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Chapter 22 Taxes on Savings Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

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Page 1: Gruber Ch 22

Chapter 22Taxes on Savings

Jonathan GruberPublic Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Page 2: Gruber Ch 22

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?

Page 3: Gruber Ch 22

Introduction

This lesson proceeds as follows: Basic theoretical model with two-period

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

Page 4: Gruber Ch 22

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.”

Page 5: Gruber Ch 22

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 1Figure 1 illustrates the basic model.

Page 6: Gruber Ch 22

C1

C2

C1 Y

S

BC1

BC2

Y(1+r)

Y(1+r(1-τ))

C2

S(1+r)

slope = -(1+r)

slope = -(1+r(1-τ))A

Figure 1

Initially savings is S, and consumption is C1.

Taxing savings rotates the budget constraint, and creates

income and substitution effects.

Page 7: Gruber Ch 22

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.

Page 8: Gruber Ch 22

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.

Page 9: Gruber Ch 22

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 2Figure 2 shows possible responses to the taxation of savings.

Page 10: Gruber Ch 22

C2 C2

C1

BC1BC2 BC1BC2

C1 C1C1* C1*

C2

C2*

C2

C2*

C1S S

Substitution effectis larger

Income effectis larger

Figure 2

Savings can fall. Or rise.

Page 11: Gruber Ch 22

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.

Page 12: Gruber Ch 22

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.

Page 13: Gruber Ch 22

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.

Page 14: Gruber Ch 22

Taxation and savings – Theory and evidence

Inflation and the taxation of savings In the late 1970s, 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.

Page 15: Gruber Ch 22

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 individual’s 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 1Table 1 illustrates the impact of capital taxation in an inflationary environment.

Page 16: Gruber Ch 22

Table 1

Capital taxation in an inflationary environment

CaseInflatio

n

Tax rate on

interestSaving

sNominal

rate

Interest

earnings

After-tax resource

s

Price of

skittles

Bags of

skittles

No inflation 0% 0% 100 10% $10 $110 $1.00 110

0% 50% 100 10% $10 $105 $1.00 105

Inflation 10% 0% 100 10% $10 $110 $1.10 100

10% 50% 100 10% $10 $105 $1.10 95.5

Constant real rate

10% 0% 100 21% $21 $121 $1.10 110

10% 50% 100 21% $21 $110.5 $1.10 100.5

With 10% inflation and a 10% return, the real return is

zero.

With taxes on nominal returns, the real return is

negative!The nominal rate

will likely adjust for inflation, however.

Page 17: Gruber Ch 22

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.

Page 18: Gruber Ch 22

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.

Page 19: Gruber Ch 22

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.

Page 20: Gruber Ch 22

Social insurance andSocial insurance andpersonal savingspersonal savings

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.

Empirical

Empirical

EvidenEviden

cece

Page 21: Gruber Ch 22

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.

Page 22: Gruber Ch 22

Alternative models of savingsSelf-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.

Page 23: Gruber Ch 22

Alternative models of savingsSelf-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.

Page 24: Gruber Ch 22

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

Page 25: Gruber Ch 22

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 worker’s 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.

Page 26: Gruber Ch 22

Tax incentives for retirement savings

Available tax subsidies for retirement savings A 401(k) 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.

Page 27: Gruber Ch 22

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 low-income and middle-income taxpayers, who make pretax contributions and are then taxed on future withdrawals.

The contribution limit is currently $3,000 per person.

Page 28: Gruber Ch 22

Tax incentives for retirement savings

Available tax subsidies for retirement savings A Keogh account is a retirement

savings account specifically for the self-employed, 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.

Page 29: Gruber Ch 22

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.

Page 30: Gruber Ch 22

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.

Page 31: Gruber Ch 22

Tax incentives for retirement savingsWhy do tax subsidies raise the return

to savings? Table 2Table 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.

Page 32: Gruber Ch 22

Table 2

The tax advantage of IRA savingsAccount type

Earnings

Tax on earning

s

(=25%)

Initial deposi

t

Interest earned(r=10%)

Taxes paid upon

withdrawal

Total amount withdrawn

Regular

$100 $25 $75 $7.50 $1.88=0.25x($7.5

0)

$80.62=$75+$7.50-$1.88

IRA $100 0 $100 $10 $27.50=0.25x($11

0)

$82.50=$100+$10-

$27.50

With an IRA (or 401k), the

investment accrues at the before-tax

rate of return.

This “tax subsidy” leads to greater overall wealth.

Page 33: Gruber Ch 22

Tax incentives for retirement savingsTheoretical 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 3Figure 3.

Page 34: Gruber Ch 22

C1

C2

C1 Y

S

BC3 = BC1BC2

Y(1+r(1-τρ))

Y(1+r(1-τ))

C2

S(1+r(1-τ))

slope = -(1+r(1-τρ))

slope = -(1+r(1-τ))

A

B

C

Figure 3IRAs increase the after-tax rate of

return, and rotate the budget constraint.

The effect of IRAs on savings is ambiguous, however.

Page 35: Gruber Ch 22

Tax incentives for retirement savingsTheoretical 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).

Page 36: Gruber Ch 22

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 4Figure 4 illustrates this situation.

Page 37: Gruber Ch 22

C1

C2

Y

Y(1+r(1-τ))slope = -(1+r(1-τ))

$3,000

slope = -(1+r(1-τρ))

A

B

D

E

Figure 4

With a cap, savings is subsidized, but only up to a point.

Page 38: Gruber Ch 22

Tax incentives for retirement savingsTheoretical 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 5aFigure 5a.

Page 39: Gruber Ch 22

C1

C2

Y

1,000

Y(1+r(1-τ))

C1g

?A

B

C

Figure 5a Low saver

For a low saver, the income and

substitution effects go in opposite directions.

Thus, the net effect is ambiguous for low

savers.

Page 40: Gruber Ch 22

Tax incentives for retirement savingsTheoretical 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).

Page 41: Gruber Ch 22

Tax incentives for retirement savingsTheoretical effects of tax-subsidized

retirement savings

On the other hand, consider an initially high saver in Figure 5bFigure 5b.

Page 42: Gruber Ch 22

C1

C2

C1W Y

Y(1+r(1-τ))

$4,000

$5,000

A

B

C2W

Figure 5b High saver

For high-savers, IRAs represent an income

effect only and therefore lower savings.

Page 43: Gruber Ch 22

Tax incentives for retirement savingsTheoretical 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.

Page 44: Gruber Ch 22

The Roth IRAThe 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.

Applicati

Applicati

onon

Page 45: Gruber Ch 22

Tax incentives for retirement savings

Implications of alternative models The retirement tax 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.

Page 46: Gruber Ch 22

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.

Page 47: Gruber Ch 22

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.

Page 48: Gruber Ch 22

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.

Page 49: Gruber Ch 22

The impact of tax incentivesThe impact of tax incentivesfor savings on savings behaviorfor savings on savings behavior

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 don’t 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.

Empirical

Empirical

EvidenEviden

cece

Page 50: Gruber Ch 22

The impact of tax incentivesThe impact of tax incentivesfor savings on savings behaviorfor savings on savings behavior

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.

Empirical

Empirical

EvidenEviden

cece

Page 51: Gruber Ch 22

Recap of Taxes on Savings

Taxation and Savings – Theory and Evidence

Alternative Models of Savings Tax Incentives for Retirement Savings