Gruber4e ch22

Public Finance and Public Policy Jonathan
CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 36
Taxes on Savings
22
22.1 Taxation and SavingsTheory and

Evidence
22.2 Alternative Models of Savings
22.3 Tax Incentives for Retirement Savings
22.4 Conclusion
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
2 of 36
22
C HAP TE R 2 2 TAX E S O N S AV I N G S
Taxes on Savings
Capital income taxation: The taxes

levied on the returns from savings.
This chapter explores:
o How capital income taxation affects
behavior in theory and in practice.
o How capital income taxation works in the
United States.
3 of 36
22.1
Taxation and Savings: Traditional Theory
The intertemporal choice model is the main

model for understanding how taxes affect
savings.
o Intertemporal choice model: The
choice individuals make about how to
allocate their consumption over time.
o Savings: The excess of current income
over current consumption.
The model focuses on tradeoff between
consumption today and consumption
tomorrow.
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22.1
Jacks Two-Period Savings Problem
Jack has income from working.

Jack chooses how much to consume while
working () and while retired ().
Savingsis the difference between income
and first-period consumption,
Savings earns interest, and Jack consumes
net savings:
)
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22.1
Jacks Two-Period Savings Problem
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 one dollar of first

period consumption is (1 + r) dollars of
second period consumption.
Taxes on savings affect behavior by
changing the effective interest rate, shifting
the budget constraint.
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22.1
A Simplified Model
Consumptio
n
while
retired
in period 2,
C RY x (1 Slop
e=
+ r)S
(
lop
1+
(1 e =
r)
Y x (1 + r x [1 + r x
[1
])
])
S x (1
+ r)
0
Indifference
curve, IC1
Budget
constraint,
BC2
BC1
Y Consumpti
on
while
S
working
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22.1
Substitution and Income Effects of Taxes on Savings
Taxes and other price changes affect savings

in two ways:
o Substitution effect: Lower after-tax
interest rates cause first-period
consumption to rise, reducing savings.
o Income effect: Lower after-tax interest
rates reduce the lifetime value of income,
reducing first-period consumption and
increasing savings.
o Substitution effects may seem more
natural, but a target savings model
generates complete income effects.
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22.1
Effect of Taxes on Savings: Substitution Effect Is

Larger
CR
Slo
pe
=
(
Slo
1
p
e
+
(1
=
r)
+r
Y x (1 + r x [1
x[
1
])
])
Y x (1
+ r)
S1 x (1 +
r)
S2 x (1 + r x [1
])
IC
1
IC
2
BC2
0
BC
1
CW
S1
S2
9 of 36
22.1
Effect of Taxes on Savings: Income Effect Is Larger

CR
Slo
pe
Y x (1
=
+ r)
(
Slo
1
pe
+
(1
=
r)
+r
Y x (1 + r x [1
x[
1
])
])
S1 x (1 +
r)
S3 x (1 + r x [1
])
A
C
IC
IC
BC2
0
BC
1
CW
S1
S3
10 of 36
22.1
Evidence: How Does the After-Tax Interest Rate

Affect Savings?
Evidence is ambiguous: either no impact or
positive.
Studying the connections between after-tax
interest rates and savings is a difficult
problem:
o Hard to measure the relevant interest
rate.
o Interest 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.
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22.1
Inflation and Capital Taxation
The United States taxes nominal, not real,

interest income.
o Nominal interest rate: The interest
rate earned by a given investment.
o Real interest rate: The nominal
interest rate minus the inflation rate; this
measures an individuals actual
improvement in purchasing power due to
savings.
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22.1
Inflation and Capital Taxation
The relationship between real and nominal

interest rates is:
Inflation increases the nominal but not the

real interest rate, but taxes are levied on
nominal interest rates.
Inflation reduces the real after-tax return on
savings.
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22.1
Inflation Exacerbates Capital Taxation
No
Inflation
Inflatio (Constant Real
n
Rate)
Inflation
0%
10%
Nominal interest
rate
10
21
Interest earnings
After-tax
resources
$10
105
$21
110.5
Price
of $100,
Skittles
Save
10% real 1
interest rate, 1.1
50% tax
on interest.
Bags
of Skittles
105
100.5
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22.2
Precautionary Savings Models
The traditional model assumes that people

only save to smooth consumption, not to
self-insure.
Precautionary savings model: A model
of savings in which individuals save, at
least partly, to smooth consumption over
future uncertainties.
Liquidity constraints make it harder to
borrow in tight times, so people develop a
buffer stock.
Liquidity constraints: Barriers to credit
availability that limit the ability of
individuals to borrow.
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22.2
EVIDENCE: Social Insurance and Personal Savings
Theory predicts that social insurance

reduces precautionary savings.
Chou et al. (2003) study the introduction of
National Health Insurance (NHI) in Taiwan in
1995.
o After NHI, savings fell among the
public
o But rose among people unaffected by
NHI.
In the United States, Medicaid expansions
significantly reduced the savings of lowincome groups.
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22.2
Self-Control Models
Individuals may not be able to save as

much as they would like because of selfcontrol problems.
Use of commitment devices is evidence for
this model:
o Christmas clubs, other traditional
devices, save more tomorrow plans.
o Keep money away from impatient shortrun self. Rising credit card debt, rising
housing wealth.
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22.3
Tax Subsidy to Employer-Provided Pensions
Employer contributions to pensions are taxdeductible.

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: Upon
retirement, the workers benefit depends on
tenure and earnings.
Defined contribution pension plan:
Employers set aside a certain proportion of
a workers earnings in an investment
account, and upon retirement, the worker
18 of 36
22.3
Available Tax Subsidies for Retirement Savings
401(k) accounts and IRAs also subsidize

savings.
401(k) accounts: Tax-preferred retirement
savings vehicles offered by employers, to
which employers will often match
employees contributions.
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.
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22.3
Individual Retirement Accounts
For moderate income households, IRAs work

as follows:
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 taxfree each year (deducted from their taxable
income).
Interest on IRA contributions accumulates
tax-free.
IRA balances cant be withdrawn until age
59-12, and withdrawals have to start at age
70.
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22.3
Keogh Accounts
Keogh accounts provide a savings subsidy

for the self-employed.
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.
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22.3
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.
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22.3
Why Do Tax Subsidies Raise the Return to Savings?
Account
Type:
Regular
IRA
Earnings
Tax on
earnings
Initial deposit
Interest
earned
Taxes at
withdrawal
Net amount
withdrawn
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22.3
Theoretical Effects of Tax-Subsidized Retirement

Savings
Tax subsidies for retirement savings

increase the after tax return to savings by
reducing the tax rate from to .
This can encourage savings through the
substitution effect, or discourage it through
the income effect.
But IRA contributions are capped, so there
is only an income effect for high savers.
o High savers will just reshuffle their
assets from non-IRA to IRA accounts.
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22.3
Theoretical Effects of Tax-Subsidized Retirement

Savings
CR
Slo
( pe
1+ =
Y x (1 + r[1r[1
])
-
Slo
pe
])
(1
=
Y x (1 + r x [1
+rx
])
])
[1
B
C
S2 x (1 + r x [1
])
BC2
BC
3
CW
S4
S2
S3
25 of 36
22.3
Limitations on Tax-Subsidized Retirement Savings
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22.3
Effect of Tax-Subsidized Retirement Savings for Low

Savers
CR
BC2
Y x (1 + r x [1
])
slope =
(1 + r x [1 ])
slope =
(1 + r x [1 ])
BC1
CW
S3 = $500
Public Finance and Public Policy Jonathan Gruber Fourth Edition
S1 =
$1,000
S2 =
$1,500
Copyright
2012 Worth Publishers
27 of 36
22.3
Effect of Tax-Subsidized Retirement Savings on High

Savers
CR
BC2
Y x (1 + r x [1
])
B
slope =
(1 + r x [1 ])
BC1
slope =
(1 + r x [1 ])
CW
S2 =
$5,000
S1 =
$6,000
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22.3
APPLICATION: The Roth IRA
Congress introduced the Roth IRA in 1997.

Roth IRA: A variation on normal IRAs to
which taxpayers make after-tax
contributions but may then make tax-free
withdrawals later in life.
Similar to a regular IRA, but with two key
differences:
o Individuals contribute after-tax dollars to
a Roth IRA, but make tax free
withdrawals.
o Individuals are never required to
withdraw, so earnings on assets can build
up tax-free indefinitely.
Provides more generous tax subsidy than
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22.3
APPLICATION: The Roth IRA
Why did policy makers introduce this new

option?
o The government collects tax revenues
today and loses them in the distant
future (since we dont tax interest
earnings on the account or withdrawals
from it).
o But budget implications of laws are only
evaluated over a 10-year horizon.
o The plan allowed politicians to pay for a
tax break with a tax break!
30 of 36
22.3
Implications of Alternative Models
Precautionary Savings:
o No effect for high-savers.
o Low savers may not want their savings
locked up until age 59.
Self-Control Models:
o Retirement accounts are appealing.
o Excellent commitment devices:
Contributions are taken directly out of
the paycheck and individuals cant
access their money until retirement.
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22.3
Private vs. National Savings
Impact of tax subsidies for savings on

national savings depends on the marginal
and inframarginal responses.
The size of the marginal and inframarginal
response to tax incentives for savings will
depend on two factors:
o The size of the income and substitution
effects for retirement savers below the
savings limit.
o The share of retirement savers who are
above the savings limit, for whom there
is only an inframarginal response.
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22.3
EVIDENCE: Estimating the Impact of Tax Incentives

for Savings on Savings Behavior
How do tax subsidies affect savings in
practice?
Engelhardt (1996) studied a Canadian
program (RHOSP) subsidizing savings for
home down payments.
o Ended in 1985, available only to renters,
with bigger benefits to people with
higher marginal tax breaks.
o RHOSP increased savings: Each dollar
contributed represented 56 to 93 of
new private savings, and 20 to 57 of
new national savings.
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22.3
EVIDENCE: Estimating the Impact of Tax Incentives

for Savings on Savings Behavior
Duflo et al. (2005) randomly assigned
people to different employer match rates.
o Random assignment eliminates all bias.
o People who received a 20% match
contributed four times as much to their
IRA accounts, relative to the control
group.
o People who received a 50% match
contributed seven times as much,
relative to the control group.
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22.3
Evidence on Tax Incentives and Savings
Evidence from recent studies suggests that

individuals do respond to these savings
incentives by saving moreand might even
respond enough to raise not only private
but national savings.
Several studies suggest that opt-out
policies of enrollment have an even larger
impact on savings than do tax subsidies.
These types of findings have motivated
President Barack Obamas recent plans to
reform our retirement savings system.
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22.4
Conclusion
Savings decisions are extremely important,

and likely influenced by tax policy.
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
2011, it had grown to $119 billion.
Policy makers believe that tax incentives
can make a difference in the savings
decisions of individuals.
36 of 36

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Public Finance and Public Policy Jonathan

22.1 Taxation and SavingsTheory and

Capital income taxation: The taxes

Taxation and Savings: Traditional Theory

The intertemporal choice model is the main

Jacks Two-Period Savings Problem

Jack has income from working.

Jacks Two-Period Savings Problem

Intertemporal budget constraint: The

The opportunity cost of one dollar of first

Substitution and Income Effects of Taxes on Savings

Taxes and other price changes affect savings

Effect of Taxes on Savings: Substitution Effect Is

Effect of Taxes on Savings: Income Effect Is Larger

Evidence: How Does the After-Tax Interest Rate

Inflation and Capital Taxation

The United States taxes nominal, not real,

Inflation and Capital Taxation

The relationship between real and nominal

Inflation increases the nominal but not the

Inflation Exacerbates Capital Taxation

Precautionary Savings Models

The traditional model assumes that people

EVIDENCE: Social Insurance and Personal Savings

Theory predicts that social insurance

Individuals may not be able to save as

Tax Subsidy to Employer-Provided Pensions

Employer contributions to pensions are taxdeductible.

Available Tax Subsidies for Retirement Savings

401(k) accounts and IRAs also subsidize

Individual Retirement Accounts

For moderate income households, IRAs work

Keogh accounts provide a savings subsidy

Why Do Tax Subsidies Raise the Return to Savings?

With tax-preferred retirement savings, you

Why Do Tax Subsidies Raise the Return to Savings?

Theoretical Effects of Tax-Subsidized Retirement

Tax subsidies for retirement savings

Theoretical Effects of Tax-Subsidized Retirement

Limitations on Tax-Subsidized Retirement Savings

Effect of Tax-Subsidized Retirement Savings for Low

Public Finance and Public Policy Jonathan Gruber Fourth Edition

Effect of Tax-Subsidized Retirement Savings on High

APPLICATION: The Roth IRA

Congress introduced the Roth IRA in 1997.

APPLICATION: The Roth IRA

Why did policy makers introduce this new

Implications of Alternative Models

Private vs. National Savings

Impact of tax subsidies for savings on

EVIDENCE: Estimating the Impact of Tax Incentives

EVIDENCE: Estimating the Impact of Tax Incentives

Evidence on Tax Incentives and Savings

Evidence from recent studies suggests that

Savings decisions are extremely important,

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