Deficits and National Savings

The Open CRS Network is a policy wonk's dream come true. Today's gift is the January 26th report, Federal Tax Reform and Its Potential Effects on Saving. The synopsis states one major part of the case against the Bush Administration's economic policies:

It is often argued that the saving rate in the United States is too low. Many observers suggest that the federal tax system can provide an effective way of increasing the U.S. saving rate. Indeed, one of the major directives to the President's Advisory Panel on Federal Tax Reform was to recommend modifications to the tax system that would provide simple and straightforward ways for Americans to save free of tax, which, they argue, would increase saving in the United States. The panel recommended two reform options, one based on the current income tax system and the other based on a hybrid income/consumption-based tax. The panel considered, but did not recommend, a pure consumption-based tax. Two observations can be drawn from the analysis contained in this report with respect to the effects of tax reform on the level of saving. First, public dissaving in the form of federal budget deficits reduces net national saving. So, if tax reform adds to the federal budget deficit, then, everything else being equal, tax reform would reduce net national savings. Second, even if tax reform is revenue neutral, the offsetting nature of income and substitution effects reduces the chances that changes to the tax system alone will increase saving. Indeed, because economic theory is not clear and because of the lack of compelling empirical evidence, it cannot be determined conclusively whether moving to a pure consumption tax would significantly increase the level of saving in the economy.

(My emphasis.)

The study restates one well-accepted principle pertinent to national savings rates that no one in the Bush Administration or the WSJ editorial board seems to be aware of:

[I]f there is an increase in the federal deficit then, absent any offsetting changes, net national saving will go down. Therefore, the effects of tax reform on federal revenue will have a direct bearing on the level of saving in the economy. If, under tax reform, federal revenues fall and the deficit increases, then net saving will decrease. Conversely, if federal revenues rise and the deficit decreases, then net saving will increase.

Translation: supply side economics is truly the province of (in Greg Mankiw's wonderful term) "charlatans and cranks."

The study points out:

[A]n important point with regard to the ultimate effects of tax incentives on the level of saving, a point which applies to incentives targeting both personal and business saving. If a tax incentive to promote private saving is deficit financed (the revenue loss from the tax reduction on saving is not recouped by raising other taxes), then the income effect may well dominate and the level of national saving could drop. Depending on how the tax incentive is designed, the reduction might manifest itself directly as a reduction in private saving or as a reduction in both private and public saving. (For a deficit financed tax incentive to increase total saving each dollar of tax reduction (public dissaving) would have to be matched by more than a dollar increase in private saving.)

Only if the tax incentives for saving are fully tax financed (the revenue loss from the saving incentive is made up by raising other taxes) will the income effects be eliminated. Even under these conditions, however, the overall effectiveness of the tax incentives on the level of savings is unclear.

(My emphasis.)

In other words, tax cuts will not increase the national savings rate; tax increases will. Thus:

[E]mpirical evidence regarding the effect of tax incentives on saving is inconclusive. For instance, The Economic Tax Recovery Act of 1981 reduced marginal income tax rates, expanded the availability of individual retirement accounts (IRAs), and accelerated depreciation deductions. Life-cycle models would predict that these changes would increase private savings, but that did not happen.

Finally, the study concludes that:

Because of the inconclusive empirical evidence and the theoretical ambiguities, it cannot be determined definitively that even switching to a pure consumption tax would significantly increase the level of saving in the economy.