Although, as the discussion in Section III indicated, it is difficult to identify an appropriate rate of national saving, for a number of reasons the current level of saving in industrial countries may be regarded as low. Consequently, this section focuses on policy measures that can be employed to raise national saving. The next two subsections discuss two broad categories of policies: (1) budget policies for increasing government saving and (2) tax policies that provide incentives for increased private saving. The third subsection examines issues raised by the international context in which these policies would be implemented. The section concludes with a brief summary.
Budget Policy
The most direct policy for raising national saving is to increase government saving. Such an increase can be achieved through a reduction in government consumption and transfers or through an increase in taxes. These measures are likely to have different effects on private and, therefore, on national saving. An increase in taxes will lead to a partially offsetting decline in private saving. This offset could be exacerbated if the increase in taxes falls on income rather than on consumption. Consequently, a given reduction in government consumption is likely to have a larger effect on national saving than an equivalent increase in taxes.19
The choice between reduced government consumption and increased taxes also depends on the social values of the forgone private and government expenditure. Increasing taxes causes the private sector to forgo consumption and investment, while reducing government consumption forces the society to forgo government services. In addition, reductions in public spending do not always lead to more rapid growth. Some areas of measured government consumption, such as expenditures on health and education, would be better categorized as public investment in human capital. As indicated in the discussion of the models of endogenous growth (Section III), these particular types of investment could potentially yield a large social payoff. Therefore, a reduction in government spending on social infrastructure could lower growth, if the corresponding increase in private saving is not invested as productively as public investment. These issues take on increasing importance in view of the growing concerns in many industrial countries about the deterioration in urban infrastructure, education, transportation systems, and the environment.
National saving can also be affected by the composition of government consumption. As discussed earlier (Section II), certain government transfers—such as public pensions, unemployment benefits, health care, housing allowances, and student aid—tend to influence private saving directly. Decisions on the proper level of government programs clearly cannot be made solely on the basis of their impact on national saving. Nevertheless, concerns about national saving could justify raising government saving to compensate for the adverse effect of public programs on private saving. In the specific case of public pensions, for example, it would be possible to move from a “pay-as-you-go” system to some form of funding of public pensions. Furthermore, to the extent that demographic factors may result in social security cash flow surpluses that are expected to be reversed, it is important that these surpluses be held in reserve against future payments.
Tax Policy
Comprehensive Reform20
A potential source of distortion affecting private saving in industrial countries is the reliance on the income tax. An income tax is biased against saving because it drives a wedge between the return on saving and the return on investment. While a saver earns the after-tax return on saving, the social benefit from saving is the before-tax return on capital.21 It may therefore be argued that greater reliance on a consumption tax may encourage saving through intertemporal substitution effects on the timing of consumption.
The above argument in favor of a consumption tax, however, needs to be qualified. First, reduced income tax implies that one does not need to save as much as before to attain a desired level of future consumption. Consequently, it is uncertain whether a switch from an income tax to a consumption tax would actually increase private saving. Second, while a switch to consumption tax would reduce distortions affecting the intertemporal decisions relating to saving and consumption, it would introduce other distortions by affecting the work-leisure choice. Third, a transition to a consumption tax would create serious intergenerational problems during the transition period that could last several decades. Finally, there are important issues of equity relating to the tax burden of different income groups. It is therefore difficult to advocate a drastic shift in the structure of taxes of industrial countries from direct to indirect in order to promote saving.
There is, however, scope for reducing distortions to saving by modifying the structure of the income tax. An important source of distortion is double-taxation of income from capital—once at the corporate and once at the personal income level—that takes place in several countries. This double taxation further widens the tax wedge for rate of return to capital. Another source of distortion arises because of incomplete indexation of income taxes. The tax codes of most countries levy a tax on nominal, rather than real, capital income. As a result, an increase in expected inflation matched by an equal increase in the nominal interest rate lowers the after-tax real return to saving. The tax on saving increases because the tax is levied on the nominal return, part of which is a compensation for inflation. The inflation compensation is essentially a form of the repayment of principal, which should not be taxed. The high rates of inflation during the late 1970s and early 1980s, which made after-tax real returns negative in most of the industrial economies, may have contributed to the decline in saving, although the effect of after-tax returns on saving is not likely to be substantial.
A major way to reduce income tax distortions is to reduce marginal tax rates. However, a reduction in tax rates that results in larger fiscal deficits will not have a favorable impact on national saving. Policies aimed at raising saving must therefore combine tax rate reductions with measures to broaden the tax bases. Most of the industrial countries have reformed taxes during the 1980s in order to reduce marginal tax rates.22 These rate reductions should raise private saving as well as labor supply and generate greater work effort. In the United States, however, the tax rate reductions of the early 1980s increased the fiscal deficit. Consequently, the prognosis for higher national saving in the United States must be more guarded.
Tax Incentives to Encourage Saving
Tax policy could be used more directly to promote saving by providing tax shelters for some or all forms of saving. Carroll and Summers (1987) have argued that tax incentives for saving can have substantial effects on private saving. They base their arguments on what they believe was an ideal natural experiment. In the late 1970s and early 1980s, saving rates of the United States and Canada diverged sharply after having moved in tandem for the previous 25 years.
The divergence in private saving rates of the two countries during the early 1980s coincided with three major changes in their fiscal policies. First, while government deficits rose in both countries in the early 1980s, the rise in the Canadian deficit was more pronounced. Second, the absence of tax deductions for consumer interest in Canada led to larger increases in the after-tax interest rate in the early 1980s. Furthermore, Canada undertook a major liberalization of tax shelters for retirement savings during the late 1970s. Carroll and Summers argue that the Canadian tax-sheltered saving was particularly important for explaining the divergence in the two countries’ saving rates. This conclusion, however, seems overstated, given that the rise in retirement saving in Canada can explain only a relatively small portion of the rise in the saving rate in Canada relative to that in the United States. Furthermore, as indicated in Section II, most other empirical studies suggest that the elasticity of saving with respect to rate of return is relatively small.
Other forms of tax shelters raise similar issues. For example, many countries provide tax shelters for pension contributions and the interest earned on past contributions. Other countries, such as France, Sweden, and Japan up until 1988, have given preferential tax treatment to the interest earned on most forms of household saving. Researchers find that in most of these programs, tax-sheltered saving increases, but not all the increase represents new private saving (see Smith, 1989). Furthermore, while tax shelters may raise private saving, their impact on national saving is less clear because they may reduce government saving.
In some cases, asset shifting has substantially reduced the impact of tax-sheltered saving schemes on national saving. For example, Venti and Wise (1987) estimate that less than 55 percent of the rise in saving in individual retirement accounts (IRAs) during the early 1980s in the United States came from new saving, with the associated reduction in taxes accounting for 35 percent of this rise. The net impact on national saving was therefore on the order of 10–20 percent of the increase in IRA accounts. Munnell (1988) estimates that employer-sponsored pensions raised private saving in the United States by $57 billion in 1985, but 80 percent of this increase was reflected in tax reductions. Thus, the net impact on national saving was again small. These estimates imply that the effectiveness of tax-sheltered saving for increasing national saving is limited because of both the low interest elasticity of saving and the tax losses generated by the shelters.
Removing Tax Incentives that Encourage Borrowing
Given the problems with tax shelters to encourage saving, many economists have focused on aspects of the tax code that encourage borrowing. For example, in several industrial countries (notably Sweden, the United Kingdom, and the United States) consumer purchases can be financed with credit from tax-favored mortgages. This facet of tax codes encourages borrowing that raises current spending and lowers saving. In addition, the loss in tax revenue because of the interest deductibility lowers government saving. Consequently, the elimination of the tax deductibility of consumer interest can increase both private and government saving.
There is some evidence that the tax deductibility of consumer interest has a significant effect on national saving. Tanzi (1988), for example, divides countries into two groups based on the generosity of interest deductions on consumer credit and finds that the saving rate for the group with less generous deductions was on the average almost three times that for the othergroup. Thus, the elimination of the tax incentives to borrow has the potential for a significant increase in both private and government saving. This potential is particularly large in the Nordic countries, which provide generous deductions and have relatively high marginal tax rates.
The tax treatment of owner-occupied housing has a complicated but potentially important effect on both domestic investment and saving. The preferential tax treatment of owner-occupied homes takes many forms, such as the tax sheltering of mortgage interest payments and the exclusion from taxable income of the capital gain and the implicit rental income. This tax treatment provides an incentive for residential investment over other types of investment. In addition, the tax treatment of housing can lower financial saving because, as mentioned earlier, mortgage credit can be used to finance consumer purchases in some countries. It is worth noting that increases in inflation tend to exacerbate the impact of taxes on residential investment and household borrowing in view of inadequate indexation of income tax systems.
The level and composition of private saving is also affected by the differential taxation of personal income and corporate profits. In the United States, for example, the tax system favors retaining profits over paying dividends because the personal tax rate is higher on dividends than on capital gains. This favorable tax treatment of capital gains tends to raise enterprise saving and, therefore, private saving (albeit to a lesser extent owing to the offsetting changes in household saving).
Finally, one should note that the costs of the tax distortions that encourage consumer borrowing and residential investment have increased with financial liberalization. As discussed in Section II, the increase in the availability of consumer credit has allowed households to take advantage of these tax benefits. Australia, Finland, and the United Kingdom are three countries where the interaction of financial liberalization and tax distortions is the clearest. Summers and Carroll (1987) find that the interaction of tax distortions and increased credit availability has also been a major cause of the low rates of personal saving in the United States.
The interaction of financial liberalization and distortions that encourages borrowing is a specific example of the theory of second best: removing structural rigidities in a market can increase the losses associated with remaining distortions and thereby reduce or even eliminate the net gain. In particular, the gains from financial liberalization can be largely dissipated in countries in which tax distortions encourage excessive borrowing and residential investment. The symptoms of these losses are overinvestment in housing, a decline in private saving rates, and a widening current account deficit. Consequently, financial liberalization accentuates the need to eliminate distortions that encourage borrowing and adversely affect the allocation of saving and investment (see Tanzi and Bovenberg, 1989).
International Dimension to Saving and Investment Policies
Another aspect of financial liberalization is increased mobility of capital internationally. In a world of increasing capital mobility, the efficacy of policies aimed at increasing saving should increase. In a closed economy, any policy aimed at increasing saving will reduce the return on investment, because of diminishing returns. As a result, some of the increased saving will be lost as the lower return discourages saving. With perfect capital mobility, the return to saving is determined by the highest return on investment available in the world economy. Thus, as capital mobility increases, policies aimed at raising saving will become more effective. Furthermore, such policies would directly influence the external current account position. For example, as demonstrated by Frenkel and Razin (1988a), a shift in the composition of taxes aimed at increasing saving would tend to improve the current account balance.
A greater degree of capital mobility has the potential to improve the allocation of financial resources globally. A country with a high propensity to save, but not many profitable investment opportunities, can enjoy a higher level of national income by accumulating foreign assets with rates of return above those on domestic capital. But this optimistic conclusion would have to be tempered in the presence of distortions arising from the differential tax treatment of capital income across countries. With capital mobility, financial capital will move to find the highest after-tax rate of return. World economic efficiency, however, requires the equalization of the before-tax rates of return on capital in all countries (see Frenkel and Razin, 1988b). Thus, coordination in tax policy is needed so saving will lead to an efficient allocation of the world capital stock (see Tanzi and Bovenberg, 1989).
A complication of potentially greater consequence is raised by the possibility of externalities to investment, as described in Section III. With internationally mobile capital, the country in which the new investment is located reaps all the externalities. In this case, it is even more important that adequate incentives be provided to stimulate domestic investment.
Conclusions
The most direct way that government policy can raise national saving is to increase government saving. This policy is of particular importance to countries with large fiscal deficits or to countries where government saving has declined. In addition, the structure of taxes and government transfers in industrial countries has also influenced saving behavior. But, on the whole, the effect of taxes on the level of private saving has been relatively small, although taxes have a powerful effect on the composition of investment (especially in a liberalized financial market). In view of the recent tax reform in many countries, it is unlikely that further comprehensive reforms can be put in place soon. There is, however, room for changing tax incentives to either encourage saving or discourage borrowing. Tax incentives to encourage saving suffers from the fact that some of the gain in private saving may be lost in reduced government saving. Eliminating incentives to borrow has the advantage that it increases both private and government saving.
Financial liberalization underscores the importance of further tax reform. While financial liberalization has increased welfare, it may have exacerbated the unfavorable effects of remaining tax distortions—especially those that affect the intranational and international allocation of investment. In particular, the recent increase in the availability of household credit in some countries has led to overinvestment in housing and a reduction in financial saving, as well as widening external deficits.
Increasing capital mobility holds the promise of increasing saving and providing a more efficient worldwide allocation of capital. To realize this promise, however, some international coordination in tax policies on investment may be needed to help ensure that financial capital moves to its most productive use. In addition, coordination may be necessary so that the externalities from investment will be reflected in the returns to saving used to finance that investment.