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Microeconomics of Saving BCN IC hPBRS COMMISSNil OF THE EUROPEAil COMMUI{ITIES DIRECTORATE.GETTERAL FON ECOiIOMIC AiID FII{AI{CIAL AFFAIRS Number 89 December 1991 Microeconomics of Saving Barbara Kauffmann* Internal Paper "Economic Papers" are written by the Sfaff of the Directorate- General for Economic and Financial Affairs, or by experts working in assOciation with them. The "Papers" are intended to increase awareness of the technical work being done by the staff and to seek comments and suggestions for f urther analyses. They may not be quoted without authorisation. Views expressed represent exclusivety the posifions of the author and do not necessa rily correspond with fhose of the Commission of the European Communities. Comments and enquiries should be addressed to: The Directorate-General for Economic and Financial Affairs, Commission of the European Communities, 200, rue de la Loi 1049 Brussels, Belgium i I l ECONOMIC PAPERS Number89 December 1991 Microeconomics of Saving Barbara Kauffmann* Internal Paper * I would like to thank Arnold Heertje, Franco Modigliani, Javier Santillan, Stefan Sinn, Patrick Steimer,­ and Marian Kane for helpful comments and Pierre Baut. Ierotheos Papadopoulos, and Piet van Zeeland for technical assistance. 11/548/91/-EN This paper exists in English only CONTENTS Summary Page 1. Introduction 1 2. Saving for Old Age 2.1. The life cycle hypothesis of saving 3 2.2. Population structure 4 2.3. Social security 6 3. The Return on Saving 3.1. The real interest rate 9 3.2. Taxes 11 3.3. Tax exemptions and saving incentives 13 4. Changes in Wealth and Income 4.1. Inflation 15 4.2. Increases in current wealth 17 4.3. Corporate saving 18 4.4. Uncertainty and short-run movements in income 20 4.5. Liquidity constraints 21 5. Conclusion 23 6. Tables and Graphs 24 7. References 31 SUMMARY In the past decade, saving in the industrial countries has been relatively low. The decline in funds available for financing investment needed to support growth and welfare improvement has raised much concern. One important source of low national saving has been the dissaving in the government sector in various countries. Private saving has also generally been lower in the 1980's than in the preceding decades. The contribution of business saving to this decline has been comparatively minor, whereas the fall in household saving has played an important role. The paper analyzes the households' decision-making processes to accumulate wealth, discussing the role of various factors in determining the observed personal saving patterns in the largest industrial countries. It addresses the dependence of the households' saving rate on age and retirement conditions in the context of the life cycle model and the implication of demographic changes for the aggregate saving rate. The role of the return on savings is analyzed and how tax policy interferes with the saving decision. Finally, the impact of inflation, changes in wealth, and corporate saving is examined. In this context, the important role of uncertainty and liquidity constraints is pointed out. A major conclusion of the paper is that households in a particular country or period should not be considered relatively impatient or less thrifty just because their observed overall saving rate is relatively low. Microeconomic Aspects of Saving 1. Introduction The past decade has been marked by relatively low national saving in the industrial countries. The net national saving rate in the OECD countries declined from an average of around 14 p.c. of GNP in the preceding two decades to roughly 9 p.c.; in the 1980's, the corresponding figures were 13.5 p.c. and 10 p.c. for the major seven industrial countries (Table 1). This relative decline in funds available for financing investment needed to support growth and welfare improvement has raised much concern. On the one hand, the declining supply of global funds is faced with a large demand for global savings - enhanced recently by the transition process in Central and Eastern Europe and in the Soviet Union. On the other hand, despite higher capital mobility there is still a link, even though it may be declining, between a country's saving and investment performance. 1 One important cause of low national saving has been the dissaving of the government sector in various countries (Figure 1). Certainly most of the attention has been attracted by the US federal budget deficit which relative to GNP is lower than that of Canada and Italy but stands out in absolute terms and with respect to its impact on the world's capital market. This has led to the call for a reduction in budget deficits by many economists followed by declarations at the political level, e.g., at the latest Economic Summits of the G7. So far the consolidation process has been successful only in some countries. However, this seems more a problem of political feasibility than a lack of clarity about the necessary steps to be taken since they are, at least as far as the expenditure side is concerned, unambiguous. Private saving has also generally been lower in the 1980's than in the preceding decades with the exception of Canada where it has been noticeably higher. The role of business saving in the general decline of private saving and hence national saving has been relatively minor compared to that of household saving. Not only do businesses provide a much smaller share (about one third) of net private saving than households, they also have increased their saving propensity in the course of the 1980's (despite a lower period average) as opposed to the downward movement of overall private saving until the late 1980's. Perhaps decisive is that households are the ultimate owners of businesses and hence do, 1See Feldstein and Horioka (1980) and Feldstein and Bacchetta (1989) for empirical evidence and Santillan (1991) fora survey of the general discussion. -2- at least to a considerable extent. take into account the savings of businesses (of which they own shares) when deciding how much to save out of their disposable income.2 Thus. the other important cause of low national saving in the 1980's has been the decline in the saving rat€ of the household sector in many countries, after an increase during the 1960's and early 1970's 3 (Figures 1 and 2) . In particular. the US household saving rate has attracted considerable attention since it has declined from an already relatively low level. However. it has been shown that the difference in the household saving ratios between the US and other countries is reduced considerably if the data are corrected for statistical differences.4 The causes and possible remedies for the generally low level of household saving in the past decade are far less clear than those for government saving. The saving rate of the household sector is the result of the behavior of a large number of individual household units which are influenced in their decision to accumulate capital by various factors. In order to understand the level and movement of a country's overall saving rate it is necessary to study the saving behavior of the household units. Broadly speaking there are two main reasons why households save. The first, the long run, reason is the provision for the period after lifetime employment. People save in order to be able to maintain their consumption after they stop working and possibly to leave behind a bequest. The second reason for saving arises from uncertainty either due to exceptionally low income or high necessary expenditures (precautionary saving). The common element is the maximization of the (extended) household's expected life-time utility. When making their saving plans households are affected by various variables such as the age of household members, household wealth, and corporate saving, as well as by interest and inflation rates, tax and financial regulations. The purpose of this paper is to analyze the households' decision-making processes to accumulate wealth and in particular, how they are influenced by these variables. Furthermore, it will be shown, drawing on the existing theoretical and empirical literature, which role such variables may have played in determining observed saving patterns of the household sector of various countries. Section 2 addresses 2This issue is discussed further in Section 4. 3 1t should be noted that the saving rates are not corrected for the inflation effect that usually entails an overestimation of the actual saving of households and an underestimation of that of government and business sectors as discussed in Section 4.1. " See Blades and Sturm (1982). Hayashi (1987) found that most of the difference between the US and the Japanese personal saving rates is a statistical illusion. Similarly, the US-German household savings gap can be reduced if statistical differences are taken into account (Kauffmann, 1990). -3- the dependence of the household's saving rate on age and on retirement conditions in the context of the life cycle model and the implication of demographic changes for the aggregate saving rate. The role of the return on savings and how tax policy interferes with the saving decision are discussed in Section 3. Finally, the impact of changes in wealth, corporate saving, inflation and income is analyzed in Section 4, as well as the role of uncertainty and liquidity constraints in this process. 2. Saving for Old Age 2. 1. The life cycle hypothesis ofsaving Saving is the household's decision to forego consumption at a particular moment in time to be able to consume at a future date. It is the result of the fact that households prefer a smooth consumption path, but are faced with an income stream which is not smooth - be it due to the sharp drop in income with retirement or to short-run fluctuations.
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