1 / 15

# Lecture 7 - PowerPoint PPT Presentation

Chapter 22: TAXATION AND SAVINGS – THEORY AND EVIDENCE The traditional theory of savings is to smooth consumption across periods. This is an implication of diminishing marginal utility of income.

Related searches for Lecture 7

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

## PowerPoint Slideshow about 'Lecture 7' - benjamin

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

• The traditional theory of savings is to smooth consumption across periods.

• This is an implication of diminishing marginal utility of income.

• Intertemporal choice is the choice individuals make about how to allocate their consumption over time.

• As with hours of work in the labor supply model, savings is not valued directly, but is rather a means to an end. It can be thought of as a “bad” – where the complementary “good” is “future consumption.”

The 2-period Intertemporal Consumption Model

C2

Y(1+r)

Initially savings is S, and consumption is C1.

slope = -(1+r)

Y(1+r(1-τ))

Taxing savings rotates the budget constraint, and creates income and substitution effects.

A

slope = -(1+r(1-τ))

C2

S(1+r)

BC1

BC2

C1

C1

Y

S

Responses to the Taxation of Saving

C2

C2

Substitution effect

is larger

Income effect

is larger

Savings can fall.

Or rise.

C2

C2

C2*

C2*

BC1

BC2

BC1

BC2

C1

C1*

C1*

C1

C1

C1

S

S

Taxation and savings – Theory and evidenceTraditional theory

• The lower after-tax rate of return will cause an increase in first period consumption through the substitution effect.

• But the fall in the after-tax return makes Jack feel poorer, which reduces his consumption in the first period (and increases savings).

• The first panel shows that when the substitution effect dominates, savings falls.

• The second panel shows that when the income effect dominates, savings increases.

Taxation and savings – Theory and evidenceHow does the after-tax interest rate affect savings?

• Unlike the empirical literature on labor supply, the empirical work on after-tax interest rates and savings has not reached a clear consensus.

• The elasticity of savings with respect to interest rates varies from 0 to 0.67.

• It is more difficult to compute the appropriate interest rate.

• In addition, it is more difficult to find appropriate treatment and control groups.

ALTERNATIVE MODELS OF SAVINGSPrecautionary saving 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.

Alternative models of savingsSelf-control models

• 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 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.

• Because of concern about workers under-saving for retirement, the U.S. government has introduced a series of tax subsidies for retirement savings.

• There are four major incentives:

• Tax subsidy to employer-provided pensions

• DC and BD plans

• 401(k) accounts

• Individual Retirement Accounts

• Keogh Accounts

Tax incentives for retirement savingsWhy do tax subsidies raise the return to savings?

• All of the tax subsidies have the following characteristics:

• Individuals avoid paying income tax on their contributions.

• Earnings accumulate at the before-tax rate of return.

• Withdrawals are taxed as ordinary income, not the lower capital gains tax rate.

Tax incentives for retirement savingsWhy do tax subsidies raise the return to savings?

• Since taxes are paid at retirement, how are these accounts “tax subsidized?”

• The key ingredient is that you get to earn the interest on the money that would have otherwise been paid in taxes. This is composed of three important parts:

• The initial deductibility of the contributions

• Having earnings accumulate at the before-tax rate of return

• Having the potential to withdraw the money when a person is in a lower tax bracket.

• These tax subsidies can dramatically increase the rate of return to retirement savings.

Tax incentives for retirement savingsTheoretical effects of tax-subsidized retirement savings

• One key institutional feature of 401(k) accounts, IRAs, and so forth is that the annual contributions are capped.

• This creates a non-linearity in the budget constraint, where the tax-advantaged rate of return from saving below the cap is higher than taxed rate of return above the cap.

• Figure 4 illustrates this situation.

C2

D

slope = -(1+r(1-τ))

Y(1+r(1-τ))

A

E

With a cap, savings is subsidized, but only up to a point.

slope = -(1+r(1-τρ))

B

C1

Y

\$3,000

Figure 5a

C2

Y(1+r(1-τ))

B

C

?

A

For a low saver, the income and substitution effects go in opposite directions.

Thus, the net effect is ambiguous for low savers.

C1

C1g

Y

1,000

Figure 5b

C2

B

Y(1+r(1-τ))

For high-savers, IRAs represent an income effect only and therefore lower savings.

A

C1

Y

C1W

C2W

\$4,000

\$5,000

Tax incentives for retirement savingsPrivate versus national savings

• The discussion so far has focused on private savings, but what matters for investment and growth is national savings.

• Retirement tax incentives have an offsetting effect on national savings because they are financed by a tax break.

• For example, imagine that 401(k)s raised private savings by 30¢ per \$1 of contribution. If the tax rate were 43%, then 43¢ of tax revenue is forgone.

• Since tax revenue reflects public saving, 401(k)s actually reduce national savings, even though it increased private saving.