Taxes on Savings

1. Taxes on Savings Chapter 22 22.1 Taxation and Savings— Theory and Evidence capital income taxation The taxes levied on the returns from savings. 22.2 Alternative Models of Savings 22.3 Tax Incentives for Retirement Savings 22.4 Conclusion

2. Taxation and Savings—Theory and Evidence 22 . 1 Traditional Theory intertemporal choice The choice individuals make about how to allocate their consumption over time. savings The excess of current income over current consumption.

4. Taxation and Savings—Theory and Evidence 22 . 1 Traditional Theory A Simplified Model

5. Taxation and Savings—Theory and Evidence 22 . 1 Traditional Theory A Simplified Model intertemporal budget constraint The measure of the rate at which individuals can trade off consumption in one period for consumption in another period. Theopportunity cost of first-period consumption is the interest income not earned on savings for second-period consumption.

6. Taxation and Savings—Theory and Evidence 22 . 1 When thinking about the income effect of changes in the after-tax interest rate on savings, it is helpful to reflect on the extreme case of a target level of consumption for retirement in period two. If Jack has a certain amount of consumption he wants in period two, then when the after-tax interest rate falls, he must save more and reduce CW in period one to achieve that target. Traditional Theory Substitution and Income Effects of Taxes on Savings • The price change that results from the tax on savings interest will have two effects. • The lower after-tax interest rate will cause consumption in period one to rise through the substitution effect. This will in turn lead savings to fall. • There is also, however, an income effect of lower after-tax income.

7. Taxation and Savings—Theory and Evidence 22 . 1 Traditional Theory Substitution and Income Effects of Taxes on Savings

8. Taxation and Savings—Theory and Evidence 22 . 1 Traditional Theory Substitution and Income Effects of Taxes on Savings

9. Taxation and Savings—Theory and Evidence 22 . 1 Evidence: How Does the After-Tax Interest Rate Affect Savings? Studying the connections between after-tax interest rates and savings is a difficult problem. Although we can measure a given worker’s wage, it is hard to measure the appropriate interest rate for any given saver. The interest that can be earned 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.

10. Taxation and Savings—Theory and Evidence 22 . 1 Inflation and the Taxation of Savings Before 1981, the tax brackets on which taxation is based were denominated in constant dollars that did not change with inflation. This practice led to a phenomenon known as bracket creep, whereby individuals would see an increase in their tax rate despite no increase in their real income.

11. Taxation and Savings—Theory and Evidence 22 . 1 Inflation and the Taxation of Savings Inflation and Capital Taxation 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.

12. Taxation and Savings—Theory and Evidence 22 . 1 Inflation and the Taxation of Savings Inflation and Capital Taxation

13. Taxation and Savings—Theory and Evidence 22 . 1 Inflation and the Taxation of Savings Inflation and Capital Taxation We can define the relationship between the real and nominal interest rates as: Real interest rate (r) =[1 + Nominal interest rate (i)] / [(1 + Inflation rate (p)] – 1 The problem is that taxes are levied on nominal, not real, interest earnings.

14. Alternative Models of Savings 22 . 2 Precautionary Savings Models Evidence for the Precautionary Model precautionary savings model A model of savings that accounts for the fact that individual savings serve, at least partly, to smooth consumption over future uncertainties. Studies have shown that more uncertainty leads to more savings, and that reducing uncertainty reduces savings. Other studies have shown that expansions in social insurance programs that lower income uncertainty also lower savings. liquidity constraints Barriers to credit availability that limit the ability of individuals to borrow. Studies have shown that more uncertainty leads to more savings, and that reducing uncertainty reduces savings. Other studies have shown that expansions in social insurance programs that lower income uncertainty also lower savings.

15. Alternative Models of Savings 22 . 2 Self-Control Models In this model, a key determinant of savings behavior is the ability of individuals to find ways to commit themselves to save, so that they can keep their income out of the hands of their impatient “short-run self.” Evidence for the Self-Control Model Individuals with self-control problems will demand commitment devices to help curb their self-control problems. A classic example is the “Christmas club,” a bank account into which individuals put money throughout the year, at low or no interest, to make sure they have money available at Christmastime to buy gifts.

16. Tax Incentives for Retirement Savings 22 . 3 Available Tax Subsidies for Retirement Savings Tax Subsidy to Employer-Provided Pensions 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 worker’s tenure at the firm and of their earnings. defined contribution pension plans Pension plans in which employers set aside a certain proportion of a worker’s earnings (such as 5%) in an investment account, and the worker receives this savings and any accumulated investment earnings when she retires.

17. Tax Incentives for Retirement Savings 22 . 3 Available Tax Subsidies for Retirement Savings 401(k) Accounts 401(k) accounts Tax-preferred retirement savings vehicles offered by employers, to which employers will often match employees’ contributions. Individual Retirement Accounts 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.

18. Tax Incentives for Retirement Savings 22 . 3 Available Tax Subsidies for Retirement Savings Individual Retirement Accounts • For low- and middle-income households, IRAs function as follows: • They are not a special type of savings. Almost any form of asset can be put in an IRA (from stocks to bonds to holdings of gold). • Individuals can contribute up to $4,000 tax-free each year (deducted from their taxable income). • Unlike the interest on a regular savings account, the interest earned 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 (or there is a 10% tax penalty). • IRA balances are taxed as regular income on withdrawal.

19. Tax Incentives for Retirement Savings 22 . 3 Available Tax Subsidies for Retirement Savings Keogh Accounts 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.

20. Tax Incentives for Retirement Savings 22 . 3 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.

21. Tax Incentives for Retirement Savings 22 . 3 Theoretical Effects of Tax-Subsidized Retirement Savings

22. Tax Incentives for Retirement Savings 22 . 3 Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings

23. Tax Incentives for Retirement Savings 22 . 3 Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings

24. Tax Incentives for Retirement Savings 22 . 3 Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings

25. The Roth IRA Roth IRA A variation on normal IRAs to which taxpayers make after-tax contributions but may then make tax-free withdrawals later in life. This account has many similarities to a regular IRA, but has two key differences: • Individuals contribute after-tax dollars to a Roth IRA, and when withdrawals are eventually made, the withdrawals are not taxed. • Individuals are never required to make withdrawals, so that earnings on assets can build up tax-free indefinitely. Why did policy makers introduce this new option? • The government collects tax revenues today and loses them in the future (since we don’t tax interest earnings on the account or withdrawals from it). • The plan allows politicians to enact a tax break while delaying the budgetary pain of paying for it.

26. Tax Incentives for Retirement Savings 22 . 3 Private Versus National Savings The comparison of private to national savings comes back to the notion of marginal impacts of tax incentives (new behavior encouraged) versus inframarginal impacts of tax incentives (old behavior rewarded). 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. 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.

27. Conclusion 22 . 4 One of the most important decisions made by taxpayers in the United States is how much to save, and it seems likely that taxes factor into that decision. 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 2006, it had grown to $105 billion. Clearly, policy makers believe that tax incentives can make a difference in the savings decisions of individuals.