1. PUBLIC FINANCE AND TAX POLICY
Lecture 11

2. Taxation and Savings Intertemporal choice model
The role of saving is to smooth consumption across periods of time
Two periods are considered in someone’s life:
Working period
Retirement
Before taxation on savings:
If Mr. X saves nothing:
He can consume Y
If he saves his total income
He can consume Y*(1+r)
The slope of the budget constraint line is -(1+r)

3. After taxation on interest income
Reduction in after tax return to savings
from r to r*(1-t)
The government takes a portion of (r*t)
New budget constraint
New slope= -(1+r*(1-t))
The opportunity cost has fallen
Each dollar of saving yields less consumption in the second period
Consumption
while retired CR
Y*(1+r)
Slope= -(1+r)
Y* (1+r*(1-t))
CR1
CR2
Consumption
while working Cw
Cw1 Y

4. Substitution and income effects of taxes on savings:
Substitution effect:
Imposing tax on savings interest
Lowering after tax interest rate
Lowering the price of Cw
Rising the consumption in period one
Falling the savings
Income effect:
Falling the value of saving
Lowering the consumption in period one
There is a target level of consumption for retirement in period two

5. Substitution and income effect work in opposite directions
Substitution effect is larger
Consumption
while retired CR
Y*(1+r)
Slope= -(1+r)
Y* (1+r*(1-t))
Slope= -(1+r(1-t)) A
CR1
S1*(1+r) B
CR2
Consumption
while working Cw
S2*(1+r*(1-t))
Cw1
Cw2 Y S1 S2

6. Substitution and income effect work in opposite directions
Income effect is larger
Consumption
while retired CR
Y*(1+r)
Slope= -(1+r)
Y* (1+r*(1-t))
Slope= -(1+r(1-t)) A
CR1 B
CR3
S1*(1+r)
S3*(1+r*(1-t))
Consumption
while working Cw
Cw3
Cw1 Y S1 S2

7. How does the after tax interest rate affect savings?
The impact of after tax interest rate on saving could be positive, negative or even zero!
Studying the connection between after tax interest rates and savings is not easy:
Determining the appropriate interest rate for any given saver
There are different saving opportunities available to an individual:
Bank account
Tax subsidized pensions
The interest that can be earned on any type of savings typically changes over time
The case is a bit more complicated than labour supply
The elasticity of savings with respect to the after tax interest rate remains a crucial parameter for policy analysis

8. Alternative models of savings:
According to the Intertemporal choice model, saving is undertaken solely to smooth consumption over time
However there are other factors in determining savings which should be taken into account
Alternative models of savings:
2. Precautionary Savings Models
3. Self Control Models

9. Precautionary Savings Models
Other important factors in determining savings are:
The amount of uncertainty that individuals face in their financial prospects
Desire to use savings to ensure against negative financial shocks
The top reasons for saving:
Retirement
Emergencies
Unemployment or health problem
Precautionary Savings Model is a model of savings that accounts for the fact that individual savings serve to smooth consumption over future uncertainties, at least partly.

10. liquidity constraints:
Precautionary Savings Models assumes that individuals are unable to borrow if they experience an adverse shock because they face liquidity constraints.
liquidity constraints:
Barriers to credit availability that limit the ability of individuals to borrow.
This leads to build a desire to have a buffer stock saving
Uncertainty
Saving
The expansions in social insurance programs that lower income uncertainty also lower savings

11. Self Control Models
In this model, individuals face the conflict between:
impatient, short-run preferences
patient, long-run preferences
In this models, a key determinant of savings behavior is the ability of individuals to find ways to commit
themselves to save.

12. Evidence for self-control model:
Individuals with self control problem will demand commitment devices to help curb their self-control problems.
e.g 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 Christmas to buy gifts
The strange pattern of asset accumulation in the United States:
Individuals have substantial savings in forms that are hard to access, but very little in more easily accessible forms
e.g Housing or retirement accounts vs checking accounts
Retirement accounts (interest rates 5% or less)
Credit cards (10% or more)

13. Tax incentives for retirement savings
The U.S. government has introduced a series of tax subsidized mechanisms to encourage retirement savings:
Tax Subsidy to Employer-provided Pensions
401(k) Accounts
Individual Retirement Accounts
Simplified Employee Pension IRAs

14. Tax Subsidy to Employer-provided Pensions
defined benefit pension plans
Pension plans in which workers accrue pension rights during their tenure at firm, and when they retire, the firms pays them a benefit that is a function of that workers’ tenure at the firms and of their earnings.
Over time employer provided pension plans have shifted to defined contribution pension plans
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
Any interest that accumulate on this pension savings is not taxed as it is accrued
Employees are taxed on their pension savings as regular income when it is withdrawn in retirement
2% * annual salary* years of work

15. 401(k) Accounts
401 k is one of the most common retirement savings account
The 401 k is set up by an employer and has both tax and saving advantages
eg: you just start a new job with a company, one of the advantages of this job is 401k matching
You earn $100,000 before taxes and is allowed to put 6% of your salary in a 401k account
On top of that the company agrees to match 50 cents for every dollar that you save, so if you contribute the full amount => $6000 your company will match this by 0.5*$6000=$3000
Total contribution is $9000
This contribution is tax deductible:
You only need to pay income tax on $94000
There is a limit on 401(k) contributions $17,000 (in 2012)
You only need to pay taxes when you withdraw the money from the account usually retirement or after 60
Matching is only one benefit plan
Profit sharing:
For example instead of the compony matching 50 cents to the dollar, the agreed contribution is 1% of the company’s profit
401 k is a tool for companies for recruitment
When withdrawn in retirement, 401(k) account balances are taxed as ordinary income.

16. 401 k is also used a tool for retention also known as vesting period:
The contributions are locked in for specific period of time
eg the company tells that the contribution takes 3 years to vest
You cant withdraw the compony ($3000) for 3 years
If you quit or fired you are allowed to keep all of your contribution and all the compony’s vested contribution
However if you withdraw it as cash you force to pay taxes and the penalty
Therefore it is better to role over the contribution to another registered retirement account

17. Individual Retirement accounts (IRA)
Problem with the Employer-provided Pensions and 401(k) plans:
Many individuals are not offered such plans by their employers
Only 49% of workers in private sector participate in an employer provided pension plans
Individual Retirement accounts (IRA)
A tax favored retirement savings vehicle primarily for low and middle income tax payers, who make pretax contributions and are then taxed on future withdrawals.
Low and middle income households:
Income below $58,000
Single head of households
Income below $92,000
Married couple

18. IRA functions as follows:
Individuals can contribute up to $5,000 tax free each year (deducted from their taxable income)
Unlike the interest on regular savings accounts, the interest earned on IRA contributions accumulates tax free.
IRA balances cant be withdrawn until age 59 ½ (or there is a 10% tax penalty)
IRA balances are taxed as regular income on withdrawal.
You can invest your IRA on Stocks, Bonds and Mutual funds
The money you make on this investment is not taxed

19. Higher income households only have access to nondeductible IRAs
The annual contributions are part of taxable income but for which the interest earned accumulates tax free
The tax subsidization of saving through IRA was expanded in 2001:
saver’s tax credit
This program matches the contributions to IRA accounts by low income families.
eg:
For married couples jointly filing taxes with income below $30,000 the saver’s credit equals to 50% of their IRA contribution up to $2,000 => $1,000.
The match rate then falls and for joint filers with income between $36000 and $56,000 the credit rate is only 10%.

20. Simplified Employee Pension IRAs (SEP IRA)
Retirement savings accounts specifically for the self employed under which up to $50,000 per year can be saved on a tax free basis
SEP IRA accounts function in the same way as do 401(k) accounts (without matching) except that they are not run through employers.

21. If retirement savings are taxed anyway when individuals are retired, how is this a tax subsidy?
Present discount value PDV:
Money received today worth more than money that will be received in the future because you can earn interest on the money if you have it today.
Taxes paid in the future are less costly than taxes paid today.
Another advantages:
Motivation for long run savings
Being in a lower tax bracket at the time of retirement because the income is lower than when working

22. a. Draw that person’s intertemporal budget constraint.
Suppose that a person lives for two periods, earning $30,000 in income in period 1, which she consumes or saves for period 2. What is saved earns interest of 10% per year.
a. Draw that person’s intertemporal budget constraint.
b. Draw that persons’s intertemporal budget constraint if the government taxes interest
at the rate of 30%.
The x-axis intercept is consumption out of the entire earnings of period 1: $30,000.
The y-axis intercept is income available in period 2 if the entire period 1 earnings were saved, earning interest at the rate of 10%. This amount is 30,000(1 + r) = $33,000.
When interest is taxed at 30%, the y-axis intercept becomes 30,000(1 + 10%[1 – 30%]), or 30,000 × 1.07 = $32,100. This is shown as a dashed line in the figure in a.

23. Gale and Scholz (1994) estimate that increasing the contribution limits for Individual Retirement Accounts would have little effect on the overall rates of savings. Why do you think this might be the case?
Overall savings rates only increase when people take money from current consumption and invest it in savings. When people merely switch from non-IRA savings to IRA savings, the total savings rate is unaffected. One reason for Gale and Scholz’s finding may be that the current IRA limits are so high that most people could not afford to reduce their current consumption further to invest more in retirement savings. Perhaps the only people who could or would increase IRA savings are the wealthy who already have substantial savings that could be moved to this less-liquid but tax-favored form of savings.