Taxes on Capital and Savings AGZ, Saez + Gruber

Taxes affect savings Important question in Political Economy. Savings is an important variable to understand economic growth. Savings-> We need a model with several periods. Basic life-cycle model..

(SAEZ) Distribution of capital income is much more unequal than labor income Capital income inequality is due to differences in savings behavior but also inheritances received Capital income is about 25-30% of national income. -> Equity suggests it should be taxed more than labor Capital Accumulation correlated strongly with growth (although causality link is not obvious) and capital accumulation might be sensitive to the net-of-tax return ->Efficiency cost of capital taxation might be high Capital more mobile internationally than labor (key distinction is residence vs source base capital taxation) Capital taxation is complex: tax avoidance opportunities

THE LIFE-CYCLE MODEL Individual lives for 2 periods, works L (fix), earns w L, consumes C 1 in period 1, saves S. C 2 =consumption second period Utility U (C 1, C 2 ) Wage w, interest rate r. T(θ) tax function The individual solves:

C1C1 C2C2 w W(1+r) E0E0

Labor income tax T(θ) = t w L The budget constraint: In the model labor supply is fix. This tax is equivalent to a lump-sum tax T = tw If consumption in bot periods is a normal good -> consumption in each period decreases

C1C1 C2C2 w w(1+r) E0E0 w-T w(1+r)-T E1E1

Reduction of consumption in second period ->private savings fall. And Why? Total savings (private+public)?: It depends. If T goes to public consumption total saving falls. If T is saved total savings increase

Consumption tax T is the same in both periods The budget constraint is. or:

The relative price of C 1 and C 2 doesn’t change. This tax is equivalent to a labor income tax of t/(1+t) Private savings different. In te case of a tax on consumption private savings are higher. The reason is that taxes are collected in a different way over time. Total savings are the same, but with a consumption tax private savings are higher and public savings lower.

Capital income tax The interest rate goes from r to r(1-t). The price of future consumption increases. The budget constraint: Income effect, substitution effect. Net effect??

C1C1 C2C2 w w(1+r) E0E0 W(1+r(1-t)) E2E2 E3E3

Tax on total income Tax on labor income + tax on capital income Tax on labor income-> savings fall Tax on capital -> savings?? Total effect ???,

Some generalizations The individual obtains a wage w 2 in the second period (or other type of income). She can borrow money in the first period. The budget constraint: We can easily show that a tax on consumption and a tax on labor income have the same effect as before.

Tax on capital income T = t r S Suppose that we also subsidie borrowers at the same rate t. We have to distinguish between borrowers and lenders. For lenders the situation is similar to the one above Borrowers: income effect and substitution effect both in the same direction -> they borrow more.

C1C1 C2C2 E0E0 Lenders (as before)

C1C1 C2C2 E0E0 borrowers

Empirical evidence. Elasticity savings w.r.t. price (r). The empirical evidence is much weaker than in the case of labor supply. Hard to determine the rigth “r” Difficult to find “control groups” Estimates between 0 and 0.6. Most experts agree that the elasticity is not very high Savings depend more on income than on the interest rate r

Additional 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. (Gruber)

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.

Self-control 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.

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.

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.