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Factors Affecting Saving, Policy Toots, and Tax Reform: A Review

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1990
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A SUBSTANTIAL BODY of literature relating to the level of saving and the impact, or lack of impact, of various government policies on this level, has developed over the past 10-15 years. Unfortunately for the policymaker, this literature often reflects a disagreement among economists. This paper examines factors that affect the level of saving in industrial countries, in particular, tax policy tools and reviews available evidence on how policies may encourage or discourage saving. Interest in this subject arises, in part, from declining saving ratios and relative standards of living in some countries as well as from increased sympathy among economists for personal consumption taxation as a substitute for personal income taxation.

I. Saving: Does It Matter?

A country’s absolute ievei of saving and its level relative to that found in other countries have generated particular interest among economists in many countries over the past decade. U.S. economists have been most active in expressing this interest, but the saving issue is high on the agenda in other countries as well. Following the Depression and the advent of Keynesian economics, saving received attention because of its restrictive effect (compared with the expansionary effect of expenditures). Although the possibility of excess saving continues to receive some attention, much of the recent literature has focused on “inadequate” saving.

The stock of capital will decline in a closed economy if consumption equals production; the existing capital stock will gradually be consumed if funds are not set aside for its replacement. Gross saving must be positive and equal to economic depreciation to maintain the existing level of capital. If population growth is positive, still more must be set aside if the amount of capital per worker is to be maintained. And still more saving is required if a country wishes to increase the per capita level of capital stock. Historical evidence indicates that an increase in per capita capital stock makes an important contribution to increased productivity and a rising standard of living. As Lawrence Summers (1986a), a strong proponent of a higher level of saving in the United States, has written:

Raising our personal savings rate is important if we are again to enjoy rapid productivity growth and success in international competition. It’s no accident that Germany and France, with national savings rates twice that of the United States, have had twice as rapid productivity growth, while the Japanese, with a savings rate three times ours, have enjoyed three times as great a productivity growth rate over the last 15 years.

Bosworth (1984, p. 56) points out that in 1983 the “real income of the average American worker would today be 20 to 25 percent higher,” if the slowdown since 1973 in productivity growth had never occurred. Bosworth notes that although a slower rate of capital formation did not account for much of the fall in productivity growth in the 1970s, it did contribute.

Even a respected economist’s concern is insufficient reason to conclude that the level of saving is inappropriate. So, how do we determine if a particular saving level is too high or too low? One answer, given by Martin Feldstein (1977a) is that

If the amount of future consumption that individuals require to forgo present consumption is less than the rate at which investment produces future consumption from current capital investments, we should save more (p. 117).

Accordingly, taxes that drive wedges between the return to the individual saver and the return on the additional investment cause saving to fall short of its optimal level. Since every country will have such wedges, it is important that they be created in such a way that the welfare loss caused by the taxes is minimized, consistent with other constraints. The level of saving may or may not be seriously and adversely affected.

Another answer is that the “golden rule of accumulation,” based on the neoclassical growth theory, shows that the share of income being saved is optimal when it equals capital’s share of output or national product. As Dernburg and Dernburg (1969) state, “per capita consumption will be maximized for all time if society always saves and invests its competitive profits and consumes its labor income” (p. 184). Although the growth rate cannot be permanently raised by an increase in the share of income that is saved, it can be temporarily raised, and it does permit the long-run equilibrium rate of growth to be built upon a higher base. Net saving rates in a number of countries, including Australia, Sweden, the United States, and perhaps others, may have fallen far below this share in recent years.1

Sandmo (1985) reminds us of the earlier work of Bohm-Bawerk and Pigou, who argued that individuals in society are shortsighted and provide an inadequate stock of capital for future generations. The solution is to treat saving as a merit good and encourage saving beyond the point where Feldstein’s formulation holds. This question of shortsightedness has become more pressing as the role of social security has grown. Serious intergenerational inequity may occur if the current working generation saves little and relies on social security payments from future working generations to support its consumption in old age. But, as we shall see, it is not clear how much the saving of current working generations is affected by social security systems.

To summarize, saving is needed to maintain the capital stock. More may be needed to make sure that the capital stock grows in proportion to a growing population. Still more may be needed for an increase in the capital/labor ratio in order to increase per capita output. And if a country’s living standard is to be maintained or enhanced relative to that in other countries, it is likely that the capital/labor ratio will have to grow as rapidly as elsewhere.2 Adequate saving is also essential if intergenerational equity is to be maintained. And increased saving may be needed to reduce a country’s dependency on foreign capital and foreign ownership of domestic assets.

Saving Rates in OECD Countries

Table 1 gives the saving rates for a group of industrialized countries belonging to the Organization for Economic Cooperation and Development (OECD) for a 26- to 28-year period since 1960. The average annual gross saving rate in 15 of the 17 countries was lower during 1975-79 than during 1960-74. Only in the small countries of Greece and Ireland was the saving rate higher. From 1975-79 to 1980-87 it rose in only three of the countries—Japan, New Zealand, and the United Kingdom and only by small margins. (For Australia, Canada, the Federal Republic of Germany, and the United States, the data include the years 1980 through 1987; for all other countries, the data are for 1980 through 1985.) The unweighted average annual rate of saving for these 17 countries fell from 24,5 percent during 1960-74 to 22.5 percent for 1975-79 and to 19.7 percent for 1980-87, reflecting, on average, a 20 percent drop in gross saving as a share of gross domestic product (GDP), equivalent to 5 percent of GDP. Since these figures represent gross saving, and the rate of depreciation probably increased in many countries over this period of rapid technological change, the proportionate fall in net saving as a share of GDP was probably even greater.

Table 1.Gross Domestic Saving as a Percentage of GDP in OECD Countries(Mean values for various periods since 1960)
Country1960-741975-791980-87Most Recent

Three Years
Australia24.521.719.2a19.0
Austria28.725.024.223.7
Belgium23.320.115.215.5
Canada21.820.919.7a18.3
Denmark22.019.413.914.6
Finland28.827.624.524.0
France25.122.919.218.2
Germany, Fed. Rep. of27,022.921.7a23,0
Greece22.224.719.515.1
Ireland19.723.416.517.4
Italy23.722.119.018.0
lapan36.630.530.830.6
Netherlands28.426.921.823.0
New Zealand23.020.520.621.8
Sweden24.319.516.617.4
United Kingdom18.917.718.118.4
United States18.817.114.3a12.8
Average24.522.519.719.5
Sources: Feldstein (1983b, p. 133), Organization for Economic Cooperation and Development, National Accounts: Main Aggregates, Volume 1 (Paris: OECD, 1987), and Quarterly National Accounts, 2 (1988).

For Australia, Canada, the Federal Republic of Germany, and the United States the data in this column include the years 1980 through 1987. For all the other countries the data are for 1980 through 1985. Accordingly, the last column is for 1985-87 for Australia, Canada, the Federal Republic of Germany, and the United States.

Sources: Feldstein (1983b, p. 133), Organization for Economic Cooperation and Development, National Accounts: Main Aggregates, Volume 1 (Paris: OECD, 1987), and Quarterly National Accounts, 2 (1988).

For Australia, Canada, the Federal Republic of Germany, and the United States the data in this column include the years 1980 through 1987. For all the other countries the data are for 1980 through 1985. Accordingly, the last column is for 1985-87 for Australia, Canada, the Federal Republic of Germany, and the United States.

Table 2 shows net private saving for 1976-80 and for 1981-85, for 12 countries. The average annual rate fell in 9 of the 12 countries, rising only in Finland, the Netherlands, and Sweden. Household saving, which was, with few exceptions, more important than corporate saving, also declined in 9 of the 12 countries, to 7.8 percent of GDP, from an average of 8.6 percent, while corporate net saving fell to 1.7 percent of GDP from 1.8 percent. To date, there is no sign of a reversal of the downward trend in saving. Table 3 adds government saving to private saving and reflects the general fall in saving, both public and private, from the last half of the 1970s to the first half of the 1980s.

Table 2.Household and Nonprofit Institution Net Saving Plus Corporate and Quasi-Corporate Net Saving. 1976-80 and 1981-85(In percent of GDP)
1976-801981-85
CountryHouseholdCorporateSumHouseholdCorporateSum
Australia8.0- 0.17.97.3-2.74.6
Belgium12.50.813.311.61.312.9
Canada8.15.613.710.12.712.8
Finland2.71.84.52.74.16.8
France9.30.39.68.0-1.56.5
Germany, Fed. Rep. of7.31.89.15.32.27.5
Italy17.5-0.217.315.3-0.215.1
Japan15.02.317.311.82.314.1
Netherlands8.62.711.39.93.413.3
Sweden2.21.73.90.85.36.1
United Kingdom5.72.68.35.22.37.5
United States6.22.48.65.91.77.6
Average8.61.810.47.81.79.5
Source: United Nations, National Accounts Statistics: Main Aggregates and Detailed Tables, 1985 (New York: United Nations, 1987).
Source: United Nations, National Accounts Statistics: Main Aggregates and Detailed Tables, 1985 (New York: United Nations, 1987).

The fall in gross and net saving rates has been accompanied by increases in capital flows between countries. Given the accounting identity of X - M = S -I, an internal imbalance between saving and investment must be accompanied by an external imbalance on current account. Specifically, if investment exceeds saving, it must be offset by a deficit in the balance of payments current account.

Table 4 shows that the average gap between gross saving and gross investment has grown over the past quarter century. The average (absolute) gap, which was 1.4 percent of GDP during 1960-74, increased to 2.4 percent during 1975-79, and to 2.6 percent during 1980-87. (For Australia, Canada, the Federal Republic of Germany, and the United States, the data include the years 1980 through 1987; for all other countries, the data are for 1980 through 1985.) Even more important, the gap has grown most rapidly for some of the largest economies, such as the United States, the Federal Republic of Germany, and Japan. In the United States alone, an inflow of $157 billion in foreign capital was required to supplement domestic saving in 1987. Capital inflows into the United States, as a share of net domestic investment, were over 53 percent for the five years from 1983 through 1987. It is unprecedented for foreign investors to play such an important role in the capital formation of an industrialized country; it is a situation that is unlikely to persist indefinitely and it is one that has focused attention on the U.S. saving rate.

Table 3.Combined Private and Government Net Saving, 1976-80 and 1981-85(In percent of GDP)
1976-801981-85
CountryPrivateGovernmentTotalPrivateGovernmentTotal
Australia7.9-1.06.94.6-1.72.9
Belgium13.3-2.610.712.9-7.55.4
Canada13.7-0.713.012.8-3.69.2
Finland4.55.09.56.82.79.5
France9.61.711.36.5-0.65.9
Germany, Fed. Rep. of9.11.911.07.51.08.5
Italy17.3-4.812.515.1-7.37.8
Japan17.32.119.414.13.217.3
Netherlands11.31.012.313.3-1.511.8
Sweden3.93.57.46.1-1.34.8
United Kingdom8.3-1,27.17.5-1.65.9
United States8.6-1.17.57.(,-3.73.9
Average10.40.310.79.5-1.87.7
Source: United Nations, National Accounts Statistics: Main Aggregates and Detailed Tables, 1985 (New York: United Nations, 1987).
Source: United Nations, National Accounts Statistics: Main Aggregates and Detailed Tables, 1985 (New York: United Nations, 1987).

The data in Table 4 show a fall in the real rate of capital formation in a number of industrialized countries as well as a growing dependency on international capital flows to finance investment in some countries. The reverse side of the need for capital imports in some countries is the need for other countries to export capital to avoid the overheating of their economies. Possible interruptions of these capital flows, which are beyond domestic control, and the accompanying disruptions may motivate some countries to increase or decrease their saving rate. An additional motivation may be the political costs in some deficit countries of allowing a large share of capital to be owned by foreign investors.

Finally, it is important to realize that neither a fall in the rate of saving nor the reliance on an inflow of investment funds from other countries indicates that a country’s saving rate is too low. If investment opportunities decline, the existing level of saving may lead to an increase in the flow of capital abroad, which, in turn, may lead to an initial fall in the terms of trade. However, recent work (Goulder and Eichengreen (1988) and Mutti and Grubert (1988)) has shown that over the longer run the terms of trade may actually improve.3

Bosworth (1984), among others, has noted that if there were a real shortage of capital in the United States, it would probably be accompanied by a rise in the real rate of return. There is no evidence of such a rise.4 And as Makin (1986) has pointed out, if country A has a current account deficit with country B, which is financed by capital flows from B to A, this may reflect a real rate of interest at which it is attractive for A to consume more now, borrowing to do so, and for B to lend funds now in order to consume more in the future. In other words, differences in saving rates may reflect varying preferences for present versus future consumption, and such differences can be expected among countries. Subsequent discussion will highlight other factors that may cause saving rates to differ among countries.

Table 4.Gross Saving and Gross Investment in OECD Countries(In percent of GDP)
1960-741975-791980-87aMost Recent Three Years
CountryS/YI/YS/Y-I/YS/YI/YI/YS/YI/YS/YI/YS/YI/Y
Australia24.526.7-2.221.723.1-1.419.224.5-5.319.024.1-5.1
Austria28.728.40.325.026.7-1.724.224.8-0.623.723.70.0
Belgium23.322.40.920.121.5-1.415.217.4-2.215.515.6-0.1
Canada21.823.1-1.320.923.5-2.619.721.1-1.418.320.7-2.4
Denmark22.024.8-2.819.422.8-3.413.917.4-3.514.618.1-3.5
Finland28.830.6-2.427.631.8-4.224.525.5-1.024.024.7-0.7
France25.125.00.122.923.2-0.319.220.7-1.518.219.3-1.1
Germany, Fed. Rep. of27.026.20.822.922.20.721.720.41.323.019.43.6
Greece22.225.2-3.024.727.6-2.919.523.1-3.615.120.9-5.8
Ireland19.722.5-2.823.427.2-3.816.525.5-9.017.423.1-5.7
Italy23.722.71.022.121.40.719.020.4-1.418.018.6-0.6
Japan36.635.80.830.531.7-1.230.829.71.130.628.32.3
Netherlands28.426.61.826.921.55.421.819.22.623.019.23.8
New Zealand23.025.5-2.520.527.5-7.020.625.7-5.121.827.6-5.8
Sweden24.324.10.219.521.1-1.616.618.6-2.017.418.0-0.6
United Kingdom18.919.3-0.417.719.0-1.318.116.51.618.417.01.4
United States18.818.817.117.9-0.814.315.9-1.612.815.9-3.1
Sources; Feldstein (1983b. p. 133); Organization for Economic Cooperation and Development. National Accounts: Main Aggregates, Volume 1, 1960-1985 (Paris: OECD. 1987); and Quarterly National Accounts 2, 1988.Note: Figures represent mean values for various periods; 5 denotes saving, I denotes investment, and Y denotes GDP.

Data for Australia, Canada, the Federal Republic of Germany, and the United States are through 1987. For the other countries, the data are through 1985.

Sources; Feldstein (1983b. p. 133); Organization for Economic Cooperation and Development. National Accounts: Main Aggregates, Volume 1, 1960-1985 (Paris: OECD. 1987); and Quarterly National Accounts 2, 1988.Note: Figures represent mean values for various periods; 5 denotes saving, I denotes investment, and Y denotes GDP.

Data for Australia, Canada, the Federal Republic of Germany, and the United States are through 1987. For the other countries, the data are through 1985.

Measuring Saving—A Problem

Saving is important in the capital accumulation process. How the saving is used is equally important and will determine the impact of saving on output growth and increased productivity. Saving that is channeled into less productive uses yields a smaller welfare gain.

Significant diversity among countries’ saving rates has led to studies to determine if the common measures may, in some ways, be misleading. Blades and Sturm (1982) examined variations in the measurement of saving, including adjustments for consumer durables, education expenditures, and research and development expenditures. They concluded that although the saving rates increased significantly with the adjustments, the pattern among countries remained much the same. Lipsey and Kravis (1987a, b) came to a somewhat different conclusion, finding that saving, as measured on the national income and product account (NIPA) basis used by OECD and the United Nations, substantially overstates the difference in saving between the United States and other OECD countries. Specifically, they found that by including, sequentially, consumer durables, education, research and development, and military construction and equipment, capital formation in the United States rose from 77 percent of the OECD norm to 83 percent, 87 percent, 89 percent, and 92 percent, respectively, of the average for the OECD countries during 1970-84. Based on these estimates, and because capital goods are relatively cheaper in the United States, the insufficiency of saving in the United States is less obvious.

Boskin and Roberts (1986) analyze differences in saving rates between the United States and Japan, adjusting for consumer durables, government investment, and appropriate rents. They find that government saving accounts for a significant part of the difference in gross saving rates, and if consumer durables are included in saving, net private saving in 1984 in the United States and in Japan was 11 percent and 17 percent, respectively, of net national product, narrowing the gap in private saving between the two countries. In a still more comprehensive review of the measurement of national saving, Boskin (1988c) enumerates some of the many shortcomings of NIPA measures of saving, the measure on which international comparisons are normally based. These problems include measuring income associated with the unrecorded economy, the omission in NIPA estimates of net capital gains or losses, the treatment of durable goods as consumption, and the lack of a government capital account. Boskin also touches on the difficulties of valuing human wealth and the omission of contingent liabilities associated with public pension plans. Lipsey and Kravis’ estimates and Boskin’s discussion make clear that no single measure of saving can be expected to serve all needs. When intercountry comparisons are made, it is important to identify the purpose of the comparison and determine whether the measure being used is suited to that purpose.5

The method of measurement used affects both the overall level of saving and the distribution of saving among the public, corporate, and personal sectors. For example, inclusion of consumer durables and the underground economy raises saving and increases the role of personal saving. Inclusion of capital gains and losses changes the level and increases volatility in private (personal and corporate) saving, and inclusion of research and development expenditures particularly affects corporate and public saving. The share and level of public saving are increased if net public capital formation, including military construction and equipment is included, and decreased if social security liabilities are included. When comparisons are made among countries, it may be appropriate to compare total private saving rather than personal or corporate saving, since the division between corporate and personal saving will depend on the form of business utilized.6

The remainder of this paper is organized as follows. Section II, which is the main part of this review, discusses variables, including related evidence, that affect the level of saving. Section III reviews the variables on which policymakers might usefully concentrate their efforts if they wish to alter the saving rate. Section IV examines recent tax reforms and considers the extent to which they may encourage private saving. Concluding comments are in the final section.

II. Factors Affecting Saving

Although many considerations affect a country’s level of saving, there is some evidence, at least for the United States, that private saving as a share of gross national product (GNP) has been stable, at least until recently. Denison (1958) found “remarkable” stability in the ratio of gross private saving to GNP, making it difficult to identify the effect of other factors on the saving rate. Denison’s conclusions were extended and reinforced by David and Scadding (1974) who found, after adjusting saving to include expenditures on consumer durables and GNP to include the gross rental flow from such durables, that “there are indications that the long-run level of the [gross private saving rate] remained unchanged during the past 100 years” (p. 236).

The fall in private saving in the United States over the past 15 years seems likely to alter the conclusions reached by Denison and by David and Scadding for the United States. Moreover, similar stability between GNP and private saving may not have existed in other countries. But even more important, there is now a vast amount of literature that indicates that a number of variables, other than GNP, may affect saving. Hence, policymakers will continue to try to identify those elements that can be manipulated most effectively to achieve policy objectives. This section reviews variables identified in the literature as influencing, or potentially influencing, the level of private saving in a country.

Even when it is agreed that a variable is important—for example, the share of the population of working age—it may be a difficult one for policymakers to influence. Although other variables may affect the saving rate less, they may merit attention because policymakers can influence them—for example, deductions for retirement saving or the treatment of imputed income from home ownership. For other variables, such as social security wealth or the real rate of return, opinion is divided concerning the effecl on the level of saving, with possible effects so large that the importance of determining the actual effects is clear to ail parties. Generally, there will be a desire to increase the saving rate, but as was recently the case in Japan and the Federal Republic of Germany, there may be pressure to decrease saving.

Saving and the Life-Cycle Hypothesis

According to the life-cycle model, which has done much to enhance the understanding of saving behavior, the rate of saving (and consumption) will be affected by the rate of growth in per capita income, the stock of wealth, and various demographic characteristics such as life expectancy, the normal age of retirement, age distribution, family size, and the share of the population that is of working age and is working. Policies that affect these variables may alter the saving rate. According to the life-cycle hypothesis, most of the factors discussed below must affect one of these basic elements in the life-cycle model if the rate of saving is to be affected. Unfortunately, for those seeking to understand saving behavior, neither the life-cycle model nor any other model fits all of the evidence.

Saving Rates and International Capital Markets

The openness of an economy and the workings of international capital markets influence the impact of saving and investment incentives on the rate of saving. For example, Figure 1 shows that for a closed economy, the increase in saving that occurs when a saving incentive is introduced is choked off by the fall in the downward-sloping domestic investment curve. Saving will rise from 51 to 52, rather than to S3. If an objective for providing the saving incentive is to raise saving to benefit the savers at retirement as well as to benefit future generations, the policy has less impact in a closed economy. In a small open economy, the level of domestic saving does not affect the rate of return on saving, and the saving incentive does more to raise the saving rate, reducing present consumption and increasing resources available for future consumption. Thus, saving incentives can be more effective in increasing the rate of saving in an open economy than in a closed economy.

Figure 1.Effect of Saving Incentives on Saving

The openness of an economy also influences how investment incentives affect the saving rate. In a dosed economy, the shift in the investment function causes interest rates to rise, and saving increases from S1 to S2 in Figure 2 as we move up the saving function. Hence, the investment incentive leads to a higher rate of saving, assuming a positive interest elasticity. In a small open economy, where the supply of capital is completely elastic, the investment incentives lead to no change in market rate of interest, and, accordingly, to no change in domestic saving. In such a situation, investment incentives do not alter domestic saving, nor do they help to increase the future consumption that will be available for retirement or for future generations. In such an open economy, the level of “domestically owned” capital is unaffected, but the total capital stock in the country rises, owing to the inflow of foreign capital. In the United States, for example, even though it is an open economy, we may find that an increase in investment incentives has a sufficiently large “world” impact to cause interest rates to rise.7

Figure 2.Effect of Investment Incentives on Saving

To summarize, open capital markets increase the impact of saving incentives on a country’s saving rate. Since the increase in saving has no effect on the availability of capital to investors or on the market rate of interest, it will not affect the level of investment. Hence, if the objective is to reduce present consumption in order to increase future consumption, saving incentives will be more effective in an open economy.

The opposite will be true for investment incentives. A more open economy and better working international capital markets will lessen the effect of investment incentives on domestic saving. Increased capital accumulation results from an inflow of foreign funds, while domestic saving remains unaffected. Therefore, if the objective is to increase the saving rate in an open economy, saving incentives can be effective, whereas investment incentives are likely to have little effect.

Although we know that world capital markets will influence the effect of policy measures, we do not yet know how well these markets are working. According to Feldstein and Horioka (1980), there is a strong correlation between the levels of saving and investment in a country. Countries with high saving levels have high investment levels, and vice versa. Increased or decreased saving leads to increased or decreased investment, in very nearly equivalent amounts, over a relatively short period. It may therefore be possible for significant differences in rates of return to exist between countries without their leading to large capital flows.

Other studies have reaffirmed the results of Feldstein and Horioka, although there appears to be a perception of some weakening in the link between investment and saving.8 The data in Feldstein’s (1983b) study and updated data (as reported in Table 4) show that the gap between gross saving and gross investment ratios grew from 4.8 percentage points in terms of GDP (-3.0 percent to 1.8 percent) for 1960-74, to 9.6 percentage points (-4.2 percent to 5.4 percent) for 1975-79, and to 11.6 percentage points (-9.0 percent to 2.6 percent) for 1980-87. The coefficient for b in the equation I/Y = a + b (S/Y) fell from 0.993 for 1960-74 to 0.865 for 1975-79, and further to 0.701 for 1980-87. The evidence on increased international capital mobility is, however, still more suggestive than conclusive.

Harberger’s (1980) view, in contrast, is consistent with the notion that world capital markets generally work toward equalizing rates of return. While acknowledging that the adjustment is not immediate, he argues that the capital markets work to equalize returns, and that returns on capital as a result are much more equal than returns on labor. He points out that saving and investment activity will be more internalized as the unit becomes larger—starting with a city block as a unit and moving up to a large country. A wealthier unit is more likely to have the investment as well as the saving opportunity. This argument, plus the use of data on gross rather than net investment and saving, supports Feldstein and Horioka’s results.

There are, in fact, many imperfections in both international capital markets and international goods markets, imperfections recognized by all parties to varying degrees. These imperfections permit differences in real rates of return among countries over a significant period of time, if not indefinitely.9 At the same time, the capital flows caused by changes in the real cost of capital in a country can be enormous. Fukao and Hanazaki (1987) estimated the elasticity of the change in business capital stock to the real user cost of capital at between 0.8 and 1.7 for seven major countries, concluding that “if the United States introduced a tax measure equivalent to a cut in the real cost of capital by 1 percentage point at any level of the real interest rate, the world real interest rate would rise by 0.41 percentage points. The net external asset position of the United States would decline by about $260 billion (1985 value)...” (p. 71). Summers (1988a) and Sinn (1988) recently cited the massive capital flows that would be required to bring after-tax rates of returns to prereform levels following tax changes such as those in the United States in 1981 and 1986.10 International capital flows of this magnitude simply do not occur other than over an extremely long period of time.

The foregoing indicates that there is much that we do not yet know about the functioning of world capital markets. We know that there are imperfections. We also know that these markets may significantly alter the influence of domestic policies, and that international capital flows have grown rapidly and are now very large. Further work in the area is needed.

The Real Rate of Return and the Saving Level

The dominance of the Keynesian perspective that consumption is determined largely by disposable income prevented the effect of the real rate of return on saving from receiving much attention until well into the 1970s. The work by Denison (1958) and David and Scadding (1974), for example, indicated that in the United States the effect of elements other than GNP, including the rate of return, on the level of saving was far from apparent.11 Lack of attention may also have been due to economic theory’s ambiguous answer to how a higher rate of return will affect the level of saving. The income and substitution effects work in opposite directions. A higher rate of return decreases the present cost of purchasing a dollar of future consumption, making it attractive to substitute future for present consumption and to save more. At the same time, in order to achieve a given level of consumption in the future, it is no longer necessary to save as much. It is possible to save less now and consume more, both in the present and in the future. The income effect causes a reduction in saving. Given the theoretical ambiguity, whether or not saving is interest elastic is a matter for empirical analysis.12

Wright’s (1969) study was among the first to show a significant interest elasticity of saving, which he estimated to be between 0.18 and 0.27. Hence, a 50 percent increase in the real rate of return, from 4 percent to 6 percent, might raise saving by as much as 10 percent. Although this finding had important policy implications, the saving rate at the time may not have been of sufficient interest to focus attention on these new results.

Work by Blinder (1975) yielded a positive interest elasticity of 0.03 for saving, a relativly small response to rate of return changes. Boskin’s (1978) well-known work sharply altered the debate over the interest elasticity of saving. His interest elasticity estimate of 0,4 indicated that saving may change dramatically with a change in interest rates, and that large welfare losses may be created by taxes that discourage capital accumulation by sharply reducing the after-tax rate of return.13 Summers (1981a), noting that a higher rate of return would reduce the present value of human wealth and thus discourage consumption and encourage saving, estimated interest elasticities for saving that were as high as 3.7.

A study by Gylfason (1981) supported Boskin’s findings, estimating the interest elasticity of saving at 0.3. In reviewing other contemporary studies, Gylfason found that “the bulk of the empirical evidence accumulated since 1967 supports the view that consumption and interest rates are inversely related” (pp. 233 and 235). Recently, Makin (1987) estimated an interest elasticity of saving of 0.39 for the United States; his earlier estimate (Makin (1986)) was 0.1.

All of the foregoing estimates are for the United States. Tullio and Contesso (1986), in estimating consumption functions for eight industrial countries, including the United States, found “unambiguously that after-tax interest rates, either real or nominal depending on the country, have a very significant negative effect on private consumption” (p. 4).

In an admirable study on saving and taxation in Canada, Beach, Boadway, and Bruce (1988) used models similar to those used by Boskin (1978) and Summers (1981a) and consistently found interest rate elasticities that were insignificant for Canada. However, the main thrust of the Canadian study was to examine saving behavior by age group, and in doing so the authors found that the most sophisticated equations and those with the best fit... show an interest elasticity of about 0.5 to 0,6 (pp. 75-76).

What is clear... is the importance of age as a determinant of saving behaviour. Not too much importance should be attached to the overall elasticities since they are contingent on the age pattern of the population.... [T]he first two age groups [under 25 and 25-29] constitute over 35 percent of the tax-filing population, and that causes the overall average elasticity to be large and positive for the life-cycle equations (p. 76).

The foregoing results may lead policymakers to conclude that the substitution effect significantly outweighs the income effect, and that the saving rate can be altered by affecting the after-tax rate of return. However, here, as in the case of social security, conflicting evidence exists.

Shortly after Wright (1969) showed that saving would respond positively to interest rate changes, Weber (1970), using U.S. time-series data, considered the effects of interest rates on consumption. Although he presents no numerical estimates of the interest elasticity of saving, Weber concludes that “when the rate of interest increases, consumers have an opportunity to maintain the same level of consumption in the future with less saving today. Consequently, they increase current consumption in response to the interest rate increase” (p. 600). In a subsequent study, Weber (1975) confirmed his earlier findings that an increase in interest rates would increase consumer expenditures. It was the debate between Howrey and Hymans (1978) and Boskin (1978), however, that attracted particular attention. Howrey and Hymans analyzed the impact of interest rate changes on personal cash saving, excluding owner-occupied buildings and consumer durables from the saving concept. They found no significant interest rate effect and “no strong evidence that [personal cash] saving can be manipulated by policy aimed at changing the after-tax rate of return to saving” (p. 684).

Additional studies by Friend and Hasbrouck (1983) and Evans (1983a) added to the case for little or no interest elasticity for saving. Friend and Hasbrouck, using U.S. quarterly time-series data from 1952 to 1980, obtained results suggesting, if anything, that increases in the real rate of return were more likely to increase consumption and reduce saving. Evans found that when intergenerational transfers were allowed for, the interest elasticity of saving might well be negative instead of positive. Hendershott and Peek (1985), in their time-series analysis, found that the “real after-tax interest rate (which obviously measures the returns to savers with some imprecision) does not have a direct influence on the saving ratio” (p. 95). This conclusion was reinforced by Montgomery (1986) and Baum (1988). Using quarterly time-series data from 1953 to 1982, Montgomery found that the effect of the real after-tax rate of return on saving was small. Baum arrived at a similar conclusion: “real interest rates have a small and statistically insignificant direct impact on consumption-saving decisions” (p. 99). Makin’s (1986) estimate of the interest elasticity of saving for Japan was very small—only 0.02.

The difficulty in estimating the interest elasticity of saving is further illustrated by Starrett’s (1988) recent study, which, starting with Summers’ preference function, shows that estimates of elasticity are significantly affected if some fraction of consumption is composed of necessities that it is difficult to do without; and if some consumption is made up of “big ticket” items. Starrett found elasticity estimates to be particularly sensitive to changes in the proportion of consumption considered to be for necessities and concluded that “one cannot be sure whether steady-state savings elasticities are positive or negative” (p. 244). In a brief discussion of bequests, he also observes that these elasticities will be affected substantially by the form of the bequest function, and this is something about which we know very little.

Although the econometric evidence provides no clear answers concerning the effect of the real after-tax rate of return on saving, this has not prevented economists from taking positions. Shoven (1984), after reviewing the evidence, concluded that the interest elasticity of saving has been recognized as “one of the most important behavioral parameters affecting the economy” (pp. 218-19), and “despite disagreements among researchers, the center of the debate has moved toward higher estimates for this elasticity” (p. 219). However, U.S. data for the first half of the 1980s, a period of high real interest rates and declining private saving, have further muddied the waters. As Blinder (1987) notes, “titanic increases in the rates of return during the 1980s failed to raise private saving. This suggests that the response of saving to the rate of return may not even be positive, much less large” (p. 638). What McLure (1980) said nearly a decade ago following the Boskin/Howrey-Hymans debate is as valid today as it was then:

Determining the effect interest rates have on saving is no mean trick. It involves considerable conceptual and econometric difficulties that still defy the best efforts of bright and dedicated economists (p. 318).

Income Distribution and Saving

Before the interest elasticity of saving became a major issue, the effect of tax policy on after-tax income distribution was considered a major means by which tax policy might affect the level of saving. Individuals at subsistence and low income levels could save little, if at all. At higher points on the income scale, the marginal propensity to save would rise. Accordingly, tax policy that shifted the tax burden from individuals with high incomes to those with low and middle incomes would increase the level of saving. As reported in Break (1974), Musgrave found in 1963 that substituting an equal-yield general sales tax for the federal individual income tax would increase personal saving by 13 percent. Goode (1976) estimated that a similar change for 1960-61 would increase personal saving by 6 percent, and Break’s estimate for 1960 was a 10.5 percent increase.

The life-cycle model, which indicates that the share of income saved should be stable through the income scale, casts doubt on the likelihood that saving can be affected by policies that reallocate the tax burden. Blinder (1975) found “that equalizing the income distribution will either have no bearing on or (slightly) reduce aggregate consumption” (p. 472). Thus, the effect appeared to be opposite to that expected. Blinder offered the “demonstration effect” and deficiencies in the data as possible explanations for his results. Commenting on a 1983 study by Emily Lawrence, Boskin and Kotlikoff (1985) report that she “found that even significant intragenerational redistribution, such as that characterizing U.S. welfare programs, has only minor effects on saving in life-cycle models” (p. 59). Boskin and Kotlikoff suggest that redistribution through transfer payments to the poor may add to saving. This is because liquidity contraints on the poor limit their increase in consumption, while those paying the higher taxes adjust their consumption to the present value of the anticipated increase in taxes. The cross-country study by Kopits and Gotur (1980) included an income-inequality variable in its regressions and found insignificant coefficients for both industrial and developing nations.

A recent two-part study by Boskin and Lau (1988a, b), based on U.S. data, found a sizable difference in the propensity to consume out of wealth between those born before 1939 and those born after 1939, which indicated that any policy enhancing the wealth of the first group at the expense of the second would add to total saving. Hence, growth in the portion of wealth in the hands of those born after 1939 will over time have an adverse effect on saving in the United States. These results reinforce the point by Beach, Boadway. and Bruce (1988) that different age groups in the population may respond very differently to changes in wealth or in rates of return.

Still, the logic that transfers to those with very low incomes and liquidity constraints will lead to increased consumption and decreased saving seems powerful. It led Evans (1983b) to conclude that it is by this means, rather than through the wealth effect, that social security may lead to a significant fall in saving, although the data to support this conclusion are not evident. Given the uncertainties and the high “equity” costs involved in using redistribution to effect increased saving, this tool is likely to be of limited usefulness.

Corporate Saving and Total Private Saving

Alternatively, taxes can be redistributed between corporations and individuals. Is this likely to affect total private saving? Consider shifting a dollar of taxes from the corporation to the individual. If the marginal propensity to consume from disposable income is 0,75, household saving falls by 25 cents. With a rise in retained earnings of 1 dollar, the initial effect seems to be a 75 cent rise in total saving. The relevant question is the extent to which an individual who owns the corporation sees the additional dollar of retained earnings as a substitute for household saving. If the two are perfect substitutes, the individual dips into personal saving by a further 75 cents, and consumption and total saving are unaltered by the relocation of the saving.

Denison’s (1958) study questioned whether any redistribution of taxes would affect private saving. He found that the division of income between individuals and corporations did not seem to affect private saving, and that “this pattern suggests that individuals’ consumption expenditures are not affected by changes in the proportion of corporate profits paid out as dividends” (p. 264). This corresponded with the finding by David and Scadding (1974) that a sizable shift in private saving to consumer durables and corporate saving appeared to have little effect on the total rate of saving. Nevertheless, other evidence indicates that the corporate veil is only partially transparent and that additional corporate saving will affect total saving.

Feldstein (1973) and Feldstein and Fane (1973) show that although individuals “see through the corporate veil,” an increase in saving by the corporation will be offset only partially by a decrease in saving by individuals. Feldstein found that the marginal propensity to consume retained earnings in the United States was about 0.5 in contrast to a marginal propensity to consume disposable income of 0.75. Therefore, if the corporation retains 1 more dollar, while the individual is deprived of 1 dollar in disposable income, saving should increase by 25 cents. For the United Kingdom, Feldstein and Fane estimated a marginal propensity to consume retained earnings of 0.27, predicting that shifting 1 pound from disposable income to retained earning would increase saving by between 12 pence and 50 pence. The work by Bhatia (1979) also supports the notion that changes in corporate retained earnings may have little effect on other forms of personal saving. He finds that the effect on personal saving is reflected mostly through the wealth variable, and that this “can be a long drawn out process because the coefficient of wealth in most cases is rather small” (p. 133). Von Furstenberg (1981) found that “two thirds of corporate saving... appear[s] to be substituted for private saving at the margin” (p. 369). This rinding is quite consistent with more recent evidence. Poterba (1987) found that “time series evidence on persona! and corporate saving suggests that changes in corporate saving are only partly offset by opposite movements in personal saving. A 1 dollar decline in corporate saving is likely to result in a 25-50 cent decline in total private saving” (p. 503). A dollar increase in corporate saving should result in a similar (25-50 cent) rise in total saving.

Although corporate saving is a substitute for personal saving, it is an imperfect substitute. The foregoing indicates an imperfect offset, and a chance for policymakers to increase total saving by shifting taxes from corporations to individuals. Indeed, Musgrave and Musgrave (1984) observe that “the savings impact of the corporate tax dollar is... substantially above that of most other taxes. A policy designed to foster growth, therefore, calls for restraint in the taxation of business profits” (p. 662).

Public Pensions and the Saving Level

Economic theory indicates that social security programs affect private saving in a number of ways. First, financing social security benefits through debt or taxes will have an impact on patterns of consumption. Second, promised social security benefits have a wealth effect as the anticipated benefits net of contributions have a positive present value. The need to save is decreased as “social security wealth” is substituted for private wealth. Third, there is a retirement effect as expected social security benefits alter retirement timing; individuals retire earlier and must save more during their years of employment. The wealth and retirement effects work in opposite directions. Two important questions are which of the two effects dominates, and by how much?

We still do not know the answer to these questions in spite of extensive research by leading economists. The results of empirical research have been contradictory from the beginning. In his first of many studies—this one based on U.S. time series—Feldstein (1974) concluded that “in the absence of social security, personal savings would be at least 50 percent higher than they are now and probably closer to 100 percent higher” (p. 916), reflecting that the wealth effect far outweighed the retirement effect. In that same year, a study by Munnell (1974), using the social security wealth time series developed by Feldstein, found both effects to be significant, and that “the apparent neutral influence of social security on saving has really been the net result of two strong but offsetting forces” (p. 563). However, she anticipated that the retirement effect would weaken with a slowing of the decline in labor force participation by the aged. Given these conclusions, it might have been thought that future studies would consistently indicate dominance of the wealth effect.

In subsequent years, cross-country studies, studies based on micro-economic data bases, and further time-series studies by Feldstein (1977b, 1980,1979 (with Pellechio), and 1983c, 1978, 1982) supported his earlier conclusions. His cross-country studies concluded that “the average level of benefits reduces the private saving rate by 4.2 percentage points” (1977b, p. 191); and that “an increase of the benefit to earnings ratio by 10 percentage points reduces the saving rate by approximately 3 percentage points” (1980, p. 225).14 He drew equally forceful conclusions from his studies using U.S. microdata, while recognizing weaknesses in the data, finding “that each extra dollar of social security wealth reduces accumulation of ordinary fungible net worth by 93 cents” (Feldstein and Pellechio (1979, p. 366)), and that “on balance [there is] a substantial substitution of social security wealth for private wealth accumulation” (1983c, p. 21), perhaps as much as a dollar-for-dollar substitution. His later U.S. time-series studies reinforced earlier work, finding that the reduction in personal saving attributable to social security wealth “is approximately 80 percent of current social security benefits and about 90 percent of current personal saving” (1978, p. 47), and that “the level of social security wealth in the final year of the sample (1971) depressed personal saving by an amount equal to 44 percent of the actual personal saving in that year” (1982, p. 630).

Research by others has supported Feldstein’s findings. Using micro-data for Canada, King and Dicks-Mireaux (1982, p. 265) found a smaller (but significant) wealth effect than Feldstein. They estimated that an additional dollar of social security wealth would be offset by a 25 cents fall in other saving, and that this fall would be dollar for dollar for the top decile group. Diamond and Hausman (1984), using microdata for the United States, got similar results, estimating for social security benefits “the range of the offset to be about $0.25-50.40 on the dollar” (p. 110). Hubbard (1986), also using microdata for the United States, estimated that “an increase in social security wealth of 1 dollar reduces net worth by 33 cents” (p. 174).

Additional U.S. time-series analysis also supports Feldstein’s findings. Hendershott and Peek (1985) concluded that two factors that worked “to depress the savings ratio throughout the 1950-81 period [were] a marked increase in the retired portion of the population and rapid growth in unfunded pension wealth (both social security and pensions for government employees)” (p. 95), but indicated that the precise role of the two factors was uncertain. Gultekin and Logue (1979) agreed with Feldstein that social security had an adverse effect on private saving, but found that much of this adverse effect may be due to social security taxes rather than social security wealth.

Two recent studies using Japanese annual time-series data examined the impact of social security on household saving. Shibuya (1988) found that, for the period 1955-85, “public pension benefits are a perfect substitute for personal savings as predicted by the life-cycle hypothesis” (p. 16). For 1946-82, Yamada and Yamada (1988) found a lesser, but still substantial effect. They estimated that social security depressed personal saving by between 53 percent and 68 percent during 1970–80, with the negative benefit effect between five and ten times as large as the positive retirement effect.15

As the foregoing review shows, there is a sizable body of scholarship indicating that social security systems cause significant reductions in private saving—perhaps as much as a dollar reduction in private saving for each dollar increase in social security wealth, and no less than 25 cents for each dollar. Regrettably for those seeking clear policy direction, for each study indicating that the wealth effect of social security outweighs the retirement effect, there is at least one study that challenges this conclusion.

Cross-country studies by others have questioned Feldstein’s conclusions. Barro and MacDonald (1979), considering a sample of 16 industrial countries for the period 1951-60, got mixed results, finding “that the time series movements of social security exhibit a positive relation to consumer spending [and that] cross-sectional variations reveal a negative association” (p. 275); they conclude that “there is no support for the proposition that social security depresses private saving” (p. 288). Crosscountry studies by Kopits and Gotur (1980), Modigliani and Sterling (1983), and Koskela and Viren (1983) support this conclusion. For the 14 industrial countries in their sample, Kopits and Gotur found “the (positive) retirement effect outweighs the (negative) wealth substitution effect of old-age transfers” (p. 185), although, like Munnell, they expected the wealth substitution effect to strengthen as social security systems became older. They concluded that social security systems were more likely to increase private saving in industrial countries than to reduce it. Modigliani and Sterling (1983) found the indirect effect of social security on retirement to be unexpectedly large for their 21-country sample, concluding that, for private saving, “the net impact of social security is close to zero, though possibly on the plus side” (p. 50). Kosketa and Viren (1983) found, based on a sample of 16 industrialized countries, that the social security variables used in their study had no effect on the household saving ratio.

Using the social security wealth time series-data developed by Feldstein, Barro (1978) achieved results that differed sharply from Feldstein’s. He found the coefficient for the social security wealth variable to be insignificant, and claimed results that were relatively robust with respect to a variety of specifications. Horioka (1986), in his time-series study of the Japanese saving rate found that “the wealth-replacement and induced-retirement effects of public pensions roughly offset one another, as a result of” which their net impact on private savings is roughly zero” (p. 15). Using quarterly time-series data from 1962 to 1979 for the United Kingdom, Browning (1982) came to the conclusion that although it is not possible “to reject the hypothesis that marginal changes in pensions cause changes in aggregate consumption... the effects are.., relatively small” (p. 963). This conclusion was consistent with the earlier review by Barros (1979), which found that “the provision of state pensions, ancillary social security benefits, and free health care [has] not appreciably depressed the long-term trend of growth of personal saving” (p. 251).

At least until the late 1970s, evidence from a number of other countries indicated that social security was not adversely affecting saving. In Sweden, where the public pension plan was largely funded, Markowski and Palmer (1979) found that the public pension program “contributed to an increase in the level of national saving during the period studied” (p. 214), although there was a 2 percentage point fall in personal saving. In Sweden, the effect of the funded public plan may be similar to that of private plans in other countries. A Canadian study by Boyle and Murray (1979), using time-series data similar to Feldstein’s, found that “Canada’s public pension plans have had no visible effect on household savings behaviour” (p. 467). Similar results were achieved in a Canadian study by Denny and Rea (1979), which found that the private saving rate would not have been higher in the absence of social security. However, like Munnell (1974), they noted that with an anticipated decline in the importance of the retirement effect, the longer-run effect on saving might be adverse. A study by Pfaff, Hurler, and Dennerlein (1979) for the Federal Republic of Germany concluded that “the regression results reported lend support to the conclusion that an expansion of the old-age social security system has not led to a reduction of personal saving...” (p. 298), A review of the evidence for France (Oudet (1979)), where unfunded social security benefits were a larger share of disposable income than in the United States, found “no firm evidence that expansion of social insurance programs has lowered the net private saving rate out of GNP” (p. 257).

Ando and Kennickell (1987), using microdata, found that for their sample of U.S. families, the “saving and dissaving pattern for assets and liabilities other than social security wealth appears to be little affected by social security wealth” (p. 208). Eisner reasoned that a pay-as-you-go system may decrease the consumption of the working young by more than it increases the consumption of the elderly, particularly since the elderly have a tendency to leave estates. The result would be a social security system that increases rather than reduces saving.

As the above indicates, social security may have had little effect on the level of private saving. In the U.S. context, Munnell (1982, pp. 89-90) notes that, in a sense, little changed with the introduction of a pay-asyou-go social security system, since a similar private system had previously been in place. Before social security, families had contributed the resources to support the aged, and the introduction of public programs brought the government into this process as a middleman. Viewed from this perspective, why should social security affect the saving level?16

Economists agree that theory does not yield a clear answer concerning the effect of social security on personal saving. The answer to the question therefore lies in empirical analysis, which has so far yielded unclear results. The state of our knowledge still remains where it was when Aaron (1982) concluded that “the evidence falls grossly short of establishing the size, or even the direction, of the effects of social security on capital formation” (p. 52).

Private Pensions and the Saving Level

Private pension plans affect the need for households to save in other forms. The extent to which this form of household wealth has been offset by decreases in other household saving determines how much private pensions add to total private saving. To the extent that benefits are vested in the employees, we might expect close to a one-to-one substitution of pension fund saving for other forms of saving. If, in general, early retirement is required, this retirement effect may encourage additional saving. The retirement effect, plus the fact that vested pension benefits are less liquid than other forms of saving and are only partially vested, means that private pension plans are likely to add to total saving. An important question is by how much?

Munnell (1976) found that for the United States private pension plans add to total saving about one third of the amount contributed to the private plans—$8 billion in 1973. Subsequent studies have found the effect of private pension plans to be greater. Hubbard (1986), using microdata for the United States, found that “an increase in private pension wealth of one dollar reduces nonpension net worth by sixteen cents” (p. 174). This estimate was consistent with the range of 10 cents to 19 cents estimated by Guitekin and Logue (1979). Ando and Kennickell (1987), also using microdata, found that “those families participating in private pension programs do not seem to change their behavior toward assets and liabilities other than the value of pension fund reserves, so that contributions to pension funds, by both employers and employees, and interest earnings on pension reserves appear to constitute additional savings for these families” (p. 208).

It is important to narrow the range of the above estimates. Munnell (1988, p. 314) noted that if a dollar in a private plan added 30 to 40 cents to total private saving, the addition to private saving in 1985 was around $57 billion in the United States. The tax expenditure resulting from the employer-sponsored plans was $45 billion, and the net effect on total saving may have been close to zero. If the effect on private saving were closer to the estimates of Ando and Kennickell, the contribution of private pension plans to national saving could be significant even in the face of a sizable reduction in tax revenues.

Increased use of both private and public pension plans may be accompanied by a “recognition effect,” which causes other forms of saving to increase as well. Barros (1979) cited this effect as a possibly important impetus to higher levels of saving in Britain. This effect was also used by Feldstein (1974) and by Buiter and Tobin (1979) to explain the results of some of the early studies (Katona (1965) and Cagan (1965)), which found that the expansion of saving in the form of private pensions led to increased private saving in other forms as well. Private pensions may give people the prospect of financial independence and security in old age, thereby motivating them to increase saving in other forms. Over time, however, it seems likely that this effect will become less important.

The statutory funding requirements for the private plans may also contribute to greater volatility in private saving. Significant capital gains or losses on the assets of these funds owing to shifts in financial markets may lead to large shifts in private saving in the form of contributions to the plans. In a time of high real returns and capital gains to corporate pension funds, Bernheim and Shoven (1988) found that net corporate contributions in the United States fell sharply from 6.02 percent of disposable income in 1982 to 4.02 percent in 1984, “enough to be responsible for the disappointing level of aggregate personal saving” (p. 86).17 Noting this significant effect on private saving (as normally measured), and the apparent lack of responsiveness to saving of high real rates of return in the early 1980s, Makin (1987) argues that this adjustment in corporate pension plan saving also affected estimates of the interest elasticity of saving.

Saving Incentives and the Level of Saving

Households will allocate funds to those assets that yield the highest, risk-adjusted, real after-tax rate of return. As a result, there is general agreement that saving incentives alter the composition of saving. In contrast, there is little agreement on the effect of saving incentives on the total level of saving. This should not be surprising since the effectiveness of saving incentives will be determined in large part by the interest elasticity of saving, and the evidence on this subject is mixed.

Byrne (1976), in his review of household saving incentives, concluded that experience in the Federal Republic of Germany showed that permitting deductions for saving earmarked for particular purposes, such as life insurance, dwellings, and the acquisition of securities, could encourage saving throughout a large part of the population. Even though such measures seemed to “spread the savings habit,” he found “no evidence at the aggregate level that these savings incentives have affected total household saving” (p. 477). Nevertheless, he, as others have, noted that “countries with a relatively lenient tax treatment of savings do have higher saving ratios” (p. 487). Is there more conclusive empirical evidence? Three types of factors are considered briefly.

Deductions for Retirement Saving

In addition to deductions for fixed-benefit pension plans, countries often allow other deductions for retirement saving. For example, Canada permits individuals to deduct contributions to individual Registered Retirement Saving Plans (RRSPs), and the limit on the deductions has been changed from time to time. More recently, the United States, through its Individual Retirement Accounts (IRAs), has permitted similar deductions. The effect on aggregate saving has been considered in each of the countries, and the existence of RRSPs in Canada during the 1970s, before the introduction of IRAs, allows consideration of the role of RRSPs in the higher Canadian saving rate.

Jump (1982) examined the effect of the investment income exclusion (C$1,000 a year) as well as the RRSP deductions on the rate of saving in Canada; he concluded that the effect of these incentives was not at the margin for most people. Since most investment income went to taxpayers who had more than C$1,000 in investment income, the incentive would effectively be a lump-sum transfer and would not encourage investment or saving at the margin. Similarly, the RRSP deduction would not affect those taxpayers who were already saving an amount in excess of this limit, although it might well affect a reallocation of saving. Jump observed that such incentives require the government to set higher tax rates, and accordingly “may actually have perverse effects insofar as they have been financed by increases in distortionary taxes.... The tax incentives may actually have caused a decline in measured personal saving in Canada. At most, they may have added something in the neighborhood of 1.3 percentage points to the measured personal saving rate over the 1975-81 interval” (p. 64).

Carroll and Summers (1987) ran a series of regressions that attempted to explain the difference in saving rates between the United States and Canada. They noted particularly the divergence in saving rates in the mid-1970s when Canada raised the limits on RRSP contributions. They found that “in essentially all of our regression specifications the coefficient for the level of sheltered savings was significantly positive” (p. 269). Thus, consistent with Carroll and Summers’s view that saving is interest-elastic, sheltering some forms of saving appears to encourage total saving. However, Carroll and Summers note that even if “two thirds of RRSP saving would not have been done had there been no RRSP program, then RRSPs can directly account for at most a third of the increase in Canadian personal saving” (p. 262). Based on casual observation, it seems unlikely that the two thirds was new saving. Carroll and Summers also recognized other factors that might account for the divergence in U.S. and Canadian private saving from the mid-1970s onward. These include uncertainties accompanying the increase in Canada’s relative unemployment rate, the large increase in the size of the Canadian government deficits, and, in a time of inflation, the growing importance in the differing tax treatment for interest on mortgages and consumer credit in the two countries.

The Carroll and Summers study identified a number of factors— including sheltered saving in Canada—that help to explain differences in private saving between the two countries. Several other economists, agree that sheltered savings may have contributed to the higher saving rate in Canada, although their conclusions are not based on further empirical work. Bosworth (1984), for example, noted:

The strongest international evidence that rates of return may affect saving emerges from the comparison of Canada and the United States—two countries with similar economic institutions and social values—during the 1970s. In the United States household saving as a percentage of after-tax income declined from about 8 percent at the beginning of the decade to 5.5 percent at the end. The comparable rate for Canada rose from 6 to 10 percent (p. 93).

Beach, Boadway, and Bruce (1988) also comment on U.S.-Canadian savings differences. They note that whereas declining after-tax real rates of interest accompanied falling saving in the United States in the 1960s and 1970s, in Canada the same fall in rates was not accompanied by declining saving. They express surprise therefore that interest elasticity estimates similar to those of Boskin (1978) and Summers (1981a) were not found for Canada. But, in fact, tax-sheltered saving may have kept the after-tax real interest rate from falling, and “the divergence of Canadian savings rates from those in the United States may well be explained by Canadian tax policies toward saving” (p. 34). Still, based on the analysis of Jump and Carroll and Summers, as well as on casual observation, it seems likely that RRSPs accounted for little of the difference in saving rates between the United States and Canada, unless the recognition effect (discussed below) is significant.

Venti and Wise (1987) examine the impact of IRAs on private saving in the United States. Their results are striking and raise questions about the wisdom of capping IRAs in the 1986 Tax Reform Act. They conclude that “increasing the IRA limits would lead to substantial increases in tax-deferred saving.... The weight of evidence suggests that very little of the increase would be offset by reduction in other financial assets, possibly 10-20 percent, maybe less. Our estimates suggest that 45-55 percent of the IRA increase would be funded by reduction in consumption, and 35 percent by reduced taxes” (p. 37). This paper is considered to be an extremely clever piece of econometrics in a difficult area, but as Deaton’s (1987) comments on the paper reflect, many remain dubious about the impact of higher IRA limits on the total level of saving, rather than simply on its composition. More work is needed to support the initial, but extremely interesting, findings by Venti and Wise.18

A number of authors have mentioned the recognition effect. Both in Canada and the United States, savings and investment institutions have had an incentive to advertise the benefits of saving through RRSPs and IRAs, raising public consciousness about the importance of saving for retirement. This may well be a significant, if unmeasured, element affecting the total level of saving. This so-called recognition factor was also cited as possible early evidence that corporate pension plans, rather than substituting for other forms of private saving, caused other forms to increase as well.

Exemption of Interest Income

Many countries give preferential treatment to interest income and other forms of returns on savings. Interest income on most personal saving in Japan was exempt from tax until the tax reform of 1988, Tanzi (1987) observed that “around 70 percent of total personal savings are now in tax-exempt deposits. A consequence of this is that most interest income escapes taxation” (p. 350). Pechman (1987) refers to the 2.7 million savings accounts in Sweden where interest is exempt from taxation, noting that “estimating how much this type of saving has been substituted for other forms is impossible” (p. 13). Byrne (1976) mentions that “it has been an established principle of French tax policy since 1950 that personal savings should be exempt from tax,” and finds that “40 percent of such income [from financial capital] was completely exempt, and a further 27 percent was subject only to a withholding tax of 25 percent; only one third was included in the base of the progressive income tax” (pp. 480 and 485-86), Japan has had a very high rate of household saving, France’s rate has been about average, and the rate in Sweden has been very low (see Tables 1 and 2).

The extent to which tax-exempt interest income has contributed to a higher household saving remains unclear. The position of any economist on this issue will be directly related to his views concerning the interest elasticity of saving, and on this basis it is appropriate to refer the reader back to the earlier section on the interest elasticity of saving.

Jump’s (1982) earlier observations concerning the exclusion of investment income in Canada must be kept in mind—-to be effective the exclusion or lower rate must apply at the margin. Some studies on saving in Japan, in particular, have commented on the effect of tax-free saving on total saving, but in general offer little evidence to suggest that the tax treatment of savings accounts in Japan has been a significant factor contributing to the high level of saving in that country.

Shibuya (1987,1988) constructed a variable called the “tax-exemption ratio” in an attempt to measure the impact of tax-exempt saving. He concluded that tax exemptions on interest income have only a minimal effect on saving. Makin (1986), although considering the low tax burden on interest income to be a strong incentive for saving in Japan, offered evidence that other factors were more important in contributing to the large difference in saving between Japan and the United States. Horioka (1986), also finding that other factors adequately explained the different saving rates between Japan and the United States, concluded that tax incentives accounted for little of the difference between the two countries. These conclusions are consistent with that of Hayashi who found “no strong evidence for a high interest elasticity of saving or for the effectiveness of the tax incentives for saving” (p. 197). The evidence suggests that preferential tax treatment of saving, rather than contributing to the level of saving, may occur in those countries where saving for other than tax reasons is important. Conversely, where saving is important, pressure is exerted to keep taxes on interest low.

Imputed income on owner-occupied housing is often exempt, and is another case of exempting the return on a particular form of saving. Tax treatment of homeownership has affected the form in which individuals save, causing them to put more saving into housing. Treatment of capital gains on housing and the deductibility of mortgage payments are other means of increasing the attractiveness of this form of saving. The effect on the total level of private saving is. however, not clear.19

Interest Deductibility on Consumer Credit

Deductibility of interest for tax purposes, when coupled with relatively high marginal tax rates, substantially reduces the cost of borrowing for consumption purposes. In times of inflation, the deductibility of nominal interest may lead to negative real rates of interest and create incentives to consume rather than to save. Deductibility of interest on housing and consumer loans varies widely among countries. Is there evidence that countries that treat interest deductions liberally have low private saving rates relative to those that strictly limit interest deductions? If so, at a time when insufficient saving is a growing concern, countries with inadequate saving might well review their policies in this area.20

Tanzi (1988) divided countries into two groups—those with the most generous provisions for interest deductions, and those with the least generous treatment. He found that “the saving rate for the second group was on the average almost three times that for the first group” (p. 134) for the period from 1974 to 1985, In particular, he noted that the northern European countries, in addition to the United States, have been particularly generous with their interest deductions, and it is in these countries that the saving rate is noticeably low. Although others (Blinder (1982), Bradford (1982), Carroll and Summers (1987), Friend (1986), and Makin (1986)) frequently mention the deductibility of consumer interest, particularly in the United States, as contributing to a low saving rate, there is little empirical evidence on this matter.

The effect that interest deductions on purchases of consumer durables and housing have on total private saving depends on how private saving is measured. If consumer-durable “investments” are included as part of saving, the impact of interest deductibility on total saving may be favorable, but the allocation of saving is further distorted since the income from these investments is not taxable.

Saving and Wealth—Additional Evidence

The effect of wealth on saving was considered briefly in previous sections on interest elasticity and public and private pensions. Summers’ (1981a) results concerning interest elasticities depended to a significant extent on his human wealth effect—that is, a higher rate of interest would cause a fall in the present value of anticipated future employment earnings, thus reducing human wealth. This would cause a fall in consumption and a rise in saving. The effect of private pension wealth on other forms of private saving was also considered, as well as how statutory funding requirements could result in significant shifts in private saving when these funds realize large capital gains and high real rates of return.

Bovenberg (1988a), following his review of factors affecting saving in the United States, concluded that “empirical studies generally suggest that improvement in wealth positions due to the rising values of the stock market and housing have been a major factor behind the declining trend in private saving” (p. 2). His conclusion followed the study by Hender-shott and Peek (1985), which showed that “the most important variables explaining longer-run swings in the saving rate are real wealth and income” (p. 95). Carroll and Summers (1987) also found the level of personal wealth as a fraction of disposable income helped explain the gap between U.S. and Canadian saving rates.

Several studies of saving in Japan have considered the effect of wealth on saving. Hayashi (1986) concluded that “Japan’s saving rate has been high because the Japanese desire to accumulate wealth in order for their children to live as well as Americans do” (p. 199). This observation is consistent with Shinohara’s (1983) view that one of the factors affecting the Japanese saving rate was the “asset effect”—that is, the share of liquid assets in national income in Japan did not return to its 1935 level again until 1965. It seems likely that current asset levels relative to past levels, and to those in other countries, will affect the level of saving. A “demonstration” effect regarding the stock of capital may have had an important role in postwar saving. Rather than emulating present consumption in countries that are better off, current generations have been prepared to save in order to place future generations higher on the list of relative well-being. Shibuya (1988), in his time-series analysis of Japan for the 1955-85 period, found that the ratio of household assets relative to expected lifetime income plays a significant negative role in explaining the rate of household saving in Japan. Asset composition as well as the level of assets may have an effect, and Barros (1979) and Oudet (1979), writing on the United Kingdom and France, respectively, observed that the level of liquid assets relative to disposable income has a negative effect on the level of saving.

One further piece of evidence relates to the demonstration effect. Lipsey and Kravis (1988b) estimated that the level of per capita capital formation in the United States was as high as or higher than that of either Japan or the Federal Republic of Germany in 1980, even though the rate of saving was much lower. If there is a demonstration effect as countries try to climb the ladder of relative well-being, it may not be realistic to expect a country at the top of the ladder to maintain a saving rate as high as the rates of countries striving to climb the ladder.

The effect of government bonds on saving is another unresolved issue. Barro (1974) argues that government bonds will not affect the level of saving or consumption since intergenerational transfers connect current and future generations. The current generation realizes that the wealth represented by the bonds is offset by the present value of tax payments that will be required to redeem the government debt. Accordingly, individuals will save an amount to pass on in bequests that is sufficient to cover the higher taxes. This issue is directly related to that of unfunded social security programs where the current generation anticipates significant benefit payments that will have to be met by higher taxes on future generations. Government bonds and “social security wealth” would have the same wealth effect, but in neither case does the empirical evidence provide a clear answer.

In contrast to the above case, whereby a future government liability has been created without any other change, is the situation whereby government debt rather than taxes is increased to make a certain expenditure. In such a situation Buchanan (1976) pointed out that the “differential impacts” of taxation and debt issue must be considered, and it is quite possible that the future tax liabilities are not fully capitalized. Even if they are fully capitalized, there is insufficient evidence to show that the combined effects of this and the existence of the bonds on the level of saving are the same as an increase in taxes.21

A number of studies in the United States have pointed to the effect of investment incentives on the value of old capital. Reductions in incentives lower the value of new capital relative to old capital, and thus may create significant gains for holders of old capital. Similarly, increases in investment incentives lead to capital losses for owners of old capital. This has important implications in a world of tax reform that has focused on base broadening, including the elimination or reduction of investment incentives. Since the elderly hold a large share of old capital, Auerbach and Kotlikoff (1982) have noted that “the intergenerational redistribution of resources away from the elderly, arising from investment incentives, leads to a major reduction in the economy’s current consumption” (p. 40). Kotlikoff (1983) reports an implicit tax on holders of U.S. plant and equipment ranging from $230 to $290 billion resulting from the 1981 Tax Act. Such a change in the wealth of the elderly—that is, those with a high propensity to consume out of wealth—would be expected to have a positive effect on saving. In contrast, they note that something like a reduction in tax rates on corporate profits, offset by a reduction in investment incentives, would lead to a capital gain for the elderly that would cause saving to fall. This might suggest a sizable adverse effect on saving caused by the corporate tax changes of 1986 in the United States, although evidence is still lacking. Other changes, of course, complicate the isolation of any such effects.22

Shibuya’s (1988) study of household saving in Japan found that household wealth substituted for saving on a one-for-one basis, and that the sharp increase in saving in Japan in 1975 was a result of the capital losses and negative real interest rates that followed the first oil crisis.

The Bequest Motive

Do individuals save in order to transfer accumulated wealth to their heirs? The net worth of many individuals is positive and sizable at time of death, suggesting that a powerful bequest motive may exist. But it is not clear whether bequests really are a separate motive, or that they result from a realization, through intergenerational links, that if future generations are not to be unfairly burdened with public debt it is necessary to accumulate private wealth to pass on to the next generation. The importance of saving for bequests as an independent motive is still unknown. If the bequest motive is an important separate motive, how can policymakers influence that motive? Will demography affect the level of capital accumulation owing to a fall in the incentive to save for bequests because of smaller families? More needs to be understood about the bequest motive if policy actions are to have anticipated and desired effects.

Kotlikoff (1988) summarizes evidence that suggests that saving may occur for reasons other than consumption during retirement. He mentions the propensity of the retired to hold on to their savings, the weakness of annuity markets, and the fact that substantial saving existed before retirement became commonplace. Such evidence is consistent with the existence of a bequest motive for saving and capital accumulation. Estimates of the share of wealth accounted for by intergenerational transfers in the United States range from 10 percent to 80 percent. The reasons for these differences are discussed by Kotlikoff (1988) and Modigliani (1988). As noted earlier, Starrett (1988) points out that the form of the bequest function is also likely to have a significant impact on the elasticity of saving.

The frequency with which the elderly live with their children in Japan, and the past inadequacies of the social security system have facilitated incorporation of bequests into the life-cycle models of saving in Japan. In the United States it has been more difficult to explain bequests on the same basis.

According to a growing number of Japanese economists, bequests in Japan are really a form of private annuity, with the elderly receiving income and care from their children in return for a bequest. This is equivalent to paying for an annuity, benefits from which were previously received, at the time of death. It is also a means by which the risk associated with insufficiently providing for retirement is transferred from the elderly to their children. Horioka (1984) and Hayashi (1986, p. 177) observe that a high percentage of the elderly in Japan live with their children,23 and Horioka notes that the elderly “in effect ‘borrow’ from their children in order to finance their living expenses during retirement and repay these ‘debts’ in the form of a bequest at the time of their death” (p, 54). Hayashi, after examining the various possible explanations for the high rate of saving in Japan, concludes that “bequests” are the most important factor, and that saving in Japan is based to some extent on intergenerational altruism and cannot simply be explained by the life-cycle model. Ando and Kennickell (1987) view the Japanese saving that results in bequests as similar to the private pension funds in the United States, again seeing the bequest as an implicit agreement to pay at time of death for previous service rendered. Shibuya (1988) agrees with this view and its consistency with a life perspective on saving.

Although the bequest motive may be important in saving decisions outside of, as well as within, a life-cycle model, we know little about how this motive affects the level of saving, and still less about how to affect the motive.

Other Factors Affecting Saving

Many other factors have been cited as affecting the saving rates. A partial listing follows.

Energy Prices

Blinder (1987) suggests that the price of energy may have an important effect on the rate of saving. Higher energy prices may directly affect expenditures on consumer durables, including automobiles. According to some measures of saving, expenditures on consumer durables are a major reason for the relatively low saving rate in the United States. No major European or Asian country approaches the United States in automobiles or other consumer durables on a per capita basis. This may offer an additional dimension to the argument for higher motor fuel taxes as a means of raising total saving, or at least reallocating saving, in countries such as the United States and Canada.

Relative Affluence of the Elderly

Summers and Carroll (1987) offer “the improving relative economic fortunes of the elderly” as probably “the single most important cause of reduced saving” (p. 631). They argue that this rise in the relative well-being of the elderly, much of it resulting from the increased role of social security, reduces the perceived need by those of working age to save for retirement. If this is a factor, reduced social security payments can simultaneously increase government saving by reducing expenditures and increase private saving as the working population becomes aware of the greater need to save for retirement.

Availability of Consumer Credit

The availability of consumer credit (in addition to the deductibility of interest) is often mentioned as a factor contributing to low saving in the United States, and high saving in other countries. Historically, consumer credit has been limited in Japan, and Makin (1986), Hayashi (1986), and Shinohara (1983) all mention either lack of consumer credit, or the large downpayment required on homes as factors contributing to a high rate of saving in Japan. Sturm (1983), Friend (1986), and Summers and Carroll (1987) are three others who have identified the availability of consumer credit as a factor contributing to the relatively low level of private saving in the United States.

Cultural Considerations

Agreement on whether cultural factors affect the level of saving in a country may depend on how cultural factors are defined. Strumpet’s (1975) paper on saving differences between the United States and the Federal Republic of Germany emphasizes cultural factors more than most observers, but he is not alone. He concludes that the higher saving rate in Germany is caused by factors such as (1) a greater desire for precautionary reserves owing to “characteristically pessimistic expectations for the future,” (2) a greater satiation of wants given the level of expectations, and (3) the habit of saving in advance of purchasing real estate and consumer durables. Shibuya (1988) finds that the Japanese save more than is necessary, given the expected length of their retirement. This might reflect some risk aversion, but comparable evidence for other societies is not available. Horioka (1984), although he does not refer specifically to “cultural factors,” notes that “substantial bequests are a custom” in Japan. Hayashi (1986) appears to have little sympathy for cultural explanations, but mentions that Horioka found mixed evidence when he examined the various studies that considered cultural factors. In general, most studies on saving in Japan explain the level of saving without reference to cultural factors.

After examining the degree to which economists have been able to explain widely differing cross-country saving rates. Friend (1986) concludes that “although these differences have not been satisfactorily explained in the literature, it is my judgment that to a major extent they represent cultural differences or differences in tastes (perhaps like those reflected in the Puritan ethic)” (p. 57). The view that cultural factors may be of some significance persists, but hard evidence is lacking.

Individual Proprietors

Individual proprietors, in general, tend to save a larger portion of their income than other individuals. This is at least partly due to the limited access that proprietors have to debt and external equity financing, as a result of which they depend on internally generated funds to expand. It may also be because farmers often account for a significant share of proprietors, and they tend to be conservative and must live with uncertain weather and commodity markets. Shinohara (1983) mentions the relatively targe share of proprietors in Japan as one reason for a high saving rate. This could also be a factor in various European countries relative to the United States. Cross-country evidence on the importance of this factor does not yet exist.

Inflation

A number of studies have linked the level of inflation to the rate of saving. This might be expected for at least two reasons. First, the real value of assets denoted in fixed dollar terms, such as bonds, falls in times of inflation. Second, rapid changes in prices lend uncertainty to the economic environment, including increased uncertainty as to the real value of many assets. The loss in wealth associated with inflation will cause individuals to save more and consume less. Increased uncertainty increases saving for precautionary purposes. However, if nominal interest expenses can be deducted for tax purposes, real interest rates after tax may be negative. Carroll and Summers (1987) are among those who suggest that this may offer an incentive for consumption. In spite of these potentially offsetting forces, most empirical evidence appears to support the hypothesis that the relation between the rate of inflation and the rate of saving is positive.

Deaton (1977) argues that if actual inflation is higher than expected inflation, each individual who seeks certain goods in the market finds the price of those goods to be higher than expected. Since individuals are unaware of the price of other goods, each consumer will think that the relative price, as well as the absolute price, has risen and will decide to buy less of that particular good. When this decision is made by all consumers, there is a “mass illusion that all goods are relatively more expensive so that, as each consumer attempts to adjust his purchases, real consumption falls, and if real income is maintained, the saving ratio rises” (p. 899). Using both U.S. and U.K. data, Deaton demonstrated that unexpected inflation did in fact lead to higher saving. His results reinforced a similar conclusion reached earlier by Juster and Wachtel (1972) in a study based on U.S. time-series data.

In other studies, Shiba (1979) found the inflation rate to be an important determinant of the saving ratio in Japan, and Boskin (1978) and Montgomery (1986) found the rate of inflation to be directly related to the saving rate in the United States. In a cross-country study, Horioka (1986) found the rate of inflation to be positively related to the rate of saving, a factor which caused saving ratio differences between the United States and Japan to be smaller than they would otherwise be. There is, however, evidence on the opposite side. Both Howrey and Hymans (1978) and Gylfason (1981) found the rate of saving to be inversely related to the rate of inflation, although Howrey and Hymans found that greater uncertainty about inflation would increase the rate of saving.

Work Patterns

Makin (1986), in his analysis of saving differences between the United States and Japan, suggests “work/leisure patterns” as one possible explanation for higher saving rates in Japan. Since the Japanese work six more hours a week than their U.S. counterparts and must retire at age 55, they have less time while working to spend money on leisure activity and a greater need to save for a retirement period that is longer relative to their working life. Whereas the ratio of retirement years to work years is included in many saving functions, the length of the work week is generally ignored. It may be a factor, but measurement of its impact is not available.

Another element in work patterns relates to two-earner families. Sturm (1983) and Summers and Carroll (1987) suggest that as women have become more active in the work place, two-earner families have become more common. This has reduced variability in family income and lessened the need for saving for precautionary purposes.

Transitory Income

Bonuses in Japan account for as much as one fourth of the income of employees. Shinohara (1983) argues that these bonus payments are a significant reason for the high saving rate in Japan. If such payments could be “transitory income,” such an explanation would be consistent with a life-cycie consumption pattern. However, the bonus system has long been institutionalized, and it is likely that this form of remuneration is no more transitory than normal wages and salaries. Accordingly, most writers (Shibuya (1987), Horioka (1986), and Hayashi (1986)), conclude that bonuses do not influence the rate of saving in Japan.

If, however, a change in income is expected to be either a one-time phenomenon or only temporary, the effect on the saving rate may well be substantial in the short run. For example, capital gains and losses occurring in unstable financial markets may have little effect on saving in other forms, since they may be ephemeral. If the gain or loss is considered to be relatively permanent, the effect on saving will be similar to that of other changes in wealth.

Quality of Public Institutions

The number and quality of public institutions, particularly those providing education, may decrease the need to save (Summers and Carroll (1987)). Although not likely to be a significant factor, during the 1970s and 1980s this may have contributed to a decline in saving in some countries, the United States for one. A decline in perceived quality of public institutions may produce the opposite result.

Improved Insurance

Private pensions are a form of insurance against the risk of living beyond retirement. Before the introduction of private pensions, individuals needed to save to protect against this risk. And since the risk was not pooled, individuals saved, on average, more than was necessary. With the expansion of other forms of insurance—for example, life insurance and disability—it became possible, on average, to reduce saving to ensure against the premature death of the breadwinner or a disabling event. Thus, as Summers and Carroll (1987) suggest, the expansion may have contributed to a drop in private saving.

Stability of Tax System

Although stability in the tax system is often mentioned as contributing to a positive investment environment, it is seldom seen as affecting the rate of saving, Makin and Shoven (1987) mention the stability of the Japanese tax system, along with the exemption of much of interest income from taxation, as the two main advantages Japanese investors have over their U.S. counterparts. Individuals who have attempted to do tax planning for saving purposes in the face of frequent changes in the tax system are aware of the frustrations these changes create. On-again, off-again incentives for private saving and investment may create an unattractive saving environment in the same way that tax instability inhibits investment. The effect of stability in the tax system on the rate of saving may deserve further attention by researchers.24

III. Policy Handles

Some factors that affect saving can be more easily manipulated by policymakers than others. If, however, the effect of a factor on the level of saving is ambiguous, policy changes may result in losses rather than gains. For this reason it is important to summarize our discussion in an attempt to identify tools that policymakers can use with confidence knowing the direction of their effects.

It is clear that demography affects the rate of saving, with the dependency level at both the low and high ends of the age spectrum having an inverse relationship to the rate of private saving. In the postwar period, differing demographic patterns have contributed to differences in saving rates among countries. Although the effects of demography on saving may be both clear and large, policies that alter demographic patterns may be difficult or inappropriate to use as a tool to alter the saving rate in industrialized countries, particularly over a short period.

The effects of private pensions and corporate saving on total private saving are generally agreed upon, and these may be areas open to policy action. Increased saving through private pensions may cause reductions in other forms of private saving that range from zero to 70 cents on the dollar. Tax policies and/or laws that favor the expansion of private pension programs may therefore increase private saving. Likewise, available evidence indicates that increased private saving occurs with a shift of the tax burden from corporations to individuals. The higher propensity to save by corporations may lead to increased private saving of 12 cents or more when personal income taxes are raised by 1 dollar and corporate income taxes are reduced by the same amount. Some evidence suggests that funded social security plans can make a net addition to national saving, since reductions in private saving are not fully offsetting. Sheltered saving may also be a policy tool, although the evidence is more ambiguous. Even if the interest elasticity of saving is low, effective advertising of sheltering opportunities may increase awareness of the inadequacies of public social security programs, the possibility of excessive tax burdens on future generations, and the need for private sector saving to play a more important role in the support of retirement. Evidence suggests that this recognition effect may be important.

For other factors, although the available evidence is tenuous, some policy actions may increase saving. It is generally agreed that the deductibility of interest for consumer credit discourages saving, and that easier access to consumer credit is likely to have the same effect. But there is little, if any, solid evidence on the importance of either of these factors.

In addition, specific policy tools may be more or less relevant, depending on the circumstances in a particular country. For example, energy pricing policy in the United States may be a means to influence the level and composition of spending on consumer durables and other goods. The magnitude of this effect and its welfare implications as it affects the supply of transportation and other services require further attention.

Economists are largely in agreement on the direction of the effect of several of the above factors, although some of the most important policy tools—for which economic theory and a large body of empirical work yield ambiguous or contradictory results—may not be included among them. Policies that alter the level of social security wealth, the after-tax rate of return on saving, the rate of inflation, the level of government debt, or the openness of capital markets may or may not significantly affect a country’s level of saving. And, the effect of a particular policy may depend on its timing.25

A number of studies, including those by Feldstein (1974, 1977b, 1978, 1980, 1982, 1983c) and Feldstein and Pellechio (1979), conclude that social security wealth has a large, adverse effect on private saving, which may be reinforced by a growing perception that the retired and elderly segment of our population is relatively well off and it now requires less saving to have a comfortable retirement. But there is, in fact, no clear evidence that lowering social security benefits would increase private saving, A large number of studies show that social security wealth has little, and in some cases, even a positive, effect on private saving. Although it is fair to say that estimated positive effects of social security wealth on private saving may never have been as large as estimated negative effects, the policymaker still lacks clear evidence that private saving will increase with a reduction in social security benefits. This evidence appears to support the finding that funded social security programs are likely to add to national saving.

Government debt is closely related to social security. Social security wealth (associated with an unfunded plan) may, in fact, be viewed as a future claim upon the government similar to the claim represented by a government bond. Thus, if social security wealth adversely affects private saving, government debt can be expected to have a similar effect. If the effect of one is ambiguous, the effect of the other is also likely to be ambiguous. It is nevertheless important to recognize the difference between social security wealth and government debt. Government debt obligations are much less open to change, are marketable, are more easily measured, and are less uncertain. For these and other reasons, changes in government debt are more apparent and certain than those in social security wealth, and there will probably be greater agreement on their likely effects.

How saving responds to changes in the after-tax rate of return remains unresolved, in spite of considerable research. Recent studies reflect the instability in elasticity owing to changes in age composition and differences in elasticity among age cohorts. Among the problems in estimating elasticities are their sensitivity to the functional forms used in the estimates, and the importance of bequests and other factors. From a policy perspective, the ambiguity is unfortunate since many policies are designed to affect the saving rate through the after-tax rate of return. And, it is the responsiveness of saving to changes in rates of return that determines whether opening capital markets is likely to influence the effectiveness of saving incentives. Analysis of the effects of exempting interest income in Japan appears to indicate that the impact on the rate of saving is small.26,27

The evidence concerning the effect of inflation on private saving is also mixed. Although the greater uncertainty of, and the fall in, the real value of assets with fixed-dollar returns may encourage an increase in the saving rate, high rates of inflation may discourage saving. Neither the direction nor the magnitude of the effect on saving is likely to be clear, creating a problem for the policymaker. In any case, inflation is unlikely to be a very attractive way to alter the private saving rate.28

The evidence on a wide variety of other factors suggests either that they will have little effect on the saving rate—for example, altering aftertax income distribution, or increasing the role of bonuses and other forms of transitory income—or that they are unlikely to respond to policy manipulation—for example, cultural considerations and the prevalence of individual proprietors in the economy.

The level of wealth relative to expected lifetime income and to some past standard of wealth both affect the level of saving. Causing a major decline in the value of financial or real assets in a country is one way to bring about an increase in the saving rate. War or a natural disaster would both sharply reduce the existing capital stock and thus affect saving, but are not manipulable phenomena. Allowing public educational institutions to deteriorate to encourage private saving for particular purposes would be counterproductive. And neither an extension of the work week to reduce the time available for consumption nor a limitation on the availability of insurance in order to increase precautionary saving seems practical.

Policymakers do not yet know the strength of the bequest motive— that is, saving with the aim of passing assets on to future generations, as opposed to paying for benefits received before death—or even whether a separate bequest motive exists. The impact of any policy to encourage bequests would therefore be very uncertain.

The contribution that stability in a tax system can make to the saving rate deserves further consideration but may be overlooked since this may tie the hands of the policymaker who wishes to act to alter the saving rate.

To summarize, among the tools policymakers may use to encourage saving are increased use of private pension plans, fully funded public pension plans, other sheltered saving plans, and a shift of taxes from corporations to individuals. The limitation of interest expenses associated with consumption expenditures and higher energy prices are other possible measures. It is, however, essential to remember that the composition of saving is as important as the level, and laws that result in larger shares of total saving in the form of private or public pension plans and retained corporate profits or sheltered saving plans may create serious inefficiencies in capital markets. Likewise, measures that reduce government revenues in order to increase private saving may have nominal or adverse effects on total saving—public and private. In all cases where one form of saving is being encouraged over others,29 intersectoral distortions are increased while intertemporal distortions are reduced, and the overall effects on welfare are likely to be uncertain.

IV. Recent Tax Reform and Saving Incentives

Tax reform may be one possible means to alter the saving rate. This is one reason why the distinction between taxing income and taxing expenditure has come to the forefront in recent tax policy discussions. Other reasons included the administrative complexity of the income tax, inefficiencies and inequities of income tax systems at a time of rapid price increases, and the decline in the relative economic position of the United Kingdom and the United States.

Saving and the Tax Base—A Personal Consumption Tax?

Blueprints for Basic Tax Reform (U.S. Treasury (1977)) was the first of several tax reform documents over the last fifteen years to urge that consideration be given to substituting a personal expenditure tax for the personal income tax. After considering the two tax bases, it concluded that:

The possible efficiency gains that would result from adopting a consumption base tax system relate closely to the frequently expressed concern about a deficient rate of capital formation in the United States. Switching from an income to a consumption base tax would remove a distortion that discourages capital formation by U.S. citizens, leading to a higher U.S. growth rate in the short run, and a permanently higher capital/output ratio in the long run (p. 51).

The Meade Report (Meade (1978)), published in the United Kingdom the following year, reinforced the view outlined in Blueprints that consumption taxation was potentially superior to income taxation. Ten of the eleven members of the Meade Committee “would prefer a shift in the direction of an expenditure base” (p. 517). I quote Meade at some length, since, as always, he writes with such clarity:

Suppose that Mr. Brown by saving an extra £100 this year would have reduced the demands on real resources this year by an amount which, if invested in real capital equipment, would have added to the annual community’s product a net annual output worth £10 a year; but suppose that because of income tax Mr. Brown could keep only £6 a year out of any £10 year in dividends or interest that an expanding business could offer him on his savings. If Mr. Brown would prefer £10 a year to spend in future years to having £100 to spend on consumption this year, but would prefer £100 to spend this year to having only £6 a year to spend in future years, then the tax will have been the cause of an economic inefficiency. If Mr. Brown had through his savings released the £100 of resources for productive investment and had been paid the full £10 a year return on it, he would have been better off; and no one else need have been worse off, because Mr. Brown would in the future years have been taking out of the national product only as much as the investment of his own savings had added to it (pp. 8-9).

It is indeed the characteristic feature of an expenditure tax as contrasted with an income tax that, at any given constant rate of tax, the former will make the rate of return to the saver on his reduced consumption equal to the rate of return which can be earned on the investment which his savings finances, whereas the income tax will reduce the rate of return to the saver below the rate of return which the investment will yield (p. 37).

A decade after the publication of Blueprints, the Economic Council of Canada (1987) urged that the Canadian Government adopt a personal consumption tax, which it referred to as a “lifetime-income tax.”30 Based on work it had done, the Council concluded that “over an extensive period of time [the lifetime-income tax] could lead to substantial increases in per capita output and real wages and, in the process, enhance the average Canadian’s standard of living by as much as 7 percent” (p. 15).

The wedge between the return to the saver and the return on the investment, together with the inefficiencies it creates, is at the center of tax reform discussions. In a discussion of tax reform the U.S. Treasury (1984) conceded the “manifest attractions of the tax on consumed income,” while at the same time recognizing that a variety of difficulties made it impractical to recommend a significant shift in tax base. Although subsequent analyses have shown weaknesses in some of the efficiency arguments for a personal consumption tax, Kotlikoff (1984), Boskin (1978, 1986), Bradford (1986), McLure (1988a), and Summers (1981a) are among those supporting a shift to a consumption-based tax in order to increase welfare. Others—Boadway, Bruce, and Mintz (1987), Bradford (1980a), and Modigliani (1987)—found consumption taxation preferable on equity grounds as well. And many think that a consumption-based tax can be administered more easily than an income-based tax.31 It is generally recognized that significant transition problems would result from a move to a consumption-based tax from an income-based tax; one example is the fair treatment of individuals who are moving from their high-income years into their high-consumption years. McLure (1988a, b) has emphasized the necessity for an effective estate and gift tax system to accompany a shift to consumption-based taxation.

In spite of the large and, at least until recently, growing lobby for an expenditure tax, evidence on the desirability of such a shift is less than conclusive. In one recent study, Boadway, Bruce, and Mintz (1987) concluded that ’the efficiency case for a consumption tax is ambiguous. It depends upon how one weighs the advantages of removing the distortion on capital markets against the disadvantages of increasing the distortion on labour markets” (p. 125).32 Like an income tax, a consumption tax distorts the choice between goods and leisure, or market and non-market activities. And, because the tax base for a consumption tax is smaller than that for an income tax, higher tax rates may result in larger distortions. Thus, reduced intertemporal distortions may be offset by greater infratemporal distortions.

For both equity and efficiency reasons, many economists continue to believe that tax policy should focus on improving the income tax rather than on replacing it. Specifically, the tax system must effectively reach those who accumulate, and have control over, large pools of wealth. Although a comprehensive system of gift and estate taxes can reach such pools, it is far from certain that political progress would yield effective gift and estate taxes. Goode (1980) is among those who continue to argue that the power to consume has greater appeal as an indicator of ability to pay than does actual consumption. A shift to consumption taxation would also mean higher taxes for the young and the old, whose consumption levels are high relative to their income.

The decline in inflation since the 1970s and early 1980s has made income taxes fairer, and the need for radical change less pressing. Tax systems have incorporated indexation of bases and rates to varying degrees, and Steuerle (1985) is among those calling for comprehensive indexation coupled with more effective accounting systems in order to improve, rather than replace, the income tax.

In addition, sizable transition costs are likely to result from any shift to a personal expenditure tax. Accumulated wealth that was subject to income taxes in the past would have to be protected from double taxation by a new personal expenditure tax. Income earned by foreigners and on foreign operations would have to be taxed on a different basis, and an administrative apparatus would have to be developed to account for transactions in all forms of savings and wealth accounts, including a comprehensive accounting of wealth at the time of transition. On the whole, personal expenditure tax administration may not prove to be much simpler than income tax administration.

In spite of the lengthy analysis and debate over the appropriate tax base, no country has substituted a personal expenditure tax for the personal income tax to date. Nevertheless, the “expenditure tax debate” seems to have had some impact on tax reform in the past decade.

General Trends in Enacted Reforms

The tax wedge between the pretax rate of return on an investment and the after-tax return to the saver has been an important issue in all tax reform discussions. The basic methods used to reduce this wedge have been reductions in tax rates made possible by base broadening and by increased reliance on consumption or sales taxes. Some countries have also shifted from individual income taxes to corporate income taxes. Such a shift, while making investment less attractive in a country, makes household saving more attractive and may create a better balance between saving and investment. In countries where it is difficult to eliminate preferences and broaden the base, and where a broad-based sales tax is already heavily relied upon, opportunities for income tax rate reduction may be seriously constrained.

In Australia, Canada, the Federal Republic of Germany, Japan, New Zealand, and the United Kingdom base broadening has been tied to rate reduction. In France and the Netherlands, either the desire to broaden the base is strictly limited, or the feeling prevails that there is little opportunity for base broadening. Nevertheless, even those countries where little base broadening has occurred have felt pressures to reduce marginal rates. Table 5 reflects the top marginal tax rates for 13 countries in 1984 and as they are expected to be in 1990, based on existing or proposed legislation. In all 13 countries, the top marginal rates have been reduced, and in the English-speaking countries the reductions have generally been large.

High marginal tax rates on income have a significant effect on the choice between present and future consumption.33 Lowering marginal rates reduces the bias toward present consumption over future consumption. In doing so it recognizes, at least implicitly, the need to increase saving. As noted earlier, other reasons for lowering the rates include the need to encourage work, reduce avoidance and evasion, and simplify the rate structure.

Table 5.Maximum Marginal Tax Rates in 1984 and 1990(In percent)
Country19841990
Australia6049
Canada34 (51)a29 (45)a
Denmark73a68a
France6557
Germany. Fed. Rep. of5653
Ireland6558
Italy6560b
Japan70 (88)a50 (68)a
Netherlands7270
New Zealand6633
Sweden52 (82)a45 (75)a
United Kingdom6040
United States50 (55)a28 (33)a
Sources: Pechman (1988, p. 4), Tanzi (1987, p. 344), and International Bureau for Fiscal Documentation (1987, 1988).

The figures in parentheses include a significant component for a representative state/provincial or local government.

In August 1988 the Italian Government introduced draft legislation to reduce the top rate to 50 percent.

Sources: Pechman (1988, p. 4), Tanzi (1987, p. 344), and International Bureau for Fiscal Documentation (1987, 1988).

The figures in parentheses include a significant component for a representative state/provincial or local government.

In August 1988 the Italian Government introduced draft legislation to reduce the top rate to 50 percent.

In addition to rate reduction, the change in tax mix in several recent tax reforms may encourage saving. In 1979 the United Kingdom sharply increased its basic value-added tax (VAT) rate to 15 percent from 8 percent, permitting income tax rate reductions. In 1985 New Zealand adopted a comprehensive goods and services tax, explicitly raising indirect taxes to one third of tax revenues from one fourth. Reductions in the income tax rates in these two countries have been particularly sharp. Although the Australian “white paper” (Australia (1985)) proposed a broad-based consumption tax on goods and services to make possible sharp reductions in personal income tax rates, the sales tax reform was not approved, and the reduction in income tax rates was smaller as a result. Canada is actively designing a more effective national sales tax, to be coupled with provincial sales taxes, which will shift the tax mix toward indirect consumption taxes, so as to keep income tax rates at their new low levels. The possibility of using VAT revenues to reduce corporate income taxes continues to be discussed in the United States, although no action is likely to be taken in the foreseeable future. In each case, the proposed or adopted action is a shift toward taxes that do not distort the choice between present and future consumption—that is, that do not discriminate against saving.34,35

Policymakers have often stressed that tax reform should be revenue neutral—as in Australia, Canada, New Zealand, and the United States— and thus would not be expected to affect the level of public saving. Although revenue-neutral reform may not directly reflect a need to increase total saving, it would be inappropriate to conclude from this that the reform is not designed to affect saving. Political considerations may simply make it necessary to carry out a reform in an environment of revenue neutrality.

Base-Broadening Provisions That May Discourage Saving

The following discussion identifies tax changes that, by themselves, may discourage saving. However, it is important to view them in conjunction with other changes, including lower tax rates, to understand the overall effect of any reform on saving.

The Federal Republic of Germany, Italy, and Japan have all recorded generally high rates of private saving in recent years. Tax reform in these countries has significantly reduced the amount of interest income that was previously exempt from taxation. Japan’s 1988 reform imposes a 20 percent flat rate tax on interest on personal savings, 70 percent of which was previously exempt from tax.36 Germany’s 1988 reform imposes a 10 percent withholding tax on interest income, which previously was not reported by financial institutions to the Government. Germany has also imposed a similar tax on life insurance returns. In 1987 Italy removed the exemption of government debt interest received by individuals and imposed a flat rate tax of 12.5 percent on this income. Each of these actions discourages some form of saving and moves away from the concept of consumption taxation.

Although tax reforms have generally maintained generous deductions, the base-broadening exercise has led to stricter limits on some deductions for retirement saving. Canada’s 1987 reform, for example, slowed the phasing in of significant increases in deductions for contributions to its RRSPs. The 1986 U.S. Tax Reform Act denied IRA deductions to those earning above a certain income level unless neither the worker nor spouse was part of a qualified pension plan. And, reforms in both New Zealand and the United Kingdom have eliminated the deduction of life insurance premiums on new policies. Such steps may be a way to treat various forms of investment and saving more equally; they are also steps away from the concept of consumption taxation.

The fuller inclusion of capital gains, another means of broadening the tax base, was part of the 1985 reform package in Australia, with a provision for indexing so that only real gains would be taxed. Before this provision, Australia had not taxed capital gains. The 1986 reform in the United States increased the share of capital gains in the tax base to 100 percent from 40 percent, without indexing. The 1987 reform in Canada reduced the lifetime capita! gains exemption to C$100,000 from C$500,000, and raised the share of capital gains to be included in the tax base to 75 percent from 50 percent, also without indexing. Each of these acts reduced or eliminated previously existing incentives to realize income in the form of capital gains.37 A provision by the United Kingdom to index the base for computing capital gains after 1982783 had the opposite effect.

Tax reform in a number of countries has financed reductions in individual income taxes, at least in part, through increases in corporate income taxes. The 1987 Canadian tax reform projected an increase of C$5 billion in corporate taxes over five years to partially offset the C$11 billion in individual cuts, with revenue neutrality to be achieved through increased sales tax revenues. The Danish tax reform also involved a substantial reduction in taxes on individuals, offset by an increase for companies (Drejer (1988)). The 1986 U.S. tax reform, although revenue neutral, offset reduced individual income taxes with a $120 billion increase in corporate income taxes over five years. The adverse effect of such shifts on total private saving may be significant.38,39

Reduced deductions for business investment expenditures have raised business taxes. Included are moves to eliminate initial allowances for plant and machinery and industrial buildings in the United Kingdom in 1984, to reduce first-year depreciation allowances and accelerated depreciation in New Zealand, and to bring depreciation for tax purposes more into line with economic depreciation in Canada and the United States. These measures, by themselves, reduce the incentive to save and invest in certain forms, and are more consistent with steps toward comprehensive income taxation and away from consumption taxation.

Although it is difficult to generalize, even though tax reforms have often lowered corporate tax rates, they have not reduced the effective rate of tax on income arising in the corporate sector. Reform, as it has affected the corporate sector, has not contributed to an increase in the rate of private saving. In fact, the reverse may be true in a number of cases. Reform has, however, generally reduced distortions within the corporate sector created by various incentives and preferences and has contributed to more effective use of the existing pool of saving by reducing intersectoral distortions. Welfare gains from this may be substantial.40

Reform Provisions That May Encourage Saving

The discussion so far suggests that reforms may have proceeded with little attention being paid to the level of private saving. In general this may be true. Nevertheless, the need for greater private saving has prompted tax reform in a number of countries, and a number of tax base changes in recent years, as well as lower marginal rates, are likely to encourage saving or discourage consumption.

As Tanzi (1988) shows, saving rates have been particularly low in countries that provide generously for the deduction of interest. The United States has now eliminated the deduction of interest on consumer expenditures and has placed other limits on interest deductions. Denmark has limited the value of interest deductions (including mortgage interest) to 50 percent even when the personal tax rate is higher, and Sweden has placed a similar limit on interest deductions when they result in a deficit from a particular source. Such limitations reduce incentives to spend and promote saving.

Recent changes in French tax law raise the tax-exempt ceiling on saving and reduce taxes on saving set aside for retirement (Milleron and Mailiard (1988)). New laws have also been introduced to encourage investment in housing through special tax credits and deductions for principal residences and for rental housing (International Bureau for Fiscal Documentation (1987)). Sweden has also moved to encourage saving by exempting some types of saving and increasing the amount of interest that can be received free of tax (Ljungh (1988)), In the United Kingdom several schemes have been devised to encourage “noninstitu-tional” saving and investment. These include a Business Expansion Scheme, which exempts gains on amounts up to £40,000 annually from capital gains tax, and a Personal Equity Plan, which permits limited investment in quoted shares without being subject to capital gains tax or tax on reinvested dividends.

V. Conclusions

The level of saving affects the rate of capital formation, the rate of economic growth, and the standard of living. In all industrialized countries individuals have come to expect an ever-increasing standard of living. For many the increase must at least enable a country to maintain its standard of living relative to that of other countries. High rates of saving in the Federal Republic of Germany and Japan in particular, but in other industrialized countries as well, have contributed to rapid rises in the standard of living. The Republic of Korea, Singapore, and Taiwan Province of China are clear current examples that high saving rates go hand in hand with rapid economic growth. A country experiencing a low saving rate and a fall in its relative standard of living might be expected to wish to influence the saving rate. National security as well as national pride is at stake.

Many factors affect a country’s saving level. Some of the more important ones—demographic factors and the existing stock of wealth—are difficult for policymakers to influence, at least in the short run. Others, such as cultural factors including attitudes toward bequests, may also be difficult to influence. Still other factors of possibly great significance, such as the rate of return and the level of social security wealth, may be open to policy action, but we do not know enough to accurately predict the outcome. While evidence suggests that encouraging corporate retained earnings, fully funded private and public pension plans, and other forms of sheltered saving may positively affect total saving, both efficiency and equity arguments will limit the use of these tools.

Government deficits appear to have significantly reduced national saving in a number of countries during the 1980s. Belgium, Canada, Italy, and the United States may be the most obvious examples, but Australia, the Netherlands, Sweden, and the United Kingdom have also had significant public sector deficits during the 1980s.41 Reducing government deficits is seen by many as the best way to increase the saving level. This position is supported by the mixed evidence concerning the effects of various policy tools on the level of private saving. Although a substantial group of able economists believe the interest elasticity of saving is such that effective policies can be designed to increase private saving, others remain unconvinced.

Because there are no clear guidelines on how to alter the rate of private saving, tax reform appears to have given very limited attention to the level of private saving, even in those countries where there is a desire to increase saving sharply. Reform has focused on the allocation of saving and investment in a more efficient manner, rather than on the level of saving and investment. This is consistent with the general advice from many, if not all, economists urging policymakers to broaden tax bases and lower tax rates in order to minimize distortions. This does not preclude a shift from a comprehensive personal income tax to a comprehensive personal consumption tax. However, the tax reforms of the past decade reflect policymakers’ decisions, in spite of the imperfections of income taxation and the much-touted advantages of consumption taxation, to improve, rather than shift away from, income taxation. Intertemporal allocation has been improved by reducing income tax rates and by relying on traditional sales taxes rather than by shifting to a progressive personal expenditure tax.

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Roger S. Smith is Professor of Economics at the University of Alberta. His graduate work was done at Harvard University and the University of California, Berkeley. This paper was prepared while the author was a Visiting Scholar in the Fiscal Affairs Department of the Fund.

The capital share of net output in the United States may be around IS percent. This is substantially higher than net saving rates have been in recent years. See Summers (1981, p. 124).

As subsequent discussion will indicate, a relatively close relationship seems to remain between domestic investment and domestic saving, even though perfectly working international capital markets would suggest that this need not be so.

In the longer run the flow of capital abroad may lead to an improvement in the terms of trade for at least three reasons. First, a lower level of domestic investment reduces the supply of domestically produced goods, and the greater investment abroad increases the supply of foreign-produced goods. Second, the higher incomes abroad increase the demand of foreigners for imports and increase their desire to invest in other countries. Third, the initial flow of investment funds abroad leads to a reverse flow of investment income to the capital exporter. These three elements may lead to terms of trade that are more favorable for the capital exporter than before the fall in domestic investment opportunities.

Available evidence, in fact, reflects a fall in the rate of return. Auerbach and Poterba (1987 , p. 6) report the following profit rates (as a percentage of assets) for nonfinanrial corporations in the United States: 1961-65, 10.96 percent; 1966-70,10.88 percent; 1971-75, 7.43 percent; 1976-80, 6.92jpercent; 1981-85, 4.91 percent. Ten years earlier, Feldstein and Summers (1977, p. 25), after analyzing the decline in profits in the 1970s, concluded that there was nothing to suggest a permanent fall, and that the existing levels were within the cyclical norms as well as “the type of random year-to-year fluctuations observed previously.” The conclusion now might be different. Even with a fall in the real rate of return, the U.S. rate of return could be rising relative to that in other countries, possibly reflecting a capital shortage in the United States relative to other countries. Although definitive evidence on this point may be lacking, there seems to be no reason to believe that the U.S. return on capital has been rising relative to that in other countries.

There is more than one automobile for every two people in the United States, less than one for every three people in most other Organization for Economic Cooperation and Development (OECD) countries, and less than one for every four in Japan. Investment in automobiles can be encouraged by low user charges or fuel taxes and subsidized road networks. Deduction of interest charges and exclusion of imputed rents also encourage spending on housing and consumer durables. There is general agreement that these and other policies are designed to encourage saving for particular purposes—to purchase a home, to purchase insurance, to make deposits in certain types of accounts. Such measures may affect the level of saving and most certainly affect the use to which the saving is put. Hence, as tools to influence the rate of saving are considered, it is important to keep in mind that the costs of distortions in use may more than offset gains from increased saving.

Bovenberg (1988a) provides a useful review of the impact of a number of these adjustments on the measured level of saving in the United States.

It may also be important to consider the wealth effect, which is discussed in a later section. Investment incentives that favor new over old capita! may create a capital loss for owners of old capital, dampening their consumption and increasing their saving. This may cause a righrward shift to the saving function in Figure 2, thus causing the level of domestic saving to rise in the open as well as the closed economy case.

See, for example, Feldstein (1983b), Fieleke (1982), and Summers (1988b).

Imperfect markets for tradable goods also affect the flow of investment and the equalization of returns. Hence, the failure to equalize rates of return through the flow of capital may be as much due to imperfections in goods markets as to imperfections in capital markets. The factor-price equalization theorem shows that real returns to factors of production can be equalized through free trade in goods and without capital mobility. This occurs because trade raises the price of the abundant factor in a country and reduces the return to the scarce factor.

Summers (1988b) concluded that “Following the Reagan tax incentives, an increase of close to 25 percent in the capital stock would be necessary to bring the after-tax return to capital back to its former level” (p. 373), and that with mobile capital this would have meant a current account deficit of over 15 percent of gross national product (GNP) for a period of years. Sinn (1988) has also estimated extremely large capital flows that could be expected to respond to higher returns owing to the U.S. tax reform in 1981. Specifically, he estimated that the Accelerated Cost Recovery System (ACRS) of the 1981 U.S. reform, based on certain assumptions, “would have channeled about 7 percent of the world capital stock or an amount between $1 trillion and $1.5 trillion into the United States” (p. 330). See also Sinn (1987). Regardless of specific magnitudes, stock adjustments of capital resulting from changes in after-tax rates of return may encourage large international flows of capital over a protracted period. A recent International Monetary Fund study by Bovenberg and others (1989) examines how taxation of saving and investment may have encouraged a bilateral flow of capital from Japan to the United States in the 1980s by creating relatively large investment incentives in the United States, while simultaneously taxing saving more heavily in the United States.

The historical evidence of a highly stable [gross private saving ratio] suggests that the interest elasticity of saving is very low and may be approximated by zero” (David and Scadding (1974, p. 247)).

It is important to recognize that a change in interest rates may have an indirect effect on saving through its impact on the real value of wealth. Even if a rise in interest rates were to have little direct effect on saving owing to offsetting income and substitution effects, it still may lead to a significant increase in saving. This may occur if the rise in the interest rates causes a fall in the real value of assets, which in turn leads to reduced consuming and increased saving. In this section the discussion is confined to the direct effect on saving through the income and substitution effects. Although the (human) wealth effect is an important element in Summers’ (1981a) interest elasticity estimates, a general discussion of the wealth effect of interest rate changes is left to later sections.

Neither Boskin nor others have been able to replicate his results. Accordingly, any weight given to his results must be qualified.

These conclusions do not rule out the possibility that social security programs may add to total national saving if they are partially or fully funded.

As this last case indicates, the substitution of social security for personal saving may be partial, and if the social security program is funded, the existence of the social security program may have increased rather than decreased national saving. Noguchi’s (1983) findings support this conclusion for Japan.

It is advisable to keep in mind that much of the concern surrounding the impact of social security on saving in the United States is related to the pay-as-you-go system of financing. In this case, any adverse effect of social security on private saving is not offset by an increase in public saving (or a reduced deficit). If the system becomes wholly or partially funded, any effect on private saving must be combined with the effect on public saving.

The national income accounts treat corporate contributions to private pension plans as personal income and saving. Therefore, if real capital gains reduce the amounts that must (by statute) be contributed by corporations to these accounts, personal income and personal saving are lower. A more comprehensive measure than that used for national income accounts would include capital gains of private pension plans in personal income and personal saving, and in this case the fall in personal saving identified by Bernheim and Shoven (1988) would have been smaller or nonexistent.

Although the evidence of the impact of IRAs on saving may not be conclusive, their expanded use has strong supporters. The Washington Post reported on the day the new Chairman of the U.S. Council of Economic Advisers was appointed that “if Boskin can be said to hold one economic idea passionately, it is that America needs to save and invest more. He is thus likely to champion proposals aimed at encouraging savings, such as expanded versions of tax-deferred individual retirement accounts.” (December 7, 1988, p. A14).

This review does not attempt to include the vast literature on the effects of tax incentives on housing, and acknowledges this as an important omission. See Smith, Rosen, and Fallis (1988) for a review of the literature. They observe that “although the research on income tax incentives has taken numerous approaches, these studies have reached remarkably similar conclusions. They have concluded that tax preferences have strongly favored and encouraged home-ownership, have transferred resources to more heavily subsidized owner-occupiers from generally less subsidized renters, have raised the gross price of homeownership housing services but lowered the net after-tax price, and have directed resources in favor of housing and away from other capital uses. Empirical estimates (for the United States) suggest that personal income tax benefits for homeownership increased the proportion of homeowners by approximately 4 percentage points (or 7 percent) and that approximately one quarter of the increase in homeownership since the second World War can be attributed to these tax factors” (p. 55).

Here, again, we may find the direction of causation reversed. In other words, liberal treatment for interest deductions may result from rather than cause a “consumption” lobby with a high propensity to consume.

The effect of government debt on the level of saving or consumption is an unresolved issue. Buiter and Tobin (1979) find that the evidence tends to be against the “neutrality thesis,” that debt issue absorbs private saving and diminishes capital formation, and that concern over the effects of unfunded social security programs on capital formation is well-founded (p. 39). After reviewing the evidence, however, they soften their conclusion: “On the basis of currently available theoretical models and empirical evidence our provisional conclusion is that the case for debt neutrality is not well established. Further empirical work is urgently required, however, before any conclusion can be more than tentative” (p. 58).

In another study, Tanzi and Sheshinski (1984) consider possible effects of various changes in personal income taxes on persona! saving in the United States. They argue that the increased real rate of return on financial assets that followed the 1981 tax changes and capital gains that accompanied the fall in nominal rates between 1981 and 1983 disproportionately benefited the older segment of the U.S. population with its relatively high propensity to consume. Both the relative and absolute increase in the income and wealth position of this older group may have caused a rise in the share of income consumed and a fall in the share saved. Thus, the increases in income and capital gains from financial assets resulting from personal income tax changes may have offset wealth effects owing to corporate income tax changes, such as those discussed by Kotlikoff (1983).

orioka (1984, p. 53) reports that “41 percent of the elderly surveyed in Japan live with their married sons whereas the corresponding figure for the United States and Europe is only 0.5 and 3.5 percent.” Hayashi (1986) reports that in Japan in 1983, 67 percent of persons 65 or over lived with their children. For persons 80 and over, this figure rises to 90 percent.

As previously mentioned, some forms of instability, for example, in the price system, have generally been found to increase the saving rate as individuals move to protect themselves. Hence, different forms of instability may well work in different directions.

or example, increased openness of capital markets may either increase or decrease the level of private saving, depending on whether there is at the time an incipient inflow or outflow of capital. If there is an incipient inflow because of higher domestic interest rates at the time of increased openness, greater openness will result in a fall in domestic interest rates and a fall in domestic saving. This fall is reinforced by a wealth effect, because a rise in the level of domestic wealth accompanies the fall in rates. If an incipient outflow existed at the time, greater openness would cause a rise in domestic rates as more capital flows abroad, and domestic savingwould increase. Again, a fall in wealth would reinforce the increase in saving. The author is indebted to Lans Bovenberg for this point.

Uncertainty surrounding the interest elasticity of saving has not prevented numerous policy recommendations designed to stimulate saving by raising the after-tax rate of return. For example, Feldstein recently called for lower tax rates on capital gains, tax-free bonds to finance college education, and greater use of IRA-type savings accounts to increase the rate of return on savings and thereby increase the saving rate (see Wall Street Journal (November 21. 1988, p. A16)).

Again, reflecting the belief in interest elasticity of saving, external pressure (including some from the United States) encouraged the Japanese to stop exempting interest on postal savings bank deposits, to encourage the Japanese to save less and consume more. With the end of this exemption, the Postal Bank, with 20,000 outlets offering banking services, has been given greater freedom in its investments and is expanding types of deposit instruments offered. If, in fact, saving is not very interest-elastic, the effect of the change on saving may be the reverse of that expected. This could occur if the more active marketing role by the Postal Bank increases awareness of the need to save, and there is an “advertising effect” (which, for example, may have been an important part of the effect of RRSPs in Canada or various pension plans in the United States) that more than offsets any reduction in saving resulting from lower after-tax interest rates (see The Economist (October 22, 198S, p. 61)).

There is ample evidence that governments have used inflation to increase government saving (or reduce deficits) by failing to fully index tax systems for price level changes.

This is likely to be the case except with a shift to some form of pure personal consumption tax.

The Economic Council of Canada (1987) argued that there are five advantages to a lifetime-income tax: first, it does not discriminate in favor of present consumption. It is thus more efficient than an annual income tax system, since it does not distort economic decisions concerning the allocation of consumption through time, and, as a result, the average individual would be better off over his or her lifetime. Second, it is more equitable than an annual income tax. Individuals with equal command over goods and services would pay equal lifetime taxes, irrespective of their time preferences for consumption or the fluctuations of their income flows. Third, it is a simpler tax because it does not require accrual accounting. Fourth, it treats investment in human capital (that is, education and training) and physical capital symmetrically. Finally, with registered savings no inflation adjustment of capital income is required.

See, for example, McLure (1988a), Bradford (1986), Boadway, Bruce, and Mintz (1987), Beach, Boadway, and Bruce (1988), and U.S. Treasury (1977).

See also Beach, Boadway, and Bruce (1988, Chap. 10) for a discussion of the choice between an income and consumption tax in Canada, including uncertainty surrounding efficiency arguments.

As Bradford (1980b) has pointed out, “if the annual yield before taxes is 10 percent, a 36 percent tax on that yield raises the price today (that is, the required current saving) of a dollar a year hence from $0,909 to $0,940, a modest 3.4 percent increase. But it raises the price of a dollar in retirement at age 65, purchased at age 33, from $0,047 to $0,137; that is, it nearly triples the price” (p. 60).

Japan, where the saving level has been high, has recently adopted a 3 percent value-added tax (VAT) to permit lower taxes on corporations. Available evidence suggests that such a move should encourage higher private saving.

Although inadequate saving has been of concern in countries such as Australia and New Zealand, the argument for a shift in the tax mix has rested on equity concerns more than on the distortion between present and future consumption. The shift to indirect taxes reduces the incentive to avoid or evade direct taxes by financing lower rates, and those who do avoid or evade taxes on their income will be taxed when they consume.

Although the original tax reform proposal included a special 10 percent tax on savings for retirement and savings for home ownership, the final reform continued to exempt this form of saving (Iwashita (1988, p. 121)).

Pechman (1987) notes that an upward revision of the capital gains taxis next on the agenda for Swedish tax reform (p. 13).

Poterba (1987) concluded that “the (U.S.) Tax Reform Act of 1986 is likely to prove a particularly costly example of the neglect of corporate saving. The new law increases corporate taxes approximately $120 billion over the next five years and reduces the tax incentives for retained corporate earnings. Even if it does not affect pretax corporate earnings, it could reduce corporate saving between $30 billion and $40 billion a year by 1989” (p. 455).

In light of this discussion, which suggests that a shift from personal taxes to corporate taxes may decrease private saving, it is worth keeping in mind that Japan has had both the highest level of saving among industrialized countries and also the highest level of corporate income taxes relative to GDP.

Boskin (1988c) and Shoven (1988) are among those who point out that the gains from reducing intersectoral distortions through income tax base broadening are severely limited so long as the income tax provides major incentives to invest in housing and human capital. Base broadening may, in fact, increase distortions between investment in taxable sectors and in housing or human capital. Boskin argues that the focus should be much more on reducing intertemporal rather than intersectoral distortions since the potential welfare gains from the former are much greater. His estimates of these gains are, however, based on significantly positive interest elasticities of saving. The perceived limits on income tax base broadening and the gains from intertemporal neutrality are major reasons why Boskin and Shoven support a shift to consumption taxation from income taxation.

Those holding to the Ricardian equivalence theory would argue this point.

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