Intermediate Microeconomics and Its Application 12th Edition by Walter Nicholson,Christopher Snyder

Exercise 38

Do We Need Tax Breaks for Savers?
Personal savings rates in the United States are relatively low by international standards. In 2012 total personal savings amounted to about 5:6 percent of personal disposable income. This figure is lower than the one that existed through much of U.S. history and a markedly lower rate than exists in many other countries1 (where rates above 10 percent are common). Such low savings rates have prompted a variety of concerns. Some observers worry about whether individuals will have adequate savings for their own retirement or for various emergencies. Others worry that inadequate savings will fail to provide sufficient capital accumulation for future generations. As a result, many tax-favored plans for savings have been introduced in recent years.
Recent Savings Incentive Plans
Many savings incentive plans have a similar structure. All of them allow a tax deduction for contributions to the plans2. Savings in the plans are then not subject to the federal income tax until benefits are paid out at retirement. The three principal types of such plans are
• Individual Retirement Accounts (IRAs), which are set up by individuals acting on their own. Only low-income individuals receive an income tax deduction for IRA contributions, but everyone can avoid taxation of returns from assets in the plans until they retire.
• 401(k) plans are set up by employers who sometimes make matching contributions to their workers' plans. Both contributions and asset returns are tax-exempt until retirement.
• Keogh plans are similar to IRAs and 401(k) plans, but the plans are intended for self-employed individuals. They generally have higher contribution limits than the other plans do.
Theoretical Effects on Savings
The effect of these various tax benefits on total personal savings is ambiguous. Although special tax treatment does raise the after-tax interest rate for savers, our discussion of Figure 14.2 showed that the effect of such a change on savings is uncertain-income and substitution effects of increases in the effective interest rate work in opposite directions. In addition, the fact that the special tax treatment does not apply to all savings but only to contributions to specific plans gives individuals an incentive to shift their assets into the tax-favored plans without actually changing the total amount of their savings Hence, the rapid growth of the plans should not be taken as an indication of the plans' ability to stimulate savings.
Research on Savers and Spenders
Because savings incentive plans involve significant losses in tax revenues, much research has been undertaken to determine whether the plans are achieving their goal of increasing savings. Most studies use data on individual savings behavior to detect such influences. Unfortunately, this research has been plagued by one serious problem: it appears that different people have very different attitudes toward saving. Some people are serious savers who will accumulate assets in many forms. Other people are only spenders who never put anything aside. Individuals who participate in one of the special saving plans have shown that they fit into the "saver" category. But to compare their savings behavior to the behavior of those individuals without the plans runs the danger of concluding that the plans themselves increase savings. A more correct interpretation is that plan participation acts only to identify savers who are predisposed to save more. Researchers have been unable to resolve this sample selection problem and the true impact of the special savings plans remains largely unknown.
Low personal savings rates in the United States pose a policy problem because it is more difficult to generate adequate funds for investment than it would be if savings rates were higher. As shown in this example, however, trying to generate more savings through special tax breaks poses difficulties both because such incentives may not work very well and because most of the tax benefits may go to those people who would save a lot anyway. A somewhat different approach would be to "penalize" current consumption through, say, a general sales tax, but this approach would also pose difficulties for lower income people unless some major categories of goods were exempted from such a tax. Other approaches, such as limiting consumer credit or conducting pro-savings advertising campaigns, seem equally problematic. Hence, it appears that no one has a very promising plan for increasing savings. In fact, many government policies (such as Social Security or Medicare) seem to work against that goal.