The Case For The Tax Cut

Policy Reports | Taxes

No. 226
Sunday, August 01, 1999
by Bruce Bartlett

Saving and Investment

Figure IX - Taxes and Saving as Shares of Personal Income

One of the most troubling economic developments during the Clinton Administration has been the virtual collapse of saving. The savings rate has fallen from 5.7 percent in 1992 to just 0.5 percent last year. When saving falls, it forces businesses to borrow abroad or to cut back on investment. All economists recognize that saving is critical to the growth of jobs and incomes.

The administration pooh-poohs the decline in saving and gives no indication that it knows why it has occurred.46 The answer, however, is obvious. The sharp increase in taxes as a share of personal income has deprived Americans of the extra income they used to save. As Figure IX shows, the savings rate has fallen in tandem with the rise in personal taxes. If Americans had saved in 1998 at their 1992 rate, saving would have been $277 billion higher. If they had been taxed at the 1992 rate, their taxes would have been $215 billion lower. Assuming they saved these taxes, the savings rate would have been a healthy 4.5 percent.

The tax bill proposes to encourage additional saving by lowering taxes on saving. In particular, individual retirement account limits would rise from $2,000 per year to $5,000. Based on historical experience, this should lead Americans to contribute more to IRAs, because such contributions are tax deductible and all returns to that saving grow tax-free.

"The nation's savings rate has fallen in tandem with the rise in personal taxes."

The administration opposes a general expansion of IRAs, arguing that it mainly leads people to shift assets out of taxable accounts into IRAs and hence, there is no increase in overall saving. Also, the administration believes that IRAs should be targeted for specific purposes deemed appropriate by government.

However, there is considerable evidence that IRAs lead to increases in saving. While the initial effect of an IRA expansion may be asset shifting, most families do not have enough liquid assets to shift assets indefinitely. After a short time, they must increase their saving to take advantage of the IRA benefit. Thus the latest research concludes that expanding IRAs and other retirement saving vehicles, such as 401(k) plans, does indeed lead to increased saving.47

Virtually every major country offers more incentives for saving than the U.S. does. This is a major reason why their saving rates are higher.48 Expanding IRAs is a small but necessary step toward increasing the U.S. savings rate.

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