Results from the HMRC/HMT/ESRC Joint Research Programme on Taxation Analysis The influence of decision making costs on the effectiveness of tax incentives to save Justin van de Ven Martin Weale & Paolo Lucchino August 2013

Aims of the research Facilitate use by Whitehall of current best practice methods to analyse savings and employment responses to policy Advance our understanding of household sector savings decisions Explore the role of decision costs as influences on responses to tax incentivised savings schemes

Outline Analysing saving and employment decisions The Lifetime Income Distributional Analysis (LINDA) Model Empirical analysis The influence of decisions costs on the effectiveness of ISAs

Analysing saving & employment decisions A spectrum of behavioural assumptions very broad behavioural assumptions Back-of-an- envelope analysis detailed statistical analysis no formal model of behaviour detailed statistical analysis formal model of behaviour – poor approx. of uncertainty detailed numerical analysis formal model of behaviour – uncertainty explicitly considered

LINDA: A model for Whitehall Structural model of household consumption, labour supply, and investment decisions (van de Ven and Lucchino, 2013) Life-cycle framework –Motivating observations (Attansio & Webber, 2010) –Resolution of puzzles Model specifics –Microsimulation of individual households that vary over a range of characteristics –Decisions modelled at annual intervals from age 20 to 120 –Demographics explicit –Hard and soft liquidity constraints –Uncertainty over wages, employment, marital status, investment returns, and time of death Modelling effort represents current best practice in the micro-economic analysis of dynamic decision making at the household level

LINDA: A model for Whitehall Projects panel data forward and back through time from a population cross- section (WAS) –Policy relevant basis for analysis Effort has been expended to make the model accessible to non-specialists: –Excel front-end –Summary statistics reported through Excel –Simulated panel data reported in standard format

LINDA: model methodology Preferences: Budget constraint: Evolution of wages: Dynamic programming…

LINDA: model methodology hThT wTwT h T-1 w T-1 h T-2 w T-2 h1h1 w1w1 time

Using LINDA

LINDA: Output

Empirical analysis The innovative nature of the LINDA model has important advantages for conducting empirical analysis –see Lucchino & van de Ven (2013) Key findings: –Intertemporal elasticity of substitution at population averages in region of 0.5. –Allowing for decision costs helps to match the model to observed rates of participation in ISAs

Empirical analysis Utility price of leisure (A), unemployment rates (B), experience wages effects(C), and labour supply

Empirical analysis Discount rate (A), relative risk aversion (-A), preference for bequests (B) and consumption

Empirical analysis Discount rate (A), relative risk aversion (A), preference for bequests (A) and pension participation

Simulated effectiveness of ISAs –ISAs do not motivate appreciable increases in household saving, with or without decision costs –in the absence of decision costs, households are projected to invest heavily through ISAs, but off-set almost all of this saving against other wealth –decision costs reduce the scale of projected ISA investments, but leave most other effects on population averages qualitatively unchanged –the form that decision costs are assumed to take has an important influence on determining distributional responses to ISAs van de Ven (2013)

Behavioural Results Projected savings behaviour of individuals born between 1977 and 1986, by existence of ISAs and decision costs over ISA participation (£000, 2006)

Behavioural Results Welfare effects of ISAs (£2006)

Directions for further research Adaptation of model framework –An on-going process Testing alternative empirical specifications and behavioural hypotheses –Stylised forms to explore intertemporal elasticity (evidence of time variation?) –Appropriate moments for empirical identification (novelty of approach) –Form of decision costs? Applied policy analyses