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22
22.1 Taxation and Savings—Theory and Evidence
22.2 Alternative Models of Savings
22.3 Tax Incentives for Retirement Savings
22.4 Conclusion
Taxes on Savings
22
On January 31, 2003, the Bush administration proposed the creation of Lifetime Savings Accounts and Retirement Savings Accounts.
Would allow families to place up to $30,000 each year into special savings accounts on which the interest earned would not be subject to income taxation.
These new accounts featured fewer restrictions than existing tax-subsidized savings vehicles.
When withdrawn, any interest earned on these accounts, or increases in the value of the assets in the accounts, would be exempt from taxation.
Introduction
22
Opponents claimed the plan would drain tax revenue and be used by people of means to shelter what they already save thus savings would not increase.
Within a week of the announcement, the Bush administration realized the new accounts had very little political support and began focusing on other tax-cutting measures.
President Barack Obama took a very different approach on September 5, 2009, when he announced his plan to help Americans save for retirement.
Obama’s plan consisted of initiatives based on research in behavioral economics that has shown systematic nudges to be very effective in increasing an individual’s investment in retirement savings.
Introduction
22
The first initiative encouraged small businesses to automatically enroll their employees in retirement savings accounts by reducing expensive fees that had previously discouraged the establishment of small business savings plans.
Employers would also be encouraged to increase an employee’s savings rate automatically each year or every time the employee gets a raise.
Congress has not approved any legislation as of yet for federally-mandated retirement accounts, but some states have taken it upon themselves to require employers to automatically enroll their employees in such plans.
Introduction
22
The second initiative, which was later acted on by the IRS, enables workers to receive any amount of their tax refunds in the form of U.S. savings bonds rather than as cash.
The third initiative would make it easier for workers to deposit wages earned from overtime or unused vacation time into their savings accounts.
Last, the plan called for the creation of an easy-to-understand saving guide for employers and employees that detailed the available options for tax-favored retirement savings.
Introduction
22
Although the Obama administration has met with some marginal success, critics have blamed the plan for not addressing the major problems with retirement savings, including the underfunding of state and local retirement plans.
These competing approaches to encourage retirement savings provoke a number of questions:
Does the existing structure of income taxation in the United States reduce the amount that individuals save in this country
Should the government use the tax code to encourage Americans to save more
Introduction
22
Should the government rely on changes to the structure of retirement savings plans that provide “behavioral” incentives for higher savings for people to save more
A major source of policy debates in the United States and around the world is the appropriate role of capital income taxation.
Introduction
22
Capital income taxation: The taxation of the return from savings.
This chapter explores:
How capital income taxation affects behavior in theory and in practice.
How capital income taxation works in the United States.
Taxes on Savings
22.1
The intertemporal choice model is the main model for understanding how taxes affect savings.
Intertemporal choice model: The choice about how much to save is really the choice about how to allocate one’s consumption over time.
Savings: The excess of current income over current consumption.
The model focuses on tradeoff between consumption today and consumption tomorrow.
Taxation and Savings—Theory and Evidence: Traditional Theory
22.1
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:
)
Jack’s Two-Period Savings Problem
22.1
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.
Jack’s Two-Period Savings Problem
A
Consumption
while retired
in period 2, C R
Consumption
while working
in period 1, CW
0
B
Budget constraint, BC1
BC2
Indifference curve, IC1
Y × (1 + r)
Y × (1 + r × [1 τ])
S × (1 + r)
S
Y
Slope = (1 + r)
Slope =
(1 + r × [1 τ])
22.1
A Simplified Model
Before taxes are introduced, individuals lose (1 + r) worth of consumption in period two for every dollar of consumption in period one. Individuals save, S, in the first period, and consume S × (1 + r ) in the second period.
A
Consumption
while retired
in period 2, C R
Consumption
while working
in period 1, CW
0
B
Budget constraint, BC1
BC2
Indifference curve, IC1
Y × (1 + r)
Y × (1 + r × [1 – τ])
S × (1 + r)
S
Y
Slope = (1 + r)
Slope =
(1 + r × [1 τ])
22.1
A Simplified Model
When taxes rise, the budget constraint pivots inward, and individuals lose (1 + r × [1 t ]) worth of consumption in period two for $1 of consumption in period one. Savings may rise or fall depending on relative size of income and substitution effect.
22.1
Taxes and other price changes affect savings in two ways:
Substitution effect: Lower after-tax interest rates cause first-period consumption to rise, reducing savings.
Income effect: Lower after-tax interest rates reduce the lifetime value of income, reducing first-period consumption and increasing savings.
Substitution effects may seem more natural, but a “target savings” model generates complete income effects.
Substitution and Income Effects of Taxes on Savings
C R
CW
0
A
B
BC1
BC2
IC1
Y × (1 + r)
Y × (1 + r × [1 – τ])
S1 × (1 + r)
S1
Y
Slope = (1 + r)
Slope =
(1 + r × [1 – τ])
IC2
S2
S2 × (1 + r × [1 – τ])
Effect of Taxes on Savings: Substitution Effect Is Larger
22.1
If the substitution effect is larger than the income effect, individuals will move from point A to point B, consuming more in the first period (CW2) and thus saving less (S2). As a result, their consumption in period two (CR2) falls by a lot.
C R
CW
0
A
C
BC1
BC2
IC1
Y × (1 + r)
Y × (1 + r × [1 τ])
S1 × (1 + r)
S1
Y
Slope = (1 + r)
Slope =
(1 + r × [1 τ])
IC3
S3
S3 × (1 + r × [1 τ])
22.1
Effect of Taxes on Savings: Income Effect Is Larger
If the income effect is larger, individuals will move from point A to point C, consuming less in the first period (CW3) and thus saving more (S3). Their consumption in period two (CR3) still falls, but not by as much.
22.1
Evidence is ambiguous: either no impact or positive.
Studying the connections between after-tax interest rates and savings is a difficult problem:
Hard to measure the relevant interest rate.
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.
Evidence: How Does the After-Tax Interest Rate
Affect Savings
22.1
The United States taxes nominal, not real, interest income.
Nominal interest rate: The interest rate earned by a given investment.
Real interest rate: The nominal interest rate minus the inflation rate; this measures an individual’s actual improvement in purchasing power due to savings.
Inflation and the Taxation of Savings
22.1
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.
Inflation and the Taxation of Savings
22.1
Inflation Exacerbates Capital Taxation
Save $100, 10% real interest rate, 50% tax on interest.
22.2
The traditional model assumes that people only save to smooth consumption, not to self-insure.
Precautionary savings model: A model of savings that accounts for the fact that individual savings serve to smooth consumption over future uncertainties, at least partly.
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.
Precautionary Savings Models
22.2
Theory predicts that social insurance reduces precautionary savings.
Chou et al. (2003) study the introduction of National Health Insurance (NHI) in Taiwan in 1995.
After NHI, savings fell among the public…
…but rose among people unaffected by NHI.
In the United States, Medicaid expansions significantly reduced the savings of low-income groups.
EVIDENCE: Social Insurance and Personal Savings
22.2
Individuals may not be able to save as much as they would like because of self-control problems.
Use of commitment devices is evidence for this model:
Christmas clubs, other traditional devices, “save more tomorrow plans.”
Keep money away from impatient “short-run self.” Rising credit card debt, rising housing wealth.
Self-Control Models
22.3
Employer contributions to pensions are tax-deductible.
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: Pension plans in which
workers accrue pension rights during their tenure at the firm, and when they retire, the firm pays them a benefit that is a function of that workers’ tenure at the firm and of their earnings.
Defined contribution pension plan: Employers set aside a certain proportion of a worker’s earnings in an investment account, and upon retirement, the worker receives the investment and any earnings.
Tax Subsidy to Employer-Provided Pensions
22.3
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.
Available Tax Subsidies for Retirement Savings
22.3
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 tax-free each year (deducted from their taxable income).
Interest on IRA contributions accumulates tax-free.
IRA balances can’t be withdrawn until age 59-1 2, and withdrawals have to start at age 70.
IRA balances are taxed as income on withdrawal.
Individual Retirement 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.
22.3
Keogh Accounts
22.3
With tax-deferred retirement savings, you get to defer paying the taxes you would have paid on both your initial contribution and any interest earnings.
You also get to earn the interest on the money that would have otherwise been paid in taxes.
Why Do Tax Subsidies Raise the Return to Savings
22.3
Why Do Tax Subsidies Raise the Return to Savings
Account Type: Regular IRA
Earnings
Tax on earnings
Initial deposit
Interest earned 1
Taxes at withdrawal
Net amount withdrawn
If the account isn’t labeled as an IRA, taxes are paid on full earnings. If labeled as an IRA, however, the full $100 is invested. $10 of interest is earned and when withdrawn, the government collects 25% of the $110. The ending balance is $82.50, $1.88 more than the amount withdrawn from the non-IRA account.
22.3
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.
High savers will just reshuffle their assets from non-IRA to IRA accounts.
C
B
C R
CW
A
BC3
BC2
Y × (1 + r[1 τρ])
Y × (1 + r × [1 – τ])
S4
Y
Slope =
(1 + r[1 τρ])
S2
S2 × (1 + r × [1 τ])
Slope =
(1 + r × [1 – τ])
S3

Theoretical Effects of Tax-Subsidized Retirement Savings
22.3
Individuals initially face a budget constraint to BC2 with a slope (1 + r ×[1 ]). When retirement savings is tax-subsidized, the budget constraint moves to BC3, with a higher slope (1 + r × [1 × ]). This leads to a substitution effect toward more savings, and an income effect toward less savings.
C
B
C R
CW
A
BC3
BC2
Y × (1 + r[1 τρ])
Y × (1 + r × [1 – τ])
S4
Y
Slope =
(1 + r[1 τρ])
S2
S2 × (1 + r × [1 – τ])
Slope =
(1 + r × [1 – τ])
S3

Theoretical Effects of Tax-Subsidized Retirement Savings
22.3
If the substitution effect is larger, then first-period consumption will fall from CW2 to CW3, and savings will rise from S2 to S3. If the income effect is larger, then first-period consumption will rise from CW2 to CW4, and savings will fall from S2 to S4.
22.3
Limitations on Tax-Subsidized Retirement Savings ***NOTE: Replace with revised figure 22-4
The availability of IRAs raises the return to savings less than $5,500 from (1 + r × [1 ]) to
(1 + r × [1 – × r]), where r is the net tax preference from using an IRA. Once savings is above $5,500, the IRA simply increases period-two income, and the return to each dollar of savings returns to –(1 + r × [1 – ]).
Effect of Tax-Subsidized Retirement Savings for Low Savers
22.3
Mr. Grasshopper saves little before the IRA is introduced (point A). For Mr. Grasshopper, the effect of the IRA on savings is ambiguous: if substitution effects dominate, he will move from point A to point B (with savings rising); if income effects dominate, he will move from point A to point C (with savings falling).
Effect of Tax-Subsidized Retirement Savings on High Savers
22.3
Ms. Ant was a high saver before the IRA was introduced (point A). The introduction of the IRA does not change the price of first-period consumption, but it does have an income effect, causing her period-one consumption to rise to CW2 and her savings to fall to S2, $5,500.
22.3
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:
Individuals contribute after-tax dollars to a Roth IRA but make tax-free withdrawals.
Individuals are never required to withdraw, so earnings on assets can build up tax-free indefinitely.
Provides more generous tax subsidy than regular IRA.
APPLICATION: The Roth IRA
APPLICATION: The Roth IRA
22.3
Why did policy makers introduce this new option
The government collects tax revenues today and loses them in the distant future (since we don’t tax interest earnings on the account or withdrawals from it).
But budget implications of laws are only evaluated over a 10-year horizon.
The plan allowed politicians to pay for a tax break with a tax break!
22.3
Precautionary Savings:
No effect for high-savers.
Low-savers may not want their savings locked up until age 59.
Self-Control Models:
Retirement accounts are appealing.
Excellent commitment devices: Contributions are taken directly out of the paycheck, and individuals can’t access their money until retirement.
Implications of Alternative Models
22.3
The net impact on national savings due to tax subsidies for 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:
The size of the income and substitution effects for retirement savers below the savings limit.
The share of retirement savers who are above the savings limit, for whom there is only an inframarginal response.
Private Versus National Savings
22.3
How do tax subsidies affect savings in practice
Chetty et al. (2014) studied a retirement savings program in Denmark that experienced changes in the retirement system.
There was a sizeable reduction in the tax subsidy to savings for those taxpayers in the top bracket, but not those below that level.
This sets up a natural differences-in-differences comparison between the change in savings for those just above the top bracket and those just below the top bracket.
EVIDENCE: Estimating the Impact of Tax Incentives for Savings on Savings Behavior
22.3
The top line shows the contributions toward retirement savings by those near but above the cutoff for the top bracket; the bottom line is for those near but below that cutoff. The trends in contributions are very similar for both groups before the change.
EVIDENCE: Estimating the Impact of Tax Incentives for Savings on Savings Behavior
22.3
Once the change was put in place in 1999, contributions fell dramatically for the higher-income taxpayers, while not changing much for the lower-income group. This suggests that the decline in contributions for the highest income group was due to reduced savings incentives.
EVIDENCE: Estimating the Impact of Tax Incentives for Savings on Savings Behavior
22.3
The key question for policy purposes is what happens to total (private and national) savings.
In fact, Chetty et al. (2014) found that there was no effect on private savings.
The reduction in contributions for the highest income group is completely offset by an increase in contributions to other types of savings. That is, this tax incentive had no impact on total savings—it simply caused individuals to reshuffle savings from one source to another.
Given that there is a tax cost associated with the retirement incentive, this finding implies that national savings falls when tax incentives are introduced.
EVIDENCE: Estimating the Impact of Tax Incentives for Savings on Savings Behavior
22.3
What is particularly striking about the Chetty et al. analysis is that they are were able to compare these results of the ineffectiveness of tax subsidies to very effective results for a different change: mandating savings contributions to a pension plan.
This policy change, which mandated that all Danes contribute 1% of their earnings to a retirement savings account, led to a rise in savings of roughly 1%.
The authors argue that most savers are passive: they don’t make active decisions about savings but just do what is mandated.
A much smaller share (they estimate 15%) are active savers who reallocate their savings in response to financial incentives.
EVIDENCE: Estimating the Impact of Tax Incentives for Savings on Savings Behavior
22.3
In other words, the authors argued, retirement savers either don’t respond to price incentives and just save what they are told to, or they respond to price incentives aggressively by shifting savings from taxed sources to tax-free sources.
Either way, tax incentives for savings are not increasing total private savings. But, alternative policies that move the “defaults” of these passive savers can increase total private savings.
EVIDENCE: Estimating the Impact of Tax Incentives for Savings on Savings Behavior
22.3
Evidence from recent studies suggests that individuals do respond to these savings incentives by saving more—and 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 Obama’s recent plans to reform our retirement savings system.
Evidence on Tax Incentives and Savings
22.4
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.
Conclusion

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