Mario I. Blejer and Adrienne Cheasty
Savings in developing countries are very low, both in absolute terms and in relation to the rates of real economic growth these countries need if their incomes are to keep pace with their fast-expanding populations. In the past, inflows of foreign aid, for projects or for balance of payments support, have been a substitute for domestic savings. But the emerging budgetary conservatism of industrialized countries suggests that developing countries will have to depend more heavily on domestic resources for investment in the future.
Because of this, governments are becoming more concerned with the questions of (1) how best they can increase the total volume of domestic savings, and (2) how they can influence the allocation of what saving there is, so that investible funds are used where the economy needs them most. This article looks at the shortcomings of financial markets that tend to keep savings low in developing countries, evaluates the conventional incentive policies governments use to offset these shortcomings, and suggests an alternative approach.
LDC financial markets
In a theoretical sense, if capital markets worked perfectly, a government should never intervene to change the savings rate, because the rate of interest would move to equilibrate the supply of savings with the demand for loanable funds. However, it is not clear that private capital markets—especially those in developing countries—work well enough to induce people to save the amount that is optimal for the economy, or that these markets allocate savings to where they can be most profitably employed. Several characteristics of developing country capital markets make it likely that savings will be low and that a high proportion of them will be in the form of assets that cannot be lent, or used to purchase assets or create new capital. Wealth in developing countries is frequently held in the form of consumer durables such as jewelry, works of art, or livestock (which are not defined as savings); in the form of land or housing (types of savings and investment which only indirectly generate output); or as financial assets in informal “curb” markets (which cannot be measured as savings or offered openly to investors). These features have several origins.
Rudimentary markets. Capital markets in developing countries are small and the scope for diversification of financial institutions and financial instruments or assets is limited. Often, the banking system is largely confined to cities. Well-developed equity markets are rare—which means that investments in physical capital tend to be concentrated in a few relatively large projects. Poor communications, which hinder the flow of information and advertising about the quantities and prices of funds available, also make it likely that different interest rates will be offered on different loans. (The largest information distortion, of course, is the dissimulation of all transactions that take place in informal markets, where the government, for example, cannot bid for funds.) Furthermore, the government may pursue clearly defined sectoral priorities by making different quantities of funds available at different interest rates to different borrowers.
As a result of these imperfections, the capital market may not generate a single clearing rate of return to financial capital. Wedges between borrowing and lending rates may lead to anomalies where the saver does not find it worthwhile to bank his savings but, on the other hand, finds it too expensive to borrow to support a planned enterprise. This has the effect of raising the use of retained earnings for investment, so that the pool of loanable funds is diminished and the likelihood reduced that the rate of return to financial saving will measure the cost of capital.
Insufficient returns. The discrepancies between borrowing and lending rates described above may make the returns to savings or investments, or both, unattractive. Returns may also be inadequate for two other reasons. Policies to control interest rates, widespread in developing countries, quickly lead to financial repression if foreign interest rates rise, the domestic currency appreciates, or the inflation rate rises. In such cases, even if the capital market were characterized by complete information and open access, savings would fall short of investment needs and loanable funds would have to be rationed. Second, in less urbanized areas of some developing countries, nonfinancial assets may serve as substitutes for currency, and this may raise the liquidity premium of these assets above what bankers would perceive it to be. The rate of return to nonfinancial assets might also perhaps be higher outside the city if these assets were valued for the nonpecuniary benefits attributed to them. (An example would be the accumulation of unprofitable land with the purpose of consolidating an estate.) In cases like this it becomes difficult for the financial sector to measure the opportunity cost of alternative assets, and thus to offer a competitive rate of interest.
This article is based on a study forthcoming in the Proceedings of the United Nations Interregional Seminar on the Role of the Public Sector in the Mobilization of Domestic Financial Resources for Social and Economic Development (Bangkok, 1985).
Uncompensated risks. The distortions in returns described above would occur even in a riskless economy. In fact, however, potential savers may perceive risks to entering the financial system that they do not consider to be offset by an adequate risk premium on the interest rate. For instance, the liquidity of financial savings may not be guaranteed. In many developing countries, frequent changes of government policy close banks, change interest rates, retire bonds, or alter the purchasing power of the currency, often with little or no advance announcement. These abrupt changes in policy are often the result of unavoidable exogenous shocks. Even if such shocks do not affect the stability of the financial system, they may cause the costs of imports and exports to fluctuate widely, making financial assets denominated in domestic currency a bad risk unless interest rates are free to vary with the expected rate of exchange rate depreciation.
Savers may perceive a further risk in the prospect that financial assets will sooner or later be taxed. Typically, the tax base in developing countries is narrow and governments are constantly searching for ways to widen it. Income and wealth denominated in financial terms are by far the easiest assets to tax, so that even a government aware of all the disadvantages of taxing savings may be unable to resist the revenue-raising potential and distributional appeal of a wealth tax or a capital gains tax on financial assets. Savers may perceive nonfinancial assets, which are intrinsically harder to value and much further removed from the notice of the taxing authority, as a far more certain source of future returns.
In principle, all of the distortions described could be removed by appropriately adjusting the incentives to holding financial assets, either through taxes or by credit policy. Conventional tax policies are described in what follows.
Governments wishing to improve saving and investment flows have traditionally resorted to tax incentives. Under most tax systems, savings are taxed twice, first because total income is taxed, whether it is consumed or saved, and second when savings generate taxable interest income. It has been argued that if this discrimination against savings were to be lifted or lightened, total savings would rise, and likewise, that if the penalty for saving on some forms of asset holding were lighter than on others, people would tend to shift into these assets.
The policy recommendations that follow from this argument range from broadly based proposals to convert present income taxes into personal taxes on consumption expenditure or into a value-added tax on the basis of consumption, to highly specific tax incentives such as altering the tax treatment of social security contributions. Interest income of certain institutions or from some types of assets is exempt from taxation in many countries; some countries exempt dividend income, or certain types of dividend income; and some countries favor retained earnings. It might also be argued that countries that do not levy an inheritance tax are favoring saving, compared with countries that impose death duties.
Broadly based incentives have not been widely used. Of 96 countries surveyed for the 1983 edition of Coopers and Lybrand’s International Tax Summaries, only three had well-developed sales taxes in lieu of income taxes. The fact that no country introducing a value-added tax used it to replace an income tax suggests that revenue needs (and perhaps distributional issues) are considered far more important than any gain a country could earn from increasing aggregate savings.
Microeconomic consequences. The reluctance to apply broadly based savings incentives perhaps stems from the recognition that they may not necessarily enlarge savings. This is so because tax incentives have two opposite effects: while a reduction in the relative cost of saving makes individuals prefer to save more than before, it also raises their net interest income. Feeling better off because their income has risen, individuals may be induced to spend more than before the tax cut.
As there is no strong behavioral reason why tax incentives should increase aggregate savings, the question becomes an empirical one—whether, in reality, a reduction in the relative cost of saving (which increases the incentive to save) outweighs an increase in net interest income (which reduces the incentive to save). The net effect of tax incentives for saving (which is measured by the uncompensated interest-elasticity of savings) has been shown to be more or less neutral—or even negative in many middle- and low-income countries.
Even if savings did respond positively to increases in interest earnings, the relationship would be of value to policy makers only if the change in the interest rate needed to effect noticeable changes in saving were not too large, because changes in the interest rate have significant effects on many other aspects of the economy. But to engender even a 1 percent increase in total savings, the highest estimate of interest elasticity (an increase of 0.4 percent in savings for a 1 percent increase in the interest rate, derived by Boskin for the United States) implies that a 2.5 percent increase in interest rates would be necessary. In low- and middle-income countries (including China, India, and some oil exporters) an optimistic estimate of the ratio of gross domestic savings to GDP in 1982 (according to the World Development Report 1984) would be 20 percent. Thus to raise the savings/GDP ratio by 1 percentage point, the real after-tax interest rate would need to change by (1/0.2) x (1/0.4) percent, i.e., by 12.5 percent. Given the small or uncertain magnitude of interest rate effects on savings and output, the other potential uses of interest rates as policy instruments, and the international constraints imposed on interest rate determination in open economies, it is not surprising that governments have not very often attempted to influence aggregate savings directly through changes in the rate of interest.
Evidence from industrial countries shows that incentives to specific forms of holding wealth can significantly change the composition of savings. This evidence, however, may not be very relevant to developing countries, where the desired compositional change is usually not between different financial assets but between all financial assets on the one hand, and all “nonloanable funds” assets on the other, and thus, because of capital market imperfections, will require more fundamental action than marginal changes in the returns to financial assets. While specialized incentives of the type maintained in a sizable number of countries may succeed in changing the form of financial assets in which savings are held, they do not properly address the problem of attracting a larger supply of loanable funds from nonfinancial stores of wealth.
Even if tax incentives to save did substantially augment savings, government should not necessarily use them as policy instruments to increase aggregate financial savings, because the distortions inherent in them might be no less detrimental to economic welfare than heavier taxes. This danger is greater in developing countries, where misperceptions and lack of information about the real rate of return to various assets (including, for example, their nonpecuniary benefits) make it very difficult to set tax incentives to achieve desired directions and magnitudes of changes in saving behavior.
Some specific examples of distorting tax incentives would be the removal of interest receipts from the personal tax base—which would encourage firms to finance expansion with debt and distort the debt-equity choice unless dividend income were also exempted from tax. The exclusion of capital gains from taxation creates a distortion in that it mainly raises the rate of return to corporate income, rather than income of other institutions, and thus may change the institutional structure of an economy. Besides, the costs of administering a highly differentiated tax structure are much higher than when the tax rate is uniform and has minimal exemptions. A further distortionary effect is present even in broadly based incentives to save: incentives lead to a less progressive tax structure if the rich have a larger propensity to save than the poor.
|Tax exemption||Countries||Types of savings|
|Bank deposits||Argentina, Guatemala, Islamic Republic of Iran, Rep. of Korea, Malta, Panama, Paraguay||Liquid savings|
|Financial/investment company income||Argentina, Cyprus, Dominican Republic, Panama, Netherlands Antilles||Higher-risk savings|
|Building society income||Dominica, South Africa, Swaziland, Venezuela||Home-ownership|
|Mortgage bank income||Dominican Republic||Home-ownership|
|Life insurance/provident fund contributions||India, Malaysia||Low-risk, low-return, long-term saving|
|Pension funds||Nigeria||Low-risk, low-return, long-term saving|
|Intercorporational||India||Diversification in financing|
|Paid to foreigners||Republic of Korea||Foreign equity investment|
|New equity from retained earnings||Indonesia||Diversification in financing|
|Interest and gains from government securities||Argentina, South Africa, Swaziland, Venezuela, Panama||Nonbank government financing|
|Companies’ capital funds||Netherlands Antilles, Portugal||Depreciation funds|
It is sometimes argued that tax incentives to save are necessary to offset the disincentive effects of inflation on saving, especially where the rate of inflation may be very high. Inflation raises the nominal rate of interest without changing the real return; taxes are levied on nominal rather than real interest and therefore tax is appropriated from an artificially inflated interest income rather than merely from the real income of the saver. However, because inflation is unpredictable, especially at very high rates, and because tax incentives must be announced in advance, tax incentives can miss the intended inflation relief by a large margin, giving rise to large extra costs either to investors or to the government. Correcting the income tax directly for inflation would usually be less distortionary and less expensive.
Furthermore, the inflation argument in favor of tax incentives for saving is not valid in a financially repressed economy. In developing countries real interest rates are often very low or negative. Because nominal interest rates are not free to rise with inflation, the effective tax rate is not boosted by inflation, and there thus is no increased inflation distortion to offset. The distortion of savings decisions that is caused by financial repression may in fact be far larger than the distortion associated with the taxation of interest income. Given an interest rate ceiling, financial repression rises as inflation goes up. A more appropriate goal for a government wishing to increase savings would therefore be to use tax policy to prevent inflation, instead of trying to offset inflation indirectly by incentives which have the effect of (very imprecisely) indexing some selected returns to inflation.
To summarize, neither the theory of savings behavior nor the evidence on the response of saving to changes in its rate of return supports the use of tax incentives as an instrument to increase financial savings. Besides, tax incentives create economic distortions, which may leave the economy worse off than it would be under the distortions of a uniform tax system.
Macroeconomic consequences. Tax incentives affect individual sectors of the economy, but it is also crucial to consider their macroeconomic consequences. Tax incentives generally involve the loss of fiscal revenues, whether actual or potential, and thus they are bound to have direct budgetary implications—necessitating either an increase in some other sources of income or a commensurate cut in government expenditures.
For this reason it is very difficult, and to some extent misleading, to assess the outcome of tax incentives in isolation; information is needed on the additional measures the government will adopt in order to carry out the incentive policy. If, for example, existing taxes are to be increased or new taxes imposed, it will be necessary to evaluate their impact on the whole economy and their expected consequences for savings and investment. If, alternatively, it becomes necessary to cut government expenditures that have complemented private sector investment, the overall positive result of the tax incentives may be extremely small, but if expenditure cuts take place in areas related mainly to government consumption, the effectiveness of tax incentives may actually be enhanced.
Without measures to compensate for the loss of tax revenue, the introduction of tax incentives results in budget imbalances. The effects of these imbalances can only be assessed if it is known how the deficits are financed. In general, fiscal deficits tend to put pressures on aggregate demand, which may result in higher inflation, balance of payments disequilibrium, and, if deficits are debt-financed, in higher real interest rates and the crowding out of the private sector. All these results will be detrimental to investment and savings.
If tax incentives ultimately lead to more rapid inflation, this outcome may largely cancel the benefits that the private sector is intended to realize from the tax incentives program. High and accelerating inflation may discourage savings and investment by making the environment seem more risky and uncertain.
High rates of inflation are often accompanied by falls in economic activity or, at least, in the rate of growth, which tend to reduce the incentive to invest. The government may attempt to suppress inflation by controlling the growth of some prices, particularly exchange and interest rates. Intentional overvaluation of the exchange rate leads to scarcity of foreign exchange, which subsequently reduces imports of basic commodities and of capital goods. It also tends to depress the availability of savings for domestic use, because individuals attempt to protect themselves from future large devaluations by holding foreign securities and foreign exchange. If nominal interest rates are controlled, real interest rates may turn negative, depressing savings and worsening the currency substitution problem.
An alternative approach
In view of the microeconomic and macroeconomic costs of tax incentives, it seems reasonable to search instead for savings-mobilization policies that do not lead to fiscal imbalances, but which, instead, allow the government to alleviate some of the shortcomings of developing-country capital markets by constructing some sort of proxy for the financial market.
Planned budgetary surplus. One of the most direct policy instruments a government can use to mobilize domestic savings is a planned budgetary surplus. Here, the government should aim to set its total tax revenues and its total expenditure (both current and capital) at a level that would yield an overall surplus, which could then be made available on a competitive and nonconcessionary basis to the private sector as well as to public enterprises. That such an approach is possible is shown by the Japanese example in the decade after the Meiji Restoration (1868) and in the period following World War II.
A planned surplus is a much more powerful and flexible tool than incentives and controls. Available resources can be directed toward productive investments carried out by foreign and domestic private entrepreneurs and toward those with high social significance. In this way, the government, in addition to increasing the level of savings, can stimulate entrepreneurship, encourage the efficient allocation of private investment, and attract foreign resources, thus influencing the quality as well as the quantity of investment. Moreover, because it demonstrates a high level of economic commitment and discipline on the part of government, the generation of a government surplus tends to enhance the confidence of the private sector. This confidence, in turn, stabilizes or boosts aggregate demand and thus maintains the size of the tax base and legitimates the tax collection that caused the surplus in the first place. A tax system that is uniform and predictable, and is associated with prudent macroeconomic management, may make higher rates more acceptable than the lower rates of a tax system with many exemptions but associated with a fiscal position that is perceived to be unsustainable in the longer run.
Surveys carried out in many developing countries have shown beyond doubt that the inability of many enterprises and individuals to obtain credit is a serious obstacle to development. Tax incentives may facilitate the development of already established enterprises, by increasing their liquidity, but normally will not provide much help for potential enterprises or individuals who cannot mobilize funds for the initial fixed investment. Credit made available by government saving, on the other hand, will help both the established and the new investor.
Government as investor. The recommendation that the government should run an overall surplus and place the funds thus generated in the private capital market does not mean that the government itself should cease to act as an investor. The desire of the private sector to invest will increase if the perceived rate of return to such investment rises. And if the demand for loanable funds were to rise, the return to savings would be enhanced and domestic savings would tend to rise. It is possible then that the government could promote more domestic savings by acting to increase the perceived rate of return on private sector investments.
One way of doing this would be to invest directly in projects to provide infrastructure and public goods, thereby raising the productivity of capital, increasing the demand for the private sector’s output through increased demand for inputs and ancillary services, and augmenting overall resource availability by expanding aggregate output and savings. The empirical results of some recent studies support the recommendation that, if a government wants to mobilize domestic resources, it should run a surplus and include public infrastructure in its investment program. These results indicate that (1) if the flow of domestic credit available to the private sector is reduced, for whatever reason (including a larger absorption of credit by the public sector to finance budget deficits), then private investment, and consequently growth prospects, tend to decline; and (2) although an increase in the infrastructural component of government direct investment raises private investment (probably by increasing its potential profitability), similar increases in other types of public investment—such as in sectors producing marketable output—appear to crowd out private sector investment.
Running an overall surplus does not preclude a government from undertaking its own investments. These investments should, however, be designed primarily to permit existing resources to be used more effectively.
The characteristic limitations of developing country capital markets make traditional government policies, and tax incentives in particular, unsuitable for mobilizing domestic savings. Not only does their efficacy remain unproven, at the theoretical as well as at the empirical level, but they create distortions and budgetary and other macroeconomic problems which may leave the economy worse off than under a higher-rate, but uniform and stable, tax system. Prudent macroeconomic management and the maintenance of a public sector surplus will not only avoid these distortions but will provide a pool of loanable funds to private sector investors. This will compensate for limitations in the capital market which the private sector could not by itself overcome, and is thus a fitting role for government in a developing country, particularly in future, when alternative funds for investment are likely to become more scarce.
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