Should The Tax Laws Be Reformed To Encourage Saving

A nation's standard of living depends on its ability to produce goods and services. This was one of the Ten PrincipleS of Economics in Chapter 1. As we saw in the chapter on produclkm and growth, a nation's productive capability, in turn, is determined largely by how much it saves and invests for the future. Our fifth debate is whether policymakers should reform the tax laws to encourage greater saving and investment.

Pro: The Tax Laws Should Bl Reformed to Encourage Saving

A nation's swing rate is a key determinant of its long-run economic prosperity. When the saving rate is higher, more resources are available for investment in new plant and equipment. A larger stock of plant and equipment, in turn, raises labor productivity, wages, and incomes- It is, therefore, no surprise that international data show a strong correlation between national saving rates and measures of economic well-being.

Another of the Ten Principles of Economics presented in Chapter 1 is that people respond lo incentives. This lesson should apply to people's decisions about how much to save. If a nation's laws make saving attractive, people will save a higher fraction of their incomes, and this higher saving will lead to a more prosperous future.

Unfortunately, the US. tax system discourages saving by taxing the return to saving quite heavily. For example, consider a 25-year-old worker who saves $1,000 of her income to have a more comfortable retirement at the age of 70. If she buys a bond that pays an interest rate of 10 percent, the $1,00!) will accumulate at on this profit in the form of the corporate income tax If the corporation pays out the rest of the profit to the stockholder in the form of dividends, the stockholder pays tax on this income a second time in the form of the individual income tax. This double taxation substantially reduces the return to the stockholder, thereby-reducing the incentive to save.

The tax laws again discourage saving if a person wants to leave his accumulated wealth to his children (or anyone else) rather than consuming it during his lifetime. Parents can bequeath some money to their children without tax, but if the bequest becomes large, the inheritance tax rate can be as high as 55 percent. Toa large extent, concern about national saving is motivated by a desire to ensure economic prosperity for future generations. It is odd, therefore, that the tax laws discourage the most direct way in which one generation can help the next.

In addition to the tax axle, many other policies and institutions in our society reduce the incentive for households to save. Some government benefits, such as welfare and Medicaid, arc means-tested; that is, the benefits are reduced for those who in the past have been prudent enough to save some of their income. Colleges and universities grant financial aid as a function of the wealth of the students and their parents. Such a policy is like a tax on wealth and, as such, discourages students and parents from saving.

There are various ways in which the tax code could provide an incentive to save, or at least reduce the disincentive that households now face. Already the tax laws give preferential treatment to some types of retirement saving. When a taxpayer puts income into an Individual Retirement Account (IRA), for instance, that income and the interest it earns arc not taxed until the funds arc withdrawn at retirement. The tax code gives a similar tax advantage to retirement accounts that go by «»tiler names. Such as 401(k), ■103(b), Keogh plan, and profit-sharing plans. There are, however, limits to who is eligible to use these plans and, for those who are eligible, limits on the amount that can be put in them. Moreover, because there are penalties for withdrawal before retirement age, these retirement plans pn.ivide little incentive for other types of saving, such as saving to buy a house or pay for college. A small step to encourage greater saving would be to expand the ability of households to use such tax-advantaged savings accounts.

A more comprehensive approach would be to reconsider the entire basis by which the government collects revenue. The centerpiece of the US. tax system is the income tax. A dollar earned is taxed the same whether it is spent or saved. An alternative advocated by many economists is a consumption tax. Under a consumption tax, a household pays taxes only on the basis of what it spends. Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods. In essence, a consumption tax puts all saving automati-«•ally into a tax-advantaged savings account, much like an ISA. A switch from income to consumption taxation would greatly increase the incentive to save.

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