Tax Incentives for Saving By Harvey Galper and Eugene Steuerle*

The promotion of a healthy rate of economic saving not be very responsive to growth has long been a central goal of public changes m9ajustt increase after-tax rewards. It is policy. The two principal categories of possible, however, to identify the criteria initiatives deployed in pursuit of that goal that incentives must satisfy if they are to have been macroeconomic measures and structural have any chance of increasing saving levels. tax incentives. The tax code now contains a variety of provisions intended to encourage In this essay, we first set out those saving and investment--and, through them, criteria. Then we review existing tax growth. Because of the lagging performance of incentives and evaluate them in terms of the the economy in recent years, many new incentives criteria. Lastly, after determining that for household saving have been proposed. current incentives are decidedly deficient, we Unfortunately, few supporters of these proposals describe several tax changes that would or of the saving provisions now on the books constitute genuine saving incentives. have developed a systematic conception of the attributes required for a saving incentive to The Internal Revenue Code has numerous be effective. In this article, we will grapple provisions, involving hundreds of billions of with that crucial issue. dollars annually, that affect the return to household saving. These include special Two disclaimers should be noted at the outset. deductions for retirement saving; dividend and First, we are not suggesting that increasing interest exclusions; deferral and exclusion household saving is the only, or even the most from taxation of unrealized capital gains; and important, goal of structural . An full deductions for both real and inflationary equitable distribution of tax burdens, minimal components of interest expenses. Because these distortion of economic choices, and effective provisions were adopted in a piecemeal fashion, administration of the tax system must be con- they are uncoordinated and arbitrary in their sidered as well. Each of these goals may place distribution of tax reductions among iAdividuals serious contraints on the possibilities for and among different types of assets. changing the tax structure to promote saving. Equity objectives may limit the extent of tax In an inflationary environment, the combined changes in particular income classes. The goal effect of these special purpose provisions of a minimally distorting tax system requires become even more random and arbitrary. For that consideration be given to the impact of example, inflation may increase the tax potential saving incentives on labor supply, advantages of saving in the form of owner- consumption patterns, and resource allocation occupied housing relative to the advantages in general. Moreover, a tax system should be conferred by purchases of corporate stock; the capable of being administered without imposing reason is that the yield from housing in the excessive paperwork or record-keeping burdens form of in-kind services to the homeowner~goes on the taxpaying public. Tax reforms that are untaxed, while the inf lation-induced apprecia- designed to promote saving ought to be judged tion of stock values may lead to higher capital along these dimensions as well. gains .. Such disparities in the treatment of different forms of capital income make the Second, we make no claim that tax incentives, appropriate design of saving incentives even if well-designed, will necessarily especially crucial. generate substantially higher saving rates;

*Reprinted with the permission of the authors and Brookings Institution. Harvey Galper is a senior fellow in the Economic Studies program at Brookings. He is a former director of the Office of Tax Analysis at the Department of the Treasury. Eugene Steuerle is a federal executive fellow at Brookings and assistant director of the Office of Tax Analysis at the Department of the Treasury. (The views expressed are those of the authors and do not necessarily reflect Treasury policy.) I 2 7 Tax Incentives for Saving

DESIGN CRITERIA FOR 'AN EFFICIENT SAVING only $250 (column 2 of Table 1). Thus, the tax . INCENTIVE preference provides no additional return for. increasing net, saving. This problem can be For any tax proposal or provision accurately overcome only if the rule that is applied to to be labeled a saving incentive, three positive saving and capital income is also criteria mist be met. first, tax benefits applied to negative saving and capital income.' should not go to taxpayers who simply switch If an interest deduction were allowed as,' a assets from one form of saving (or one kind of deduction--then a taxpayer would not benefit account) to another. The shift of assets into from engaging in simultaneous. borrowing and a tax-preferred form permits taxpayers to lending transactions. achieve tax reductions with no' increase in their saving. When one asset is favored over Tax arbitrage reduces incentives' to save--and others, there will indeed be additional 'invest- incentives to work--in two ways. First, it ment in the advantaged activity. However, permits taxpayers to increase their disposable there will also be less investment in other income without doing any additional saving or activities and a less efficient allocation of productive labor--and may, therefore,, encourage investment across sectors and activities. them to devote more. time and resources, Thus, although total saving and investment including otherwise unnecessary legal . and could conceivably increase if overall returns administrative expense, to non-productiv6. to capital rise, that increase would come at efforts. Because tax arbitrage reduces taxable' the cost of, a poorer allocation of the capital income, it' also lowers a taxpayer's -marginal stock. . . However, this effect on the marginal tax rate results., from any increases in Second, no tax provision can be considered a deductions--not just those deductions that are' true incentive if it does not apply at the intended to increase saving. Second, the loss margin. A deduction with a cap--that is, one of tax revenues due to arbitrage by 'some with a limit on the amount of deduction or taxpayers necessitates increases in revenue exclusion permitted- provides little _mar9inal collections from other taxpayers. Those in the -incentive- for-a--person- already. receiving--income Fattbe~grpup ace-hig er ax ra es on t1fe-1-r- in excess of the maximum. For example, a cap labor income and on their '- income from of $500 on the amount of interest or dividends capital--and, as a result, have somewhat that can be received tax-free would have only a diminished incentives to work and to save.- very modest marginal incentive effect, since taxpayers who receive more than $500 of dividend and interest income account for more Table l.--Example of Tax Arbitrage than 97 percent of such income. Arbitrager Saver Third, a tax incentive for saving must (1) (2) provide symmetrical treatment of. positive saving on the one hand and negative saving or A. Earnings on asset $1,000 $1,000 borrowing on the other, If a taxpayer can B. Interest paid 1,000 borrow and deduct the costs of interest while C. Change in at the same time acquiring an asset yielding before exclusion (A-B) 0 1,000 income that is partially or fully tax-exempt--a D. Exclusion or other tax process that is kftown as "tax arbitrage'I--the preference Soo Soo taxpayer may achieve a tax reduction with no E. Tax savings~ 250 250. increase in net*saving whatsoever.

Imagineof a simple case in which the before~tax rate interest on borrowing and the rate of An inflationary environment intensifies- the return from- an--asset are both 10 percent. problems created by tax arbitrage because the Suppose the income from the asset is advantaged deduction of nominal interest payments may through a partial exclusion so that the taxpayer result in a negative real after-tax borrowing need include only half of the 10 percent rate rate. For example, if the interest rate is 14 of return in income subject to tax. Since the percent and the inflation rate is 8 percent, interest paid on borrowing can be deducted the after-tax cost of- furids to a taxpayer in fully and 'immediately, the taxpayer has an the 50 percent bracket is -1.0 percent (.5(14i)~ incentive to purchase the asset--but does not' - 8%). Even if the after-tax rate is not necessarily have an incentive to undertake any negative, the gap between a partially -exempt net saving. For instance*, a taxpayer'in'the 50 rate of return and the deductible rate of percent bracket who borrows $10,000 and invests interest will increase.with inflation--and so., At in the-tax-favored asset realizes.a subsidy too, will the potential rewards of -arbitragp,,, equal to $250 while,engag ing in no.net saving Thus, if inflation increases the nominal (column 1- of Table 1 below).' If that same interest:rate (and the cost of borrowing) from taxpayer invests $10,000 of new saving in the 10 percent to, 1S percent, a taxpayer in the 50 asset, the tax subsidy received still equals percent bracket who deposits borrowed money in Tax Incentives for Saving an IRA will experience a jump in arbitrage Table 2.--Assets and Liabilities of Individuals rofits from $50 to $75 for each $1,000 in the United States--1981 orrowed. Furthermore, since the taxpayer in such a transaction is both a debtor and an creditor and since inflation will affect both Billions of Dollars Outstanding sides of that transaction equally, the at Beginning of Year taxpayer's real wealth will not be eroded by inflation. In the IRA transaction just described, the taxpayer's 50 percent increase Tangible Assets $5,931 in arbitrage profits will be a pure windfall. Reproducible Assets $4,267 The practice of tax arbitrage is neither owner-occupied housing 1,920 unusual nor inconsequential. It is quite Other residential structures 486 common for individuals to borrow at the same Consumer durables 995 time that they purchase such tax-favored Inventories and non-residential investments as pensions, annuities, land or plant and equipment 864 corporate stock. The borrowing may take a variety of forms, including second mortgages, Land 1,665 increased leverage in business investments, or Owner-occupied 5.90 decreased equity in housing as an asset when a Farm business and nonfarm home is sold and a new one purchased. The noncorporate business 1,032 asset used as collateral need not be related to Other 43 the assets actually purchased with borrowed funds. Individuals who borrow will receive the same tax subsidy as those who increase their Financial Assets 4,521 net saving when they invest in tax-preferred assets. Currency, Saving Accounts, and Money Market Funds 1,657 In summary, for a saving incentive to be Demand deposits and currency 288 effective, it must meet three criteria: little Time & savings accounts 1,294 or no inducement to shift forms of asset Money market fund shares 74 ownership, a positive incentive to save at the margin, and the prevention of tax arbitrage. Securities 1,644 We now turn to a review of the saving U.S. savings bonds 73 incentives in current law and an analysis of Other U.S. government securities 210 how well these incentives satisfy our criteria State and local obligations 74 for effectiveness. Corporate and foreign bonds 87 Open-market paper 38 Corporate equities THE CURRENT TAXATION OF CAPITAL INCOME (excluding corporate farms) 1,162

Although proposed new forms of saving Pension and Life Xnsurance incentives have been the subject of public Reserves 9so debate and countless congressional hearings in Life insurance reserves 223 recent years, the extent to which capital Pension fund reserves 727 income flows are already granted deferral or exclusion from taxation may not be well-known. Miscellaneous Assets 271 Many of these preferences have been in the for a long time and reflect the fact that the tax system generally taxes realized flows Total Assets 10,452 of cash and excludes or defers from taxation both unrealized accruals of income and receipts of in-kind service flows, such as those from Home Mortgage 946 housing and durables. Consumer Credit 385 Other Mortgage Debt 240 Perhaps the easiest way to indicate the Other Debt 284 pervasiveness of these existing incentives is to relate them to the broad categories of ~ssets held by individual taxpayers. As Total Liabilities 1,8ss indicated in Table 2, there were approximately $10.S trillion of these assets at the beginning of 1981, of which roughly $5.9 trillion were in Net Worth 8,598 tangible assets--such as housing, durables, and land--and $4.5 trillion were in financial Source: Balance Sheets of the U.S. Economy assets. Very little of the income from (Washington: Board of Governors of the Federal tangible assets held by individuals is taxed. Reserve System, 1981). 4, Tax.Incentives for Saving

For example the benefits provided by of up to $3,000 ($6,000 on a joint return), but owner-occupie housing and durables are not only to the extent that interest income exceeds subject to tax (although interest payments on itemized interest expenses other than interest mortgages and installment debt are deductible, paid on debt related to a taxpayer's dwelling as are property taxes). Income from investments or conduct of a or business [2]. in real estate is not taxed fully, in part .because the owners of these assets are allowed In the aggregate, then, about 80 percent of generous investment credits and depreciation or the $10.5 trillion in individual assets is held cost recovery allowances. in forms that are subject to some type of 11saving" incentive. Much of the total return from both household and business investments in land and real Relationship of Existing Incentives -to' the estate consists of appreciation in value. Very Criteria for Efticiency little tax is collected on this appreciation because of the capital gains exclusion and, The hodgepodge 'of provisions relating to the more important, because of provisions in the taxation of income from capital may appear at tax code that defer increases in value from first glance to have moved the tax structure taxation until they are realized and exclude toward some version of a . Ibis them completely from taxation in the event of view is quite misleading, however, because it death [ I I Taxpayers who are 55 years of age bypasses the question of whether the existing or older kso receive a generous exclusion for incentives actually work. Are they efficient gains from the sale of owner-occupied housing, according to the three criteria set out earlier? while younger taxpayers are allowed to defer such gains by purchasing houses of equal or As to the first criterion--the prevention of greater value. We should note, too, that asset shifts--saving incentives adopted on a compliance data published by the Internal piecemeal basis and applying only to certain indicate a substantial amount forms of saving will almost certainly encourage of underreporting of rental income and income households to reorganize their Dortfolios.-_ --from farms-and-non-corporate businesses.- -B c__s-e___eacc __ inves. nt--decision-wTil---be-based- partly on tax considerations rather than Of the $4.5 trillion held in financial assets, exclusively on true economic productivity, the about 21 percent, or $950 billion, was in the overall efficiency and productivity of form of life insurance and pension reserves. investment will decline. Most of these assets receive favorable tax treatment because their purchase price is One especially important aspect of the deducted from - other income, or the income that efficiency losses, induced by asset shifts has they generate is excluded from the tax base, or been generally overlooked. The exclusion of tax liability for that income is deferred to interest income and payment from most incen- the future. In addition, 1981 amendments to tive's means that individuals are charged the the tax code ermit workers to deduct deposits highest effective tax rate for direct lending of up to 41,000 per ar in Individual to others, and a much lower tax rate for Retirements Accounts (IRA'sr holding their saving in other forms.

Another $1.2 trillion of the financial assets Financial intermediaries- -such as banks and of individuals were held directly in corporate thrift institutions- -typically channel money stock. Corporate stock ownership by individuals deposited by savers to investors making invest- is given favorable tax treatment through several ments for which economic returns are the provisions: the exclusion of 60 percent of greatest. However, when individuals restructure long-term gains from taxation; a dividend their portfolios to achieve the highest avail- exclusion of $100 per taxpayer ($200 per joint able after-tax returns, this process of return); a deferral from taxation and an financial intermediation is distorted. eventual conversion to capital gains for a Lower-income individuals and new businesses are limited amount of dividends reinvested in discouraged from borrowing in order to invest public utility stock; and, most important, the while higher-income individuals and establishl:~ combination of tax deferral of any gains until businesses with current flows of income are they are realized and the exclusion from encouraged to borrow and to leverage their taxation of all gains unrealized at the time of investments even further or to retain earnings a taxpayer's death. for investment in their own projects. The resulting loss in efficiency occurs not because Individuals also held $74 billion worth of of shifts in aggregate saving, but because the state and local obligations, the income from saving is not made available to those whose which is non-taxable, and .$73 billion worth of potential investments could yield the highest, U.S. savings bonds, the income from which can return. be deferred from taxation until the bonds are sold. For years after 1984, a 15 percent It is clear that inducing individuals to exclusion is provided for net interest income switch their assets from one form to another Tax Incentives for Saving 5 has adverse economic consequences. Even if income, but this restriction does not apply to saving and investment increase, the resultant borrowing against one's home or through one's net economic benefit is diminished--and perhaps business. even made negative--by the need for an increase in the capital stock just to offset the Tax arbitrage is also possible when purchasing misallocation of capital across sectors and physical capital. In many cases, the uses. combination of the investment and the vastly accelerated depreciation available As to the second criterion for effectiveness, under the new accelerated capital recovery current tax preferences for capital income system (ACRS) provides the equivalent of an provide no incentive for increased saving on immediate deduction for, or expensing of, the the margin in situations where a cap is placed acquisition costs of particular investment. on the amount of income eligible for a tax Since expensing is tantamount to exempting from reduction. The current exclusion of $100 of taxation the return on investments, failure to dividends per taxpayer ($200 for a joint deal with the deductibility of interest return) is a prime example. The tax provisions expenses results in negative tax rates for many regarding IRA's include both a cap and an leveraged investments. inducement to shift assets into tax-preferred accounts. While IRA's may provide some saving One further question needs to be addressed: incentive for persons whose current rate of Is it possible that the various preferential saving places them below the cap amount, tax provisions that we have been discussing, inevitably those who can most easily obtain the although they are sources of sectoral tax reductions that IRA's offer are those who misallocation when taken one at a time, largely need only to switch the form of their saving, cancel each other out when treated in the rather than those who actually must increase aggregate? Three considerations argue against net saving. Accordingly, it should come as no such an outcome. First, as already noted, surprise that in 1977 over half of the eligible interest income received by households is taxpayers with incomes over $50,000 made conspicuously absent from the list of items for deposits in IRA's, but less than S percent of which tax preferences are allowed. Second, the those with incomes under $20,000 did so. Data provisions are so varied in their approach and on utilization rates for more recent years are subject to so many caps and limits that the not yet available, but preliminary evidence differentials among rates of taxation (or shows a similar distribution of benefits by subsidy) for different types of assets are income class. still quite significant. Finally, the ability to arbitrage the system undercuts any possible Finally, all of the existing incentives are incentive effect, since the tax benefits can be found to be deficient in terms of the third obtained without increasing saving at all. criterion; none of them effectively disallows tax arbitrage through borrowin . Indeed, much In summary, none of the saving incentives now of the interest paid on the 11.9 trillion of in the tax code meets each of the three individual financial liabilities is deducted criteria for an efficient incentive: avoidance immediately, even though it is likely that many of unnecessary and inefficient asset shifts, of these borrowed funds are used to acquire provision of incentives at the margin, and assets--such as pensions, annuities, land, prevention of tax arbitrage through borrowing. housing, and corporate stock--for which income Most fail the first test, many fail the second, is deferred. and all fail the last.

Although the tax law reflects some recog- nition of the problem of tax arbitrage, SAVING INCENTIVES THAT WOULD WORK restrictions now in the law have had little impact. One provision bars the deduction of At this point, one might begin to question interest expenses incurred in borrowing funds whether the tax code is even capable of used to purchase tax-exempt securities. accommodating an effective saving incentive. However, the provision is difficult to We believethat it is, and we offer as evidence enforce. Unless the tax-exempt securities three options that would meet all of the above themselves are used directly as collateral for criteria for effectiveness: a comprehensive the loan that finances their purchase, it is base conjoined with a reduction in almost impossible to trace the connection marginal tax rates; a comprehensive personal between such a purchase and an increase in consumption tax; and the indexation for borrowing. Moreover, commercial banks and inflation of income from capital. Particular property and casualty insurance companies, advocates of these options may not view them as which are major purchasers of tax-exempt being intended primarily as incentives for securities, are ordinarily not affected by this saving; nonetheless, as the analysis below will limitation. A second provision limits itemized indicate, each option would be an effective interest deductions in excess of investment means to that end. Tax Incentives for Saving

,Broader-Base, Lower-Rate Income Tax percent and the interest rate 12 percent. A reduction -in a taxpayer's marginal - tax rate The adoption of a broader * income tax Jrom 33 percent to 2S. percent would initially base--and, with it,- -lower rates of taxation--is double the real after-tax rate of return for a traditional approach to tax reform. This holding . interest -bearing assets (because ' 'an course is supported by those who decry the increase from' 8 percent to 9 percent in the erosion of the tax base 'arid -the attendant nominal after-tax -yield would amount to an adverse, impacts on the distribution of tax increase from I percent to 2 percent ' in the burdens and the allocation -of resources. . In real after-tax yield). However, -the rate terms of our current perspective, however, 'a reduction would increase the retdrn'from work broader base and lower rates would also meet by only 12 percent -(from 67 cents to 7S cents all of the criteria for efficient saving of each additional dollar earned). incentives. A broader base would provide a ..more uniform treatment of capital income from Although the magnitude of potential tax rate disparate sources, thereby improving resource cuts would depend on the degree - - of allocation. Saving, ~qould be directed toward base~-broadening, even modest efforts toward a the most efficient, rather than the most broader base could represent- an improvement .tax-favored, uses. Even if some - assets over current saving incentives.. For example, a ,continued to receive tax preferences, lower tax more uniform and comprehensive inclusion-,of -rates would reinforce. the...tendency toward capital income in the- tax base, offset by -a efficient allocation by automatically reduction in the rate, would be decreasing the value of tax-preferred assets .likely to 'increase efficiency in the allocation relative to other~assets. of capital across sectors -and uses without producing any decrease in net saving. The remaining two criteria would also- be met ,Similarly, returning to the tax base certain easily by a, broader-base, lower-rate tax forts of labor income 'now excluded--such as .structure. The very nature of rate reduction employer payments of health premiums on behalf means that incentives would apply at the of employees--would encourage saving if the margin, -since-marginal-tax-rates-would-be- -resultant-revenue-increase5-- were-used-to- reduced for --most -if-not- --all-,- -transactions-. T inarfte---aT --rate redufti-on____ -for- -a- 11 fo-im'sc - --of- .'Finally, the tax arbitrage problem that is income. -characteristic of existing saving incentives ,,would be avoided because the rate reductions In terms of saving incentives, perhaos. the would apply equally to both receipts and only objection to a broader-base, lower rate deductions. In fact, lower- rates. would structure comes from those who fear that taxes actually reduce the potential gains from tax on capital income--or taxes paid by those with arbitrage by narrowing any remaining relatively high propensities to save--would be differential between the tax treatment of increased. In a revenue-neutral proposal, - for interest and. the. treatment of other types of instance, the preponderance 'of a - rate redifction .Capital income. might be directed at labor income, rather than 1 w at. capital income. Whether ~capital` income There are two aspects of rate reductions that would. face a higher average 'tax' rate would are generally ignored and that make . these depend - on the particulars of the restructured ,reductions" even better at encouraging saving tax and, in no small -part, on how the ,than is commonly recognized. First, a decrease eliminated tax preferences- had been distributed in rates is one of the easiest ways to reduce as between capital income and labor income., .-the tax incentive to borrow without actually increasing the taxes paid by any borrower. All There .are reasons, to discount this .borrowers . with positive net taxable income objection. First, it -often leads to the type would benefit from a tax.decrease because the of . "saving incentive" proposals that exist reduction in taxes on their positive income today--proposals that would cost revenue and would more than offset the increase in taxes on decrease the efficiency of capital allocation, interest payments that are now deductible. but would have at best an uncertain effect on Nonetheless,, their marginal I incentive to total saving.. Second, a proposal can always be borrow would be reduced; 'only taxpayers with designed to insure - that 1abor income comes - in zero or negative taxable income, for whom the for at least a proportionate' share :of net tax change would be zero, would have an base-broadening and that taxation of capital undiminished marginal incentive to borrow, .income' is not increased. . .. Second,;, in-,~an inflationary economy with high Comprehensive Consumption Taxation nominal interest rates, a reduction, in Aax rates would provide- ' a much,greater percentage A second effective 'method of, providing ~'a I reduction in the tax on real. interest income saving incentive would be ':to convert-." 'the ,.than in- the tax on real wages or on the real existing individual . income tax into an return from partially taxable assets. For individual consumption or expenditure tax. The instance, suppose the inflation rate were 7 nature of such a consumption tax should be made Tax Incentives for Saving 7

clear. In general terms, the tax base would be Indexing can be supported as a tax reform household consumption, defined as income minus measure on more or less the same grounds as saving. This base could be taxed at progressive base-broadening - -namely, that the more accurate rates. Advocates of a consumption tax claim measurement of income would increase the that it is superior to the income tax on a efficiency of resource allocation and tend to variety of grounds, only one of which is its equalize the tax burdens of individuals with efficiency as a saving incentive. Our purpose equal amounts of real income. But it is also here is not to spell out the details of such a possible for indexing to be a saving incentive, tax or to provide a complete evaluation of its although its force as an incentive would depend merits and drawbacks, but to indicate the ways upon whether marginal rates on all capital in which a comprehensive consumption tax would income were raised--as in the case of differ from the piecemeal saving incentives of base-broadening with no corresponding rate current law. reduction--then the outcome would be ambiguous and would turn on whether the improvement in A comprehensive consumption tax would meet the allocation of capital across uses was more our criteria for an efficient saving incentive than offset by the losses associated with a in mach the same way as would a broader-base, reduction in aggregate investment. However, if lower-rate income tax. The source of funds average marginal tax rates on capital income for consumption would not affect their tax were lowered, the gains from increasing the treatment. Saving would also be treated aggregate capital stock would reinforce the uniformly; neither the source of the saving nor gains from improving its allocation. the type of investment financed by the saving would directly affect the tax rate. Thus, a As one component of an effort to measure and consumption tax could be considered the to tax all real income uniformly, indexing equivalent for many purposes of a tax on labor would fulfill all the criteria for an efficient income accompanied by no tax on capital saving incentive. First, it would reduce the income. unnecessary asset shifts that occur under the existing tax rules. Second, to the extent that Because of its uniform treatment of all real after-tax returns would be increased, the capital income and all saving, a comprehensive incentives to save would be applied at the consumption tax provides a much more efficient margin. Finally, the indexing of capital income saving incentive than does the current tax would reduce the potential rewards of tax structure. A consumption tax would be neutral arbitrage by allowing the deduction of only as among forms of saving--in contrast to real interest expenses (even as it would permit existing saving incentives, which generally the taxation of only the real component of favor one form of saving over another. In a interest receipts). consumption tax, incentives would apply at the margin for all taxpayers; even for the There are several advantages to providing wealthiest of individuals, the tax rate for incentives for saving through full indexing. income from saving would in effect be zero. Because indexing would affect capital income Few saving incentives now in the tax code meet only, a revenue-neutral tax program containing that second criterion. Finally, while existing full indexing could be designed to avoid incentives all increase the benefits that can raising the average marginal tax rate on be obtained by borrowing and simultaneously capital income--an outcome feared by many of investing the proceeds in a tax-favored asset, those who oppose the creation of a a properly designed consumption tax would broader-base, lower-rate income tax structure. address the tax arbitrage problem directly by At the same time, indexation would work within eliminating the deduction for interest paid or the context of the income tax; it would neither by treating all borrowed dollars as receipts remove real capital income from the tax base (and gross saving as deductions from receipts). nor exempt wealth accumulation from taxation, as would a consumption tax. Finally, Indexation of Capital Income indexation would meet almost everyone's standards of fairness, because it would be a A third option--and one not generally Tove toward the more accurate measurement of considered a saving incentive--would be the income. indexation for inflation of all capital income [3]. Full indexing of capital income would Many of the existing tax preferences for mean that all depreciation deductions would be capital income were adopted as crude forms of adjusted for increases in the price level that indexing or have had the effect, whether take place after the purchase of the depreciable intended or not, of moderating the tendency of asset; real, rather than nominal, capital gains inflation to change real effective tax rates would be subject to taxation, and only the real across assets. However, such ad hoc indexing component of interest income or expense would operates in an imperfect, uneven, and haphazard be added to or subtracted from the tax base. way; some assets are fully or partially 8 Tax Incentives for Saving

shielded from inflation and others are Most cause unnecessary and inefficient asset essentially exposed. Among the current shifts, man fail to provide incentives at the instances of ad hoc indexing are: for fixed margin, anY all permit tax. arbitrage through physical capital, accelerated depreciation and borrowing. the investment tax credit; for inventories, the last- in-first-out (LIFO) method of accounting; As we have seen, however, it is possible to and for corporate stock and other assets that design an effective incentive; three appreciate in value, deferral and exclusion of comprehensive options were delineated above. realized capital gains, Of the various types Short of these more thoroughgoing measures, of capital income, interest is least protected partial reforms in the direction of a more and thus the most vulnerable to the effects of uniform treatment of income, additional rate inflation. reductions, and the indexation of interest could provide some enhancement of saving Short of comprehensive indexation, there are incentives. We would emphasize, however, -that two ways in which the existing system of ad hoc the top priority for designers of tax indexation could be brought closer to incentives--and one that has been neglected for conformance with our criteria for efficiency. too long--should be the revision of interest First, improvements could be made in how deductibility rules in order - to minimize the indexing is provided for particular items of opportunities for tax arbitrage. income. For instance, the current method of accelerated depreciation--which results in NOTES AND REFERENCES highly disparate tax rates being imposed on different types of capital income--could be NOTE: Additional materials,-not referenced in replaced with an adjustment that would lower this article, which relate to subjects tax rates simply by assuring that inflation discussed,are listed 'in [4 and S1. does not reduce the real value of allowed deductions. [11 This exclusion applies to heirs as well as to decedents and is achieved by increasing -Second,-even-par-tial-indexation-of-i.nterest-. the heirls- basis-in-an-7asset-to-the-asset-l-s---- income--would reduce-- significantly- the existing - valueat-th-e-time of the-decedent's-deith. incentive for asset shifts and portfolio reallocations. A concomitant indexation of [21 This provision - has not yet come into deductible interest expense would decrease the effect, and many bills now before Congress incentive to borrow and reduce the gains that would defer or,eliminate it. can be realized through tax arbitrage. One ossibility would be fractional inclusion of [31 We are considering- here the effects of oth interest income and expense--with lenders inf lation on the size of the tax base and paying tax on only a portion of their nominal on the measurement of real income; we are interest receipts, and borrowers deducting only not examining the so-called "bracket creep" a portion of their nominal interest payments; effect. this arrangement would clearly measure net real income more accurately than does current law. [41 U.S.~ Department of the Treasury, Internal Revenue Service, . statistics. of Income-- CONCLUSION Individual income. Tax Returns, appropriate years. Although the tax code contains numerous provisions that are designed to provide [S] U.S. Department of the Treasury, Internal incentives for saving, virtually none of them Revenue Service, statistics of Income-7- meets the criteria for an, effective incentive. 1976i Individual Retirement Arrangements.

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