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October 8, 1989
"Tax Cut Won't Promote More Savings"
San Jose Mercury News
By Timothy Taylor
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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 standards.

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.

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