1. Effects of Income Tax on Personal Savings: Evidence for Serbia Sasa Randjelovic University of Belgrade Faculty of Economics 2nd EUROMOD Workshop Bucharest, 12 October 2012

2. Outline Motivation Theoretical framework and literature review Income tax reform scenarios Research design, data and methodology Results Concluding remarks

3. Motivation Current income tax system in Serbia:  Mixed (hybrid) model, with strong scheduler component  Disadvantages: lack of equity (both horizontal and verical), limited redistributive effects, complicated..Reform needed and discussed Income tax reform – which way to take?  Optimal tax theory provides different views on capital income taxation: Zero capital income tax rate (Mankiw, et. al. (2009)) Positive rate of tax on capital income (Diamond, et. al. (2011)) The aim of the paper:  To estimate the savings response to PIT reform, by taking into account all transmitting channels (not just direct effects)  Contribute to the empirical literature on PIT-personal savings relationship Seminal research of that kind in Serbia (and CEE?)

4. Personal Savings Modelling: Theoretical Framework and Literature Review Can tax policy boost personal savings?  Absolute vs. permanent income hypothesis Taylor’s model of aggregate savings:  If W*= desired wealth, W-1=existing wealth, Y=income, S=savings, r=rate of return Literature:  Barnheim (1999) – modest impact of income tax on savings  Huizinga (2004) – elasticity of savings to income tax rates low  Peter (2006) – permanent income-permanent consumption elasticity high (0.9)

5. Tax Reform Scenarios in Serbia Flat Tax - Scenario 1 Comprehensive IT - Scenario 2 Dual IT - Scenario 3 Taxable income Sum of income from all sourcesLabor incomeCapital income Tax baseGross income decreased by deductionsCapital income Personal allowance RSD 9,000 (20% of AW) / Dep. children allowance RSD 4,000 (9% of AW) / Health care expenditures /Full amount / Educational expenditures /Up to RSD 4,000 / Tax Rate(s)15%10%, 20% and 25% 10%, 15% and 20% 10%

6. Research Design and Basic Model Specification PIT reform triggers change to savings via:  Altering net-of tax rate of return to savings  Altering net-of tax employment income Therefore, in order to capture full effects of PIT reform on personal savings it is necessary to estimate:  Elasticity of savings to the rate of return as well as to total income  Change in net return to savings due to PIT reform  Change in net employment income after PIT reform Basic model (relying on Taylor’s approach):

7. Data and Methodology Data:  Estimation of the basic model based on monthly data (January 2005 – December 2009, 60 observations)  Estimation labor demand elasticity to wage bill also based on monthly data (January 2004 – December 2008, 60 observations) Change in average wage being simulated by using SRMOD SRMOD – tax & benefit microsimulation model for Serbia  Living Standard Measurement Survey 2007  Sample: 5,557 households (17,375 individuals)

8. Step 1: Estimation of Savings Model Testing for stationarity of series:  Standard ADF and PP tests + special tests for seasonal and structural break unit root (Hegy 12, Climao 1, etc.)  Conclusion: all series d=1 Checking for direction of causality (IR-DEP)  VAR(3) model esimated, based on which Granger causality test has been run  Conclusions: Change in IR Granger causes change in DEP (p=0,000), not opposite Estimating the basic model: Engel-Granger cointegration method ADF and PP tests confirm stationarity of residuals IR-DEP elasticity 0.88 within range for group of countries (0.2-4.5, Pieter (2006))

9. Step 2: Estimating Effects of Change in Capital Income Tax Rate on HH Bank Depostis Estimations based on assumption of even tax incidence (between deponents and the bank)  …if this assumption is changed, the effects also change Flat taxCITDIT Average before tax interest rate4.58% Interest income tax rate15%20%10% Average after tax interest rate4.24%4.12%4.35% Change to the interest rate-2.63%-5.26%- Elasticity of bank deposits to interest rate0.88 Long run change in the level of bank deposits-2.3%-4.6%-

10. Step 2: Estimating Effects of Change in Capital Income Tax Rate on HH Bank Deposits Estimated changes to the level of bank deposits in Serbia, depending on the percentage of tax burden born by deponents

11. Step 3: Estimating Effects of Change in Labor Income Taxes on Savings Each scenarios of PIT reform changes the average labor tax wedge By means of SRMOD, it has been esimtated that average labor tax wedge would decline by 2.01% in case of flat tax, by 2.27% in case of dual income tax and by 2.48% in case of introduction of comprehensive income tax Due to high unemployment in Serbia (>25%), effective limitation is on demand side of labor market.  Therefore, it is necessary to estimate labor demand response to change in labor tax wedge, in order to estimate the change in labor income due to PIT reform

12. Step 3: Estimating Effects of Change in Labor Income Taxes on Savings Labor demand modelling – macroeconomic approach  Main drivers: output and labor costs (Lewis (2002), Carne (2007)) Labor demand model specification:  VAC= vacancies reported to NEB, TW=tax wedge (proxy for wage), GDP=real GDP Unit root tests – all series d=1, so E-G cointegration approach  ADF and PP tests: residuals are stationary

13. Step 3: Estimating Effects of Change in Labor Income Taxes on Savings  Error-correction model applied in order to estimate short-run relationship: Dependent variableExplanatory variables Estimates-0.99***-0.35**1.18*** t-statistics-7.14-2.35-3.65 p-value0.0000.0220.001 Other statistical properties

14. Step 3: Estimating Effects of Change in Labor Income Taxes on Savings  Estimating long run effects of PIT reform on labor demand  Assuming that increased labor demand would trigger corresponding increase in employment, it is expected that the these PIT reform scenarios would imply the increase in wage bill in the respective amounts Flat taxCITDIT Average change in labor tax wedge-2.01%-2.27%-2.48% Labor demand – tax wedge elasticity -0.38 Average change in labor demand/wage bill0.76%0.86%0.94% Elasticity of bank deposits to wage bill 0.2 Average change in bank deposits due to change in wage bill 0.15%0.17%0.20%

15. Step 4: Estimating Total Effects of PIT Reform on Savings  When taking into account both transmission channels, the results are as follows:  The direct effects of change in capital income tax rate prevail over indirect effects stemming from change in labor tax wedge Estimated change in bank deposits…Flat taxCITDIT …due to change in after tax interest rate-2.30%-4.60%0% …due to change in wage bill0.15%0.17%0.20% Total-2.15%-4.43%0.20%

16. Concluding Remarks Contribution of the paper:  Prividing empirical estimate of impact of PIT on HH savings, by taking into account both transmitting channels (net of tax rate of return and wage bill)  Among the seminal empirical studies taking this approach (particularly for transition economies)? Results:  Direct effects (of capital income tax) prevail over indirect effects (related to labor income tax)  Flat tax or comprehensive income tax would lead to decline in HH savings in Serbia (by 2.15% and 4.43% respecitvely), while in case of dual income tax the savings would rise (by 0.2%)  The results are dependent on tax incidence and parametrization, which is why the main aim of the paper was to develop framework for empirical analysis, rather than to provide definite answer on the layout of future PIT scheme in Serbia

17. Thank you for the attention! Questions or comments? randjelovic@ekof.bg.ac.rs