October 8, 1989
"Tax Cut Won't Promote More Savings"
San Jose Mercury News
By Timothy Taylor
<< Back to 1989 menu
CONGRESS is up to an old trick: promoting savings by spending money.
The House of Representatives has approved a plan to cut the tax rate on capital
gains, even though it will cost $21 billion over the next 10 years, according
to the Joint Committee on Taxation. At the moment, the Senate appears to favor
a bill to expand the tax deduction for Individual Retirement Accounts, at a cost
of $12 billion in the next five years.
The argument for both bills has rested on the need to increase the U.S. savings
rate. That need is real and severe; savings provide the pool of funds that business
can use for investment and modernization. The graph below illustrates a worrisome
trend: Personal savings have been lower in the 1980s than in the 1970s (after
adjusting for inflation), even though size of the real economy has increased by
two-thirds since 1970.
In this case, the relevant question is not about ends, but about means. Will
a cut in the capital gains tax or expanded IRAs lead people to save more? Or simply
to reshuffle their existing assets?
If these ways of stimulating savings were so effective, they should have been
working in the 1980s. The capital gains tax rate was cut in 1978 and again in
1981. The rules for contributing to IRAs were liberalized in 1981 and then restricted
in 1986, which is why the growth in IRA accounts rises in the early 1980s and
then falls in 1987 and 1988.
Moreover, when inflation fell sharply in 1982 and 1983, interest rates remained
relatively high for a few years. Thus, real interest rates (the gap between nominal
interest rates and inflation) rose to over 5 percent, exceptionally high by historical
Yet even with higher incentives from IRAs, a lower capital gains tax rate and
higher real interest rates, personal savings have been at low levels in the 1980s.
It appears that savers do not respond very well to increases in the rate of return.
This discouraging conclusion makes sense if you think about the particular incentives
provided by a lower capital gains tax and IRAs.
Cutting the tax rate on capital gains does raise the rate of return on capital
investments. For example, consider someone who buys stock in a company, sees its
price rise by 10 percent, and then sells. Under current law, the investor would
have to pay 28 percent of the gain in tax, so his after-tax return would be 7.2
percent. If the rate was cut to 19.6 percent (as the House proposes), the return
will be 8.04 percent. So for every 10 percent return, this reduction in the capital
gains tax will increase the rate of return by about four-fifths of 1 percent.
That puny incentive isn't going to turn saving into a hot new fashion.
In fact, most of the talk about cutting the capital gains tax has been frankly
anti-saving. Popular support for the capital gains tax cut doesn't come mainly
from those who are planning to cash in on one investment and save up all the gain
in new investments, but from people who want to stop saving in the form of a house
or corporate stock and spend some of their accumulated gains.
It's not clear what IRAs contribute to total savings, either. Contributions
to IRAs are tax-deductible, and interest is untaxed until retirement. These tax
benefits might either provide an incentive to increase total savings, or they
might provide a tax break for savings that the person would have done anyway.
In fact, since IRAs make it possible for people to put in less money and still
meet their savings targets -- because the tax break makes up the difference --
IRAs may actually cause some people to consume more and save less!
There's no consensus among economists on whether IRAs increase total savings
-- and that lack of consensus is interesting in itself -- but some interesting
facts are emerging from the ongoing research.
For example, more than half of all IRA contributions come from households that
have other financial assets worth more than $20,000. In addition, it appears that
households with IRAs have substantially more debt than households that don't have
IRAs. These facts imply that people who already are saving and borrowing a lot
are tipping some of that money into IRAs, but that even when they were relatively
generous in the early 1980s, IRA's don't have much effect on the savings level
of those who aren't saving much now.
When you sum it all up, the evidence is very weak that either cutting the capital
gains tax or expanding IRAs will have much impact on personal savings. But whether
they work or not, they will cost the government some tax dollars. The underlying
problem here is that the personal savings rate should not be the only goal. America's
problem is a low savings rate for the entire economy, and the national savings
rate is determined by adding the savings of households, business, and state and
local government, and then subtracting the borrowing by the federal government.
If Congress is sincere about raising overall national savings, its first step
should be to reduce the federal budget deficit. Of course, that unattractive agenda
would involve cutting spending or raising taxes; it involves political pain.
Instead, it appears that Congress is using the need for increased savings as
a smoke screen to hand out politically popular tax breaks.
<< Back to 1989 menu