1. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 33 Copyright © 2010 Worth Publishers

2. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 2 of 33 Taxes on Savings F ERNANDO Q UIJANO AND S HELLY T EFFT P R E P A R E D B Y 22.1 Taxation and Savings— Theory and Evidence 22.2 Alternative Models of Savings 22.3 Tax Incentives for Retirement Savings 22.4 Conclusion

3. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 3 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S capital income taxation The taxes levied on the returns from savings.

4. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 4 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.1 Taxation and Savings—Theory and Evidence Traditional Theory intertemporal choice model The choice individuals make about how to allocate their consumption over time. savings The excess of current income over current consumption.

5. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 5 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S A Simplified Model 22.1 Taxation and Savings—Theory and Evidence Traditional Theory

6. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 6 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S A Simplified Model 22.1 Taxation and Savings—Theory and Evidence Traditional Theory 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 first-period consumption is the interest income not earned on savings for second-period consumption.

7. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 7 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S Substitution and Income Effects of Taxes on Savings 22.1 Taxation and Savings—Theory and Evidence Traditional Theory 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. 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 C W in period one to achieve that target.

8. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 8 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S Substitution and Income Effects of Taxes on Savings 22.1 Taxation and Savings—Theory and Evidence Traditional Theory Intertemporal Substitution vs. Income Effect 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 (C W 2 ) and thus saving less (S 2 ). As a result, their consumption in period two (C R 2 ) falls by a lot.

9. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 9 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S Substitution and Income Effects of Taxes on Savings 22.1 Taxation and Savings—Theory and Evidence Traditional Theory Intertemporal Substitution vs. Income Effect If the income effect is larger, individuals will move from point A to point C, consuming less in the first period (C W 3 ) and thus saving more (S 3 ). Their consumption in period two (C R 2 ) still falls, but not by as much.

10. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 10 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.1 Taxation and Savings—Theory and Evidence 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.

11. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 11 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.1 Taxation and Savings—Theory and Evidence 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.

12. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 12 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.1 Taxation and Savings—Theory and Evidence 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.

13. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 13 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.1 Taxation and Savings—Theory and Evidence Inflation and the Taxation of Savings Inflation and Capital Taxation

14. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 14 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.1 Taxation and Savings—Theory and Evidence 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.

15. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 15 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.2 Alternative Models of Savings Precautionary Savings Models 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. liquidity constraints Barriers to credit availability that limit the ability of individuals to borrow.

16. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 16 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.2 Alternative Models of Savings Precautionary Savings Models Evidence for the Precautionary Model 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.

17. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 17 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.2 Alternative Models of Savings 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.

18. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 18 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S M P I R I C A L E V I D E N C E E SOCIAL INSURANCE AND PERSONAL SAVINGS 22.2 Alternative Models of Savings A central prediction of the precautionary savings model is that when the government provides insurance against income uncertainty, individuals will reduce the buffer stock of precautionary savings they have built up to deal with that uncertainty. Perhaps the most striking is the study by Chou et al. (2003) of the introduction of National Health Insurance (NHI) in Taiwan in 1995: Among government workers, from before NHI to after, savings rose by $30,000 Taiwanese dollars (U.S. $1,165) on average, consistent with the strong economic growth of this era. Similar evidence is available for the United States as well. For example, Gruber and Yelowitz (1999) found that the Medicaid expansions significantly reduced the savings of low-income groups.

19. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 19 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings 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.

20. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 20 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings 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.

21. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 21 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings 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 $5,000 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.

22. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 22 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 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 Tax Incentives for Retirement Savings Available Tax Subsidies for Retirement Savings Keogh Accounts

23. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 23 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings 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.

24. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 24 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings

25. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 25 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings

26. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 26 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings Low Savers vs. High Savers Mr. Grasshopper saves little before the IRA is introduced (point A), consuming C W 1 and saving only $1,000. 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).

27. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 27 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings Low Savers vs. High Savers Ms. Ant was a high saver before the IRA was introduced, consuming C W 1 and saving $6,000 (point A). For Ms. Ant, 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 C W 2 and her savings to fall to S 2, $5,000.

28. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 28 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings APPLICATION  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. 

29. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 29 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings Implications of Alternative Models Precautionary Savings Asset reshuffling will be likely if two conditions are met: if a large share of IRA contributors would have saved $5,000 anyway in the absence of the IRA, and if IRA savings and non-IRA savings are viewed as highly substitutable. Self-Control Models Retirement accounts such as pension and 401(k) accounts provide excellent commitment devices because the contributions are taken directly out of the paycheck and individuals can’t access their money until retirement.

30. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 30 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings Private vs. 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.

31. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 31 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings M P I R I C A L E V I D E N C E E ESTIMATING THE IMPACT OF TAX INCENTIVES FOR SAVINGS ON SAVINGS BEHAVIOR Those who contribute to IRAs may be “savers,” who save more in every form than the “non-savers” who don’t contribute to IRAs. The literature on 401(k)s has taken a different approach, with researchers comparing the amount of savings put aside by workers in firms with 401(k)s (the treatments) with the savings put aside by workers in firms that do not offer 401(k)s (the controls). Two studies have, however, developed convincing means of assessing the impact of these savings incentives on savings. More recent evidence on the impact of retirement savings incentives on savings behavior comes from a randomized trial run by Duflo et al. (2005). The study found that those who randomly received a 20% match contributed four times as much to their IRA accounts, and that those who randomly received a 50% match contributed seven times as much relative to the control group. Providing further incentives for people to contribute to their retirement savings can raise the level of savings.

32. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 32 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.3 Tax Incentives for Retirement Savings Evidence on Tax Incentives and Savings 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 it is not tax savings but other factors in program design that have the most impact on the effect of retirement incentives. These types of findings have motivated President Barack Obama’s recent plans to reform our retirement savings system.

33. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 33 of 33 C H A P T E R 2 2 ■ T A X E S O N S A V I N G S 22.4 Conclusion 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.