAP TE R 2 2 TAX E S O N S AV I N G S

Conclusion

Savings decisions are extremely important,


and likely influenced by tax policy.
Neither theory nor existing empirical
evidence offers a clear lesson for the
magnitude (or even the direction) of the
effect of taxes on savings.
In 1975, the tax expenditure on incentives
for savings was less than $20 billion; in
2011, it had grown to $119 billion.
Policy makers believe that tax incentives
can make a difference in the savings
decisions of individuals.
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