Assessing the Effectiveness of Saving Incentives

R. Glenn Hubbard and Jonathan S. Skinner

The AEI Press

Publisher for the American Enterprise Institute WASHINGTON, D. C.

1996 A somewhat more technical version ofthis analysis has been submitted to the Journal of Economic Perspectives. We are grateful to Orazio Attanasio, Doug Bernheim, DavidBradford, Eric Engen, William Gale, Douglas Joines, Andrew Samwick, Karl Scholz, Timothy Taylor, Steve ~nti, and David Wise for helpful suggestions. Financial support from the Faculty Re­ search Fund ofthe Graduate School ofBusiness ofColumbia University and from the Securities Industry Association is acknowledged.

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© 1996 by theAmerican Enterprise Institute for Public Policy Research, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the Ameri­ can Enterprise Institute except in the case of brief quota­ tions embodied in news articles, critical articles, or reviews. The views expressed in the publications oftheAmerican En­ terprise Institute are those of the authors and do not neces­ sarily reflect the views ofthe staff, advisory panels, officers, or trustees ofAEI.

The AEI PRESS Publisher for the American Enterprise Institute 1150 17th Street, N.W., Washington, D.C. 20036

Printed in the United States ofAmerica Contents

FOREWORD, R. Glenn Hubbard v

WHAT Do WE KNow ABOUT INDMDUAL RETIREMENT ACCOUNTS? 6

WHAT Do WE KNow ABOUT 40l(K) PLANS? 16

A CosT-BENEFIT APPROACH TO SAVING INCENTIVES 20

SHOULD WE HAVE SAVING INCENTIVES AT ALL? 25

CONCLUSIONS 28

NOTES 31

REFERENCES 33

ABOUT THE AUTHORS 39

iii

Foreword

Economists, policy makers, and business executives are keenly interested in fundamental tax reform. High mar­ ginal tax rates, complex tax provisions, disincentives for saving and investment, and solvency problems in the so­ cial security program provide reasons to contemplate how reforms of the tax code and other public policies toward saving and investment might increase economic efficiency, simplify the tax code, and enhance fairness. Many econo­ mists believe that gains to the economy from an overhaul of the income tax or from a move to a broad-based con­ sumption tax can be measured in the trillions of dollars. Most conventional economic models indicate a potential for large gains from tax reform. While many economists agree broadly on the simple analytics oftax reform, they are in much less agree­ ment on such key empirical questions as how much sav­ ing or investment would rise in response to a switch to a consumption tax, how much capital accumulation would increase under a partial privatization of social security, how reform would affect the distribution oftaxes, and how international capital markets influence the effects of tax reforms in the United States. This lack of professional consensus has made the policy debate fuzzy and confus­ ing. With these concerns in mind, Diana Furchtgott­ Roth and I organized a tax reform seminar series at the

v vi FOREWORD

American Enterprise Institute beginningin January 1996. At each seminar, an economist presented new empirical research on topics relating to fundamental tax reform. These topics include transition problems in moving to a consumption tax, the effect of taxation on household sav­ ing, distributional effects ofconsumption taxes in the long and short run, issues in the taxation offinancial services, privatizing social security as a fundamental tax reform, international issues in consumption taxation, distribu­ tional consequences ofreductions in the capital gains tax, effects of tax reform on pension saving and nonpension saving, effects oftax reform on labor supply, consequences of tax reform on business investment, and likely proto­ types for fundamental tax reform. The goal of the pamphlet series in fundamental tax reform is to distribute research on economic issues in tax reform to a broad audience. Each study in the series reflects many insightful comments by seminar partici­ pants-economists, attorneys, accountants, and journal­ ists in the tax policy community. Diana and I are espe­ cially grateful to the two discussants of each paper, who offered the perspectives of an economist and an attorney. I would like to thank the American Enterprise In­ stitute for providing financial support for the seminar series and pamphlet series.

R. GLENN HUBBARD Columbia University Assessing the Effectiveness of Saving Incentives

he low rate ofnational saving in the United States is cause for concern among economists and policy Tmakers. In 1993, U.S. net national saving was only 2.7 percent of net national product, compared with 12.3 percent in 1950. This comparison is not an anomaly: sav­ ing rates have declined significantly since the 1950s. The U.S. net national saving rate averaged 9.1 percent per year during the 1950s and 1960s but fell to 2.4 percent during the 1990s. Of central importance is the decline in domestic in­ vestment, which is equal to net national saving plus the inflow ofinternational funds to finance U.S. investment. Although net domestic investment averaged about 8 per­ cent of net national product in the 1950s, 1960s, and 1970s, it fell to 6.1 percent in the 1980s, and it has aver­ aged 3.1 percent since 1990. A low rate of domestic in­ vestment implies a lower rate ofcapital accumulation and, consequently, a lower rate of growth of labor productiv-

1 2 EFFECTIVENESS OF SAVING INCENTIVES

FIGURE 1 U.S. PERSONAL SAVING RATES, 1960-1994

Percent of disposable income 10

9

8

7

\ 3-year moving Ratio ofsaving average 5 to income ""

4

3

2L..L-..L..L.....o...,JL,-,L-..L...... L.....o...,J':::-:c'--..L...... L-L...1-L-J-.L--L...I..,-L-L...!-..L....L....l-l-L-.L-L.-'--1--'---1 1960 1980 1985 1990 1994 SOURCE: Economic Report ofthe President, 1996. ity, which in turn can cause stagnation in real wage growth. The links among saving, capital formation, pro­ ductivity, and living standards must be kept in mind as we debate public policies to raise national saving. What is the source ofthe decline in net national sav­ ing in recent decades? To a large extent, the decline can be attributed to the dramatic rise in the federal deficit, which absorbs private saving that would otherwise be available for investment. In 1978, the federal government deficit was 1.4 percent of net national product, but by 1992 it had risen to 5.1 percent. In addition, personal saving by households has fallen. Figure 1 graphs the ra­ tio ofpersonal (or household) saving to disposable income between 1960 and 1994, with the thick line representing a three-year moving average to smooth out year-to-year fluctuations in the saving rate. The decline in personal HUBBARD AND SKINNER 3 saving during the past fifteen years is very pronounced, from an average of7.8 percent ofpersonal income during the 1970s to only 4.5 percent in the 1990s. Economists debate the cause of this decline; possi­ bilities include cohort changes in saving behavior, intergenerational redistribution through social security and other government programs, and the increasing im­ portance of social insurance programs, but there is no general consensus as to the primary cause ofthis decline in household saving (Attanasio and De Leire 1994; Burtless, Bosworth, and Sabelhaus 1991; and Gokhale, Kotlikoff, and Sabelhaus 1994). Although the causes of the decline may not be en­ tirely clear, there is an increasing interest by u.s. policy makers in providing targeted saving incentives to increase the household saving rate and the net national saving rate by inducing households to save a larger fraction of their income. Many economists believe that a shift from an income tax to a consumption tax would raise net na­ tional saving.Yet there is some concern (for example, Gale 1995) that the overall effects on aggregate saving of a consumption tax would be small, and the transitional is­ sues in getting to a consumption-tax system would be thorny indeed. There is even less agreement about the effectiveness of more politically palatable, but narrowly targeted, sav­ ing incentives such as individual retirement accounts (IRAs) and salary reduction saving plans, also known as 40l(k)s. The primary concern is that such saving incen­ tives are simply windfalls to people who would have saved the money anyway. Shuffling assets from taxable to tax­ preferred accounts yields a tax break without increasing household saving at all. If anything, saving incentives could reduce national saving by worsening the govern­ ment deficit (see, for example, Gravelle 1991). In recent years there has been an outpouring of re­ search on the effectiveness of IRAs and 40l(k) plans in 4 EFFECTIVENESS OF SAVING INCENTIVES stimulating saving. Some researchers have found large and significant positive effects of IRAs and 40l(k)s on saving behavior (Hubbard 1984; Venti and Wise 1986, 1987, 1988, 1991; and Poterba, Venti, and Wise 1994, 1995). Other researchers have found no saving effects, or even negative saving effects, because contributors sim­ ply shuffied assets that they would have saved anyway (Gale and Scholz 1994; Engen, Gale, and Scholz 1994; and Engen and Gale 1995). Still others have estimated that some fraction of IRA contributions represents new saving, with the remainder shuffied from exisiting sav­ ing (Joines and Manegold 1995; Attanasio and De Leire 1994; and Johnson 1985). What can we conclude, there­ fore, about the effectiveness ofsaving incentives? Ifthere is so little agreement on the saving effects of IRAs and 40l(k)s, can economists contribute anything to the sav­ ing incentive debate? There is more to be learned from the research on saving incentives than is suggested by the wide variation in estimates. We provide a brief review of the literature, principally for studies ofIRAs but also for 40l(k) plans. The studies showing that saving incentives do nothing for national saving are probably biased downward, while the studies showing saving incentives are highly effec­ tive at generating new saving are probably biased up­ ward. We argue below that the true effect of IRAs and 40l(k)s is somewhere between these divergent views. Ofcourse, taking this intermediate ground raises an entirely new set of questions. Suppose, for example, one takes the view that only twenty-six cents of every dollar in IRA contributions represents new saving, as found in one estimate by Joines and Manegold (1995). Does this imply that IRAs are ineffective and just a drain on the U.S. Treasury? Or should twenty-six cents of new saving per dollar of IRA contribution be taken as a mark of suc­ cess for saving incentive programs? Existing studies have offered no framework in which HUBBARD AND SKINNER 5 to answer this question. We suggest a simple cost-benefit approach to ask, What is the incremental gain in capital accumulation per dollar of forgone revenue? The cost to the government of saving incentives is the lost revenue from offering the programs, and the gains are the (pre­ sumed) increased saving, whether it be for aggregate sav­ ing or the saving of specific target groups such as low­ income or low-wealth retirees. We find that for quite con­ servative measures ofthe saving effects oflRAs or 40l(k)s, the incremental gains in capital accumulation per dollar oflost revenue are quite large. For example, the estimate oftwenty-six cents ofnew saving per dollar oflRA contri­ bution (Joines and Manegold 1995) implies that even a deficit-financed IRA program would increase private capi­ tal accumulation by $2.21 for everyone-dollar increase in the deficit, leaving a net increment in the capital stock of $1.21. Even knowing this key parameter, however, does not allow one to judge whether saving incentives are a suc­ cess or a failure. What is the shadow or social value of increasing the overall saving habits or net capital accu­ mulation in the U.S. economy? Addressing this question requires an answer to a more fundamental question: What economic arguments justify having targeted saving in­ centives in the first place? We consider a number ofjustifications for IRAs and 40l(k) plans: increasing social benefits by increasing the size of the capital stock, reducing the tax distortion be­ tween current and future consumption, improving the fi­ nancial health of households to reduce the government's cost of welfare spending for impoverished elderly, and making it easier for households to exercise self-control and avoid "myopic" consumption choices. The problem with these four possible reasons for saving incentives is that at least three of them are very difficult to quantify. The current state of knowledge may preclude find­ ing "the" point at which IRAs and 40l(k)s may be deemed 6 EFFECTIVENESS OF SAVING INCENTIVES socially beneficial. Our own view, however, is that the most compelling justification for these types of saving incen­ tives is that they help people exercise self-control. Most American households approach retirement with very little in liquid assets available for consumption or medical con­ tingencies, suggesting a systematic problem with saving. To the extent that such households enroll in 40l(k)s or IRAs, and to the extent their contributions represent new saving, the social value of such extra saving in a world with myopic spenders could be very high. In this volume, we plunge into the roiled waters of the IRA and 40l(k) saving debate. Although we attempt to find a middle channel in interpreting the results from the debate, we must ultimately conclude that the prob­ lem ofdiscerning what contributors would have saved in the absence of the saving incentive program makes for a difficult job of evaluating saving incentives.

What Do We Know about Individual Retirement Accounts?

In this section we consider in turn the characteristics of IRA contributors, the theoretical effects of IRAs on sav­ ing, and the empirical evidence on IRA saving behavior.

Characteristics ofIRA Contributors. The households that contribute to IRA accounts tend to be wealthier and older and to have higher income levels than those that do not. A detailed picture of the typical IRA contributor can be taken from Venti and Wise (1991), who used 20,000 observations from the Survey ofIncome and Program Par­ ticipation (SIPP) to describe the enrollment pattern of those who held IRAs. For example, in 1985, 4 percent of households with incomes less than $20,000 and with household heads between the ages of twenty-five and thirty-four enrolled in IRAs. Holding income constant at less than $20,000, this fraction rises to 18 percent among HUBBARD AND SKINNER 7 those aged fifty-five to sixty-four. Holding age constant, we find that IRA contributions rise quite dramatically by income. For example, among those aged fifty-five to sixty-four and with income of $20,000 to $40,000, contribution rates were 50 percent (compared with 18 percent for those with income less than $20,000); for people of the same age with income over $40,000, contribution rates were above 70 percent. House­ holds with higher levels of wealth, holding income con­ stant, are also more likely to contribute to IRAs. Venti and Wise (1992) restrict their sample to those aged sixty­ five and younger; they find median non-IRA wealth of $13,500. Gale and Scholz (1994) restrict their sample to those sixty-eight and younger and include the cash value of life insurance; they find the median IRA contributor in 1986 held $21,695 in non-IRA wealth. Clearly, IRA con­ tributors have a greater taste for saving than do noncontributors.

The Theory of IRAs and Household Saving. Much of the analysis by economists of households' consumption decisions (and, hence, of saving) is conducted using ver­ sions of the life-cycle model pioneered in the 1950s by Nobel laureate Franco Modigliani and others. In its most basic form, the model implies that households save dur­ ing their working lives to finance retirement consump­ tion. The pattern of saving over an individual's lifetime depends on the rate ofreturn to saving, his or her prefer­ ences over present and future consumption, and the time profile of earnings. The current generation of life-cycle models adds two features to the basic approach-imper­ fect markets for lending (households face limits on their ability to borrow against future resources to finance cur­ rent spending) and imperfect insurance markets (so that uncertainty over future earnings, medical expenses, or lifespan can generate "precautionary saving" by house­ holds).l 8 EFFECTIVENESS OF SAVING INCENTIVES

In the context of the life-cycle model, a savings in­ centive raises the rate ofreturn on saving in the targeted form. The incentive raises a household's total saving only if the higher rate of return is available to the household at the margin-that is, for an incremental dollar of sav­ ing. Some have argued that the roughly three-quarters ofall contributors who are saving at exactly the IRA limit is prima facie evidence that IRAs could not have gener­ ated new saving, because there is no marginal incentive to save once the limit is reached (see Burman, Cordes, and Ozanne 1990; and Gravelle 1991). An analysis of consumption (and saving) decisions over a lifetime requires a focus on lifetime limits, not an­ nuallimits. That is, in the context oflifetime saving plans, the relevant limit on IRA contributions is not the annual limit of, say, $2,000 or $4,000, but the lifetime limit. The evidence suggests that the IRA limits are binding for few households, even in the relatively short term. Gale and Scholz (1994) have demonstrated that only 30 percent of IRA contributors contribute at the limit for each of three years 1983-1986, implying that the remaining 70 per­ cent of IRA contributors faced a marginal incentive in at least one ofthe three years. (Even if no contributions are made during the interveningyear, the IRA provides a mar­ ginal, if unused, incentive.)2 Some economists eschew the life-cycle model alto­ gether and focus instead on psychological issues of self­ control and myopic consumption behavior (see, for ex­ ample, Thaler 1994). In this approach, households are not optimizing life-cycle agents, responding to marginal saving incentives as they make their n-year consumption and retirement plans. Instead, they are imperfect crea­ tures who have trouble saving for retirement and who respond to saving programs that assist in enforcing the self-control necessary for setting aside assets for the fu­ ture. Then IRAs and 40l(k)s are valuable because of the immediate reward of the tax deduction and the fact that HUBBARD AND SKINNER 9 money is put "offlimits" for current consumption. At least some evidence is consistent with this view. Feenberg and Skinner (1989), for example, found that taxpayers were far more likely to contribute to an IRA ifthey owed money to the IRS in excess of taxes withheld. They interpreted this result to mean that taxpayers would rather write a check for $2,000 to an IRA than a check for $800 to the IRS.3 Similarly, the life-cycle model predicts that optimiz­ ing agents should contribute to their IRA early to maxi­ mize tax benefits. Roughly 40 percent of IRA contribu­ tors during the 1984 tax year, however, filed in the calen­ dar year 1985 (Statistics ofIncome 1984).4 Whether IRAs stimulated saving in the short run is an empirical question for two reasons. First, the empiri­ cal evidence suggests that IRAs provide a marginal in­ centive for saving for 70 percent ofcontributors during a three-year period. Second, the prediction of the behav­ ioral saving approach suggests that the availability of IRAs and 40l(k)s should promote saving in the short term, even for those contributing to the limit.

The Evidence on IRAs and Household Saving. An­ swering how IRAs affect saving in the short term is more difficult than it might first appear. The economic intu­ ition we reviewed in the previous section suggests that we need to have a significant amount ofinformation about households, including information on their taxable assets, tax-favored assets, earnings, age, and demographic char­ acteristics affecting consumption and saving decisions (for example, marital status or number ofchildren). We would also like to have data on the same households over time (panel data). Households may have different underlying preferences for saving that are not observable to statisti­ cians examining the data, and making the statistical prob­ lem even thornier, those preferences may vary over time. As a result, looking at households at a point in time (us­ ing cross-section data) may produce a misleading impres- 10 EFFECTIVENESS OF SAVING INCENTIVES sion. Data limitations constrain the ways in which econo­ mists have been able to examine the effects of saving in­ centives on household saving. Before delving into econometric issues, we might find it useful to consider what people say when asked about how they funded their IRA contributions. In a survey of IRA contributors in 1983, Johnson (1985) found that "about halfofthe respondents said they would have saved it anyway. About 10 percent said they would have spent it all, while about 40 percent said they would have spent some and saved some." He estimated that ofthe total $32 billion IRA contributions in 1983, $10 billion constituted new saving, or thirty-two cents per dollar of IRA contri­ bution. This estimate is likely to be an upper bound, given respondents' ambiguity about whether the reduction in tax liability would have been saved or spent. Moving next to structural or econometric studies, we consider the first such estimate ofhow retirement saving incentives affect private saving. Hubbard (1984) used evidence from the 1979 survey by the President's Com­ mission on Pension Policy. This survey covered both the limited enrollment in IRA plans as well as in the closely related Keogh plans. Hubbard found that individuals con­ tributing to these plans held more assets relative to their income than those who did not. He attempted to control for the selection problem-those with a taste for saving are more likely to establish IRAs-by including in his sample families who may have wanted to save in IRAs or Keoghs but failed to meet the legal restrictions. More re­ cent evidence from structural models of the joint deter­ mination of saving in tax-favored and taxable forms are described by Venti and Wise (1986, 1987, 1988, 1990, 1991) and Gale and Scholz (1994). Venti and Wise essentially treat alternative forms ofsaving as "goods" over which households make choices. They model the choice among three goods: consumption, tax-favored (IRA) saving, and taxable (liquid) saving. HUBBARD AND SKINNER 11

Their test is whether IRAs are close substitutes for tax­ able saving. Ifthey are perfect substitutes, the individual will immediately shift taxable saving into IRAs because IRAs offer the higher net-of-tax rate of return. If IRAs are imperfect substitutes, IRA contributions will come not at the expense of taxable saving but at the expense of current consumption. That is, IRA contributions repre­ sent new saving. The evidence offered by Venti and Wise supports this latter outcome. Indeed, they estimate that between 45 and 66 percent of the increase in IRA contri­ butions comes at the expense of current consumption, about 30 percent comes from the tax subsidy, and between 3 and 20 percent comes from a reshuffling ofexisting sav­ ing (Venti and Wise, 1986, 1987, 1990, 1991). Why should IRA and non-IRA saving be imperfect substitutes? Gale and Scholz (1994) make an important advance by focusing explicitly on the illiquidity of IRA balances. A household may be concerned that its savings will be locked up in an IRA when the funds are needed for some future uncertain consumption contingency (for example, a medical emergency or a decline in future in­ come). In the approach of Gale and Scholz, saving is not an end in itself (as it is in the earlier approach of Venti and Wise), but a means to an end. That end is future con­ sumption, as in the traditional life-cycle model of house­ hold consumption decisions. To sort out the explanations for the observed rela­ tionships among IRA contributions, age, and wealth, Gale and Scholz derive the implied saving function for a par­ ticular set ofhousehold preferences. Their model is more general than that ofVenti and Wise because it allows for differences in tastes for saving by IRA contributors com­ pared with noncontributors. Gale and Scholz compare saving behavior oflimit contributors with that ofcontribu­ tors who are not at the limit to identify the pure effect of changes in the IRA contribution limit on national saving. They find that IRAs are estimated to have a negative or, 1 2 EFFECTIVENESS OF SAVING INCENTIVES at best, zero effect on saving for the sample as a whole. Sensitivity analysis yields a range of estimates, from a positive saving effect ofthirty-two cents per dollar oflRA contribution for younger contributors (age thirty-five) to a negative $3.52 effect on saving per dollar of IRA contri­ bution for a sample that included very active savers and nonsavers.5 The results ofGale and Scholz, therefore, con­ tradict those of Venti and Wise; they suggest that IRA contributions come almost entirely from existing savings. What's going on here? The results ofVenti and Wise suggest that many households, even those with very high income, do not contribute to IRAs. According to the logic ofthe Venti-Wise model, iflRAs and taxable saving were perfect substitutes, then everyone should contribute. Yet even among high-income households, roughly one-quar­ ter do not contribute.6 Hence, IRAs must be imperfect substitutes for taxable saving. The Gale and Scholz ap­ proach is different. They interpret the fact that some do not contribute to IRAs as evidence that those people just have little or no taste for saving. Since noncontributors are assumed to be intrinsically different from contribu­ tors, because of their low taste for saving, they actually play little part in identifying the marginal saving effects of IRAs. Instead, as noted above, Gale and Scholz rely primarily on differences between limit contributors and nonlimit contributors to identify the marginal effects of IRAs on saving. The Venti and Wise estimates are probably biased upward. IRA contributors save more, not because of the existence of an IRA program, but because they like to save in both IRA and non-IRA vehicles. The Gale and Scholz (1994) estimates that IRAs have no effect on sav­ ing, however, are probably biased downward for the fol­ lowing reason.7 The Gale and Scholz benchmark result excludes households that reported more (in absolute value) than $100,000 in saving. A replication of their empirical analysis by Poterba, Venti, and Wise (1996) is HUBBARD AND SKINNER 13

able to mimic the Gale and Scholz benchmark result show­ ing that IRAs have a slightly negative effect on saving. When Poterba, Venti, and Wise reduced the saving limit to $90,000, however, or increased it to $110,000, thereby adding or subtracting a few limit contributors, the esti­ mated coefficient-in either case-switched completely, implying that IRAs are entirely new saving!8 From this, we suspect that the true saving effects must be larger than reported in the Gale and Scholz "base case" esti­ mates. Acknowledging the many problems with estimating specific models ofIRA contributions, a number ofauthors have conducted longitudinal studies of saving behavior. With repeated samples over a number ofyears, they have assessed the extent to which households "reshuffle" ex­ isting saving into IRAs. The basic idea is to use saving and IRA information on the same (or similar) families over time. In the first such study, Feenberg and Skinner (1989) used the IRSlUniversity of Michigan longitudinal survey oftaxpayers over the period 1980-1984. These data do not provide direct observations of asset levels, so Feenberg and Skinner used asset income (interest and dividends) as a proxy. They defined "liquid wealth" as the grossed-up balances using the average Aaa bond and S&P 500 dividend yields for each year. According to the simplest shuffling hypothesis, those who enrolled in an IRA should have experienced a fall in taxable interest and dividend income relative to those who did not enroll. The data indicate the opposite pattern: taxpayers who contributed to IRAs saved more in non­ IRA assets. For example, for households with between $2,000 and $10,000 in liquid wealth, taxpayers contrib­ uting to IRAs in all three years experienced an increase in taxable interest and dividend income of $1,279, com­ pared with only $466 for those who did not contribute.9 The Feenberg-Skinner results offer strong evidence against the basic form ofshuffling ofsaving between tax- 14 EFFECTIVENESS OF SAVING INCENTIVES able and IRA balances. They should not be interpreted as proof that IRAs generate new saving, however. Al­ though Feenberg and Skinner do control for the initial level of wealth and income, they cannot control for the variety ofreasons leading to a change in the taste for sav­ ing. For example, some households who started with $2,000 to $10,000 in wealth during 1980-1981 could have decided to increase their total saving for a variety ofrea­ sons, and they might be expected to do so in a variety of investments, including IRAs. In this hypothetical case, shuffling occurs, but more subtly, in that a given house­ hold does not have a permanent taste for saving. If so, identifying the effect ofIRAs on saving would become more difficult, given the difficulty in measuring objectively changes in tastes for saving. Joines and Manegold (1995) use the IRSlUniversity of Michigan taxpayer panel to construct a different test of the hypothesis that IRA contributions represent new saving. They compare asset wealth and income of new IRA contributors with those who purchased IRAs before the expansion of eligibility in 1982. The thrust of the Joines-Manegold test is the following: to support the claim that IRA contributions are new saving requires that new contributors in 1982 should increase their saving by more than continuing contributors do. They find that the mar­ ginal effects on saving ofincreasing the limit on IRA con­ tributions by one dollar are twenty-six cents or twenty­ nine cents, depending on the statistical approach. A slightly different question is to ask how total IRA contri­ butions were financed; in this case their estimates are either nineteen cents or twenty-six cents per dollar ofcon­ tributions. Their confidence intervals, however, are quite wide: between minus sixteen cents and fifty-four cents in the first case, and minus eight cents and sixty cents in the second. Although the Joines and Manegold evidence does achieve a middle ground between Venti and Wise and Gale HUBBARD AND SKINNER 15 and Scholz, it is still not clear that they have found the best "control group." Their maintained assumption is that their control group, people who contributed to IRAs be­ fore 1982, is more similar to post-1982 contributors than individuals never contributing to an IRA. The pre-1982 contributors, however, were also few in number and with­ out existing pension funds. Their IRA saving would have been their primary source of retirement income, rather than simply a supplemental saving program; therefore, the control group likely is not comparable to the universe of post-1982 IRA contributors.1o Another recent salvo in the empirical analysis of ef­ fects of IRAs on household saving comes from Attanasio and De Leire (1994). These authors compare saving be­ havior ofhouseholdsjustopening an IRA ("new" contribu­ tors) with that of households previously making contri­ butions ("old" contributors). By focusing on households contributing to an IRA, Attanasio and De Leire attempt to control for unobserved differences in tastes for saving. They test to see whether newly contributing households decrease their non-IRA assets or their consumption to fund contributions. Attanasio and De Leire use data from the Consumer Expenditure Survey, because that data set provides in­ formation on income, consumption, and financial assets. They note that saving behavior may differ between "new" contributors (individuals without existing IRA balances) and "old" contributors (individuals with existing bal­ ances). They find that new contributors do not have slower consumption growth but do experience slower growth of non-IRA assets. The authors interpret this result as sup­ porting the claim that IRA contributions largely repre­ sent reshuffled, not new, saving. There are problems with this interpretation, how­ ever. They are evaluating only the reshuffling that takes place in the first year for a "new" contributor but are ig­ noring entirely any saving done by "old" contributors. In 16 EFFECTIVENESS OF SAVING INCENTIVES fact, even if one assumes that all IRA contributions by "new" contributors are shuffled, one still finds that the "old" contributors-in the steady state, the vast majority ofall contributors-are barely shuffling at all. Hence, our reinterpretation of the Attanasio and De Leire results suggests as much as forty-nine cents of new saving per one dollar contribution to an IRA account. 11 To summarize, estimates ofhow IRAs affect saving in the short run range widely, from zero or negative (Gale and Scholz), nineteen to twenty-nine cents (Joines and Mane­ gold), less than thirty-two cents (Johnson), up to forty-nine cents (our interpretation of Attanasio and De Leire), and sixty cents (Venti and Wise). The "true" answer lies some­ where between zero and sixty cents; we suggest a range of twenty to forty cents as a reasonable middle ground.

What Do We Know about 40l(k) Plans?

The distributional tables for 40l(k) enrollees look much different from the distributional tables for IRA contribu­ tors. The participation rate for 40l(k) saving plans among eligible employees with low levels of income is very high relative to IRA participation. Among eligible workers in 1993 making between $15,000 and $20,000 annually, the participation rate was 55 percent, rising to 83 percent for workers making more than $50,000.Among younger work­ ers at firms with 401(k)s, contribution rates in 1993 were 55 percent for twenty-one to thirty year-oIds, rising to 67 percent for thirty-one to forty year-oIds, and more than 70 percent for older groups to age sixty-five. For a number of reasons, estimating effects of tar­ geted saving incentives on household saving should be easier with 40l(k) plans than IRAs. Individuals who con­ tribute to IRAs are likely to be more favorably disposed toward saving than those who do not, which makes the task ofdistinguishing the marginal effect ofIRAs on sav­ ing quite difficult, as we noted above. By contrast, some HUBBARD AND SKINNER 17

FIGURE 2 MEDIAN FINANCIAL ASSETS AND NONRETIREMENT ASSETS FOR 40l(K) ELIGIBLE AND INELIGIBLE HOUSEHOLDS WITH $40,000 TO $50,000 IN INCOME, 1984, 1987, AND 1991

Dollars o 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000

IDI Total financial assets. 1984 401(k) eligible ~ Nonretirement assets, 401(k) eligible ~ Financial assets, 401(k) ineligible 1987

1991

NOTE: 40l(k) balances not reported in 1984. SOURCE: Poterba, Venti, and Wise (1994). firms offer 40l(k) plans, and others do not. It is easier to assert that two different groups-those who are eligible for 40l(k)s and those who are not eligible-are house­ holds that share common characteristics. Poterba, Venti, and Wise (1994) compare the saving behavior of workers eligible and not eligible for 40l(k)s. Many eligible workers do not, in fact, contribute anything to a 40l(k) plan; Poterba, Venti, and Wise include them in the sample to avoid the criticism that individuals who choose to contribute to 40l(k)s were eager savers any­ way. They show that, controlling for incomes of workers, levels of wealth among those eligible for 40l(k)s are sub­ stantially higher than among those who were not eligible. Figure 2, which is reproduced from their study, fo­ cuses on a given annual income range, $40,000 to $50,000, 18 EFFECTIVENESS OF SAVING INCENTIVES to correct for differences in income between the two groups. In 1984, median financial assets, excluding 40l(k) and IRA balances, were roughly the same between the two groups. Those assets remained generally unchanged between 1984 and 1991. Between 1987 and 1991, how­ ever, median financial wealth of those eligible for 40l(k) plans in their data rose dramatically, largely because of 40l(k) contributions, as can be seen in figure 2. (Unfortu­ nately, no information is available in their data for 1984 on 40l(k) balances.) Assuming that the two groups­ 40l(k) eligibles and ineligibles with equal incomes-hold similar tastes toward saving, and assuming the composi­ tion of these workers did not change by much between 1987 and 1991, one might conclude that 40l(k)s are en­ tirely new saving. Engen, Gale, and Scholz (1994) have questioned the underlying assumption that the two groups of workers (for all income groups) are similar. Firms with eager sav­ ers, for example, might also have been the ones most likely to implement such plans since 1984. Another possible problem is that if firms replace defined benefit pension plans with 40l(k) plans, workers may show an increase in assets without any effects on total (pension plus indi­ vidual) saving. 12 Engen, Gale, and Scholz compared 40l(k) contribu­ tors in 1987 and 1991 with a group deemed to have simi­ lar tastes in saving, those with IRA accounts but who were ineligible for 40l(k)s. That is, they assume that 40l(k) contributors and IRA participants have a "taste" for saving because they elect to participate in a saving plan. Comparing these two groups, they found that 40l(k) contributors increased their median 40l(k) assets but reduced their non-40l(k) assets by even more. This sug­ gests, if anything, a negative effect of 40l(k) participa­ tion on saving behavior. By contrast, IRA participants not eligible for 40l(k)s show a healthy increase of24 per­ cent in median net wealth over the period. HUBBARD AND SKINNER 19

This comparison is less clear than it appears, how­ ever. While Engen, Gale, and Scholz attempt to control for heterogeneity in tastes for saving by partitioning the data into subgroups, they do not control for heterogene­ itywithin the subgroups. Suppose, for example, that there are "eager" savers and "casual" savers in the population. The earliest participants in 401(k) plans are likely to be the eager savers, with the casual savers signing up over time. Hence, over a period of time (1987 to 1991 in the authors' experiment), casual savers account for a larger fraction of 40l(k) participants (see Bernheim, 1994a). Therefore, the Engen-Gale-Scholz finding that net finan­ cial assets of 40l(k) participants did not rise relative to the net financial assets of IRA participants not eligible for 40l(k) plans could simply reflect changes in the com­ position of 40l(k) participants. A comparison that better controls for this problem was performed by Poterba, Venti, and Wise (1996). By 1987, most everyone who was going to open an IRA ac­ count had already done so. Thus, owning an IRA account might indicate a strong taste for saving. Controlling for whether households had IRA accounts (that is, whether they had strong or weak tastes for saving), Poterba, Venti, and Wise (1996) found that 40l(k) enrollees exhibited a significant increase in median net financial assets over the 1987-1991 period: IRA enrollees by 11 percent and IRA nonenrollees by 29 percent. These calculations illus­ trate the importance of"dilution" effects in making infer­ ences using panels of cross-section data. More recent research by Engen and Gale (1995) has suggested that 40l(k) assets are shuffled by a different path-through home equity lines of credit. The rise in 40l(k) contributions since 1987 has been matched nearly dollar for dollar by a runup in home equity debt, suggest­ ing little effect of 40l(k) provisions (also see Poterba, Venti, and Wise 1996; and Bernheim 1996). To summarize, the evidence supports the view that 20 EFFECTIVENESS OF SAVING INCENTIVES

40l(k) balances have not been offset by a decumulation of financial assets such as stocks, bonds, and checking accounts. The possibility remains, however, that the mar­ ginal source of funding 40l(k)s since 1986 has become the home equity line of credit, in which case the saving effect of 40l(k)s would be much diminished. If the final consensus is that there are some real ef­ fects on saving behavior of offering IRAs and 40l(k)s, we are still left with a puzzle. If they generate, say, twenty­ six cents of new saving per dollar ofcontribution, should saving incentives be deemed a failure or success? In the next section, we develop and calculate a new cost-benefit measure to assess the effect of saving incentives on sav­ ing behavior.

A Cost-Benefit Approach to Saving Incentives

Suppose that a particular saving incentive generates only four cents ofnew saving per dollar ofcontribution. Is this a successful program? The correct answer is that it de­ pends on the cost. If this program loses only one cent of revenue per dollar ofcontribution, then the answer might well be yes-after all, one gets four dollars in new saving per dollar in revenue cost. Below, we capture this ben­ efit-cost intuition for the IRA program by defining the following ratio: _ [~ private capital Q£CwruJiation per $1 IRA] . ~ net gorernment revenue per $1 IRA t Both the numerator and denominator are stocks rather than flows, and they are defined for a particular time t after the initial IRA contribution. Suppose, for example, that the taxpayer is in the 36 percent tax bracket and that twenty-six cents ofthe IRA contribution is drawn from new saving (as in Joines and Manegold 1995). The ratio in the equation above would therefore be sixty-two cents (thirty-six cents saved through reduced tax liability plus HUBBARD AND SKINNER 21 twenty-six cents of new saving) divided by the revenue loss of thirty-six cents. The benefit-cost ratio for the first year after the IRA contribution is therefore 62/36, or 1.72. In other words, there is an increase in private saving of $1. 72 per dollar loss in revenue. Ifthe IRA program were financed through deficit spending, then the net effect of the IRA on capital accumulation in the first year would be $0.72 per dollar ofrevenue loss, or the increase in private saving($1.72) less the increase in government debt($1.00).13 The benefit-cost ratio in just the first year provides a misleading picture, because there is a greater revenue loss over time from income from funds that would have been saved in taxable form. In addition, IRAs generate revenue for the government when the IRA is cashed out. In calculating the benefit-cost ratio, we therefore focus on the change in the stock ofprivate wealth accumulated over the period for which the IRA is held, divided by the accumulated revenue loss over the same period. In the extreme case in which the IRA is deficit-financed, the de­ nominator would be the net increase in government debt, t years after the IRA was issued. Such calculations require assumptions about inter­ est rates, tax rates, the length of time for which the IRA is held, and the tax treatment of the saving had it been saved in a taxable form. Because most of the estimates from existing studies are based on data from the 1982­ 1986 period, we use the tax regime for that period in our benchmark calculations. We assume a holding period of twenty-two years, which corresponds to buying the IRA at age fifty and cashing it out at age seventy-two,14 an initial marginal tax rate of 36 percent (Joines and Manegold 1995), a final retirement tax rate of 28 per­ cent, an average tax rate on interest and dividend income of32 percent, and a 60 percent exclusion for capital gains. The representative portfolio, whether invested in an IRA or taxable assets, is assumed to be 29 percent in equity initially, with the remainder in a combination oflong-term 22 EFFECTIVENESS OF SAVING INCENTIVES and short-term bonds, an aggregate portfolio consistent with 1985 data (EBRI 1994).15 During the period from 1900 to 1990, the geometric mean of the nominal return in the stock market was 9.35 percent, and the geometric mean of a portfolio with one-half short-term bonds, and one-half long-term bonds was 4.0 percent (Siegel 1992). The accumulation rate used for government debt is a weighted average (29 percent equity, 71 percent bonds) of the returns on bonds and stocks, yielding a govern­ ment nominal discount rate of5.55 percent. Ifone uses a lower discount rate for government debt, such as the de­ fault-risk-free bond rate (as, for example, in Feldstein 1995), the saving effects of IRAs per dollar of revenue loss would be substantially larger. Table 1 presents calculations of our measure of the additional private capital accumulation per dollar of for­ gone revenue for a range of estimates of new saving per dollar of IRA contribution. The first row in table 1 shows how the marginal effect of IRAs on capital accumulation depends on assumptions about the fraction ofIRA contri­ butions that are new saving. When there is no new sav­ ing from the IRA contribution (as in Gale and Scholz 1994), a debt-financed IRA program leads to an increase in private saving of $0.22. Under the assumption that the IRA is debt-financed, the net national capital stock would fall by seventy-eight cents (a twenty-two-cent in­ crease in private saving, a one dollar reduction in gov­ ernment saving). At the compromise estimate of twenty­ six cents in new saving, as suggested by Joines and Manegold (1995), the implied increase in private capital accumulation is $2.21 per dollar devoted to the IRA pro­ gram. Again, for a deficit-financed IRA, the net capital stock increases by $1.21. A relatively modest saving ef­ fect of IRAs can translate into a quite substantial "bang for the buck" in terms ofcapital growth per dollar of for­ gone tax revenue. The estimated effects are even larger when the marginal saving effect is forty cents per dollar HUBBARD AND SKINNER 23

TABLE 1 CHANGE IN NET CAPITAL ACCUMULATION PER DOLLAR IN­ CREASE IN GOVERNMENT REVENUE LOST ON IRAs (dollars)

0 10 19 26 40 60 cents cents cents cents cents cents

Baseline .22 .81 .51 2.21 4.31 12.01

Include corporate income tax revenue .22 .97 2.33 4.84

Current tax rates and portfolio share .4 .63 1.35 2.09 4.45 15.51 a. Self-financing. SOURCE: Authors' calculations. ofIRA contribution (a $4.31 increase in the private capi­ tal stock) or sixty cents (a $12.01 increase in the national capital stock). Feldstein (1995) has performed analogous calcula­ tions to measure the dynamic revenue loss of the IRA program. He focused on additional taxes collected from the corporate sector because of the increased supply of loanable funds provided by IRAs. We include the effect of corporate taxation in our model (table 1, row 2) by as­ suming that only equity investments are subject to the 34 percent marginal corporate tax rate used in Feldstein (1995). The predicted effect on private capital accumula­ tion rises to $4.84 for our benchmark saving effect of twenty-six cents per dollar ofIRA contribution. This larger saving effect occurs largely because revenue losses are 24 EFFECTIVENESS OF SAVING INCENTIVES attenuated given the increased corporate taxes paid from the incremental wealth accumulation. As Feldstein notes, for sufficiently high saving effects, the IRA becomes self­ financing; it actually generates revenue rather than los­ ing revenue. The federal tax regime has changed substantially since the mid-1980s. To assess the effect of IRAs on sav­ ing using more current parameters, we assume a mar­ ginal tax rate of28 percent for contributors, a 24 percent marginal tax rate at retirement, no exclusion for capital gains, and an average 26 percent tax rate on dividends and interest. To reflect the increasing share ofequities in IRA and Keogh plans, we also assume that plan assets are divided equally between stocks and bonds. The third row in table 1 shows the incremental effects on capital accumulation under this scenario. Although the negative effect of the IRA on capital accumulation is more pro­ nounced when there are no saving effects at all from IRAs (first column), the incremental effect is quite similar ($2.09) to the pre-1986 tax rules for our assumed mid­ point estimate of twenty-six cents of new saving. To summarize, IRAs need not stimulate very sub­ stantial new saving per lost dollar ofrevenue to generate favorable marginal increases in the capital stock per dol­ lar ofinitial revenue loss. Even ifthe aggregate effects of a given IRA program are not large-in terms of total in­ creases in new net saving-the revenue costs, once prop­ erly accounted for, are even smaller. Similarly, estimating the effectiveness of40l(k) plans depends on how they affect capital accumulation per dol­ lar of forgone revenue. There are fewer estimates of how 40l(k)s affect saving behavior, however, so developing a benchmark estimate is more difficult. If, on the one hand, 40l(k)s were entirely effective at generating new saving, the incremental private capital accumulation per dollar of revenue cost would be more than $20, which is likely to pass nearly any threshold of effectiveness. 16 If, on the HUBBARD AND SKINNER 25 other hand, sorting or reshuffiing accounts for halfofthe observed increase in wealth accumulation, the 40l(k) pro­ gram generates a net increase of $3.60 in private saving per dollar of revenue cost.

Should We Have Saving Incentives at All?

Suppose that by raising taxes by $1.00 and expanding an IRA program, we could increase private saving by $2.21. This increase in the capital stock is not manna from heaven. Rather, it is the consequence of households con­ suming less today in anticipation ofconsuming additional resources at retirement. If households make these con­ sumption decisions optimally, and these decisions are not distorted by other public policies, justifying a saving in­ centive program would be difficult. Why fund through distortionary taxes a program that shifts households away from an "optimal" level ofconsumption to one that favors retirement consumption over current consumption? Thus, to justify the existence ofsaving incentives, one must first identify the distortion that the saving incentives are de­ signed to overcome. We consider four possibilities.

A High Social Value of Capital Accumulation. Th ar­ gue for substantial external effects of increased capital accumulation, one must appeal to models in which capi­ tal or investment yield positive external effects on pro­ ductivity or output (Romer 1986; King and Rebelo 1990).17 Others have noted the close correlation between saving and investment rates and between investment rates and Solow "residual" measures of productivity growth (Schultze 1992, 242). Hence the notion that a larger capi­ tal stock yields social external benefits is certainly a valid one, but it is difficult to quantify. One problem with appealing to capital stock exter­ nalities to justify saving incentives is that our current incentives are not particularly well suited to the job. They 26 EFFECTIVENESS OF SAVING INCENTIVES include restrictions on contributions and the forced with­ drawal of assets after age seventy, mechanisms not de­ signed to entice the wealthiest households-those who account for most of the nation's saving-to save much more.

Reducing the Distortion between Current and Re­ tirement Consumption.Standard life-cycle models (for example, Feldstein 1978) predict that the tax on interest income distorts consumption at retirement years. The con­ sumer discounts future consumption at the net (aftertax) return, while at the social optimum, future consumption should be discounted at the gross (pretax) rate ofreturn. Therefore, shifting one dollar of current consumption to the future at the gross return should provide a first-or­ der welfare gain approximated by the wedge between the gross and the net return. The IRA and 40l(k) program is a leaky bucket, however, in effecting this transfer from current to retirement consumption since some revenue is lost because of partial shuffling. Calculations from Hubbard and Skinner (1996) suggest that before one can justify saving incentivessolely on these grounds, one must either have a high saving effect of IRAs (about forty-siX cents per dollar of contribution) or include the corporate income tax "wedge."

Keeping the Elderly off Welfare Programs. Welfare programs such as Supplemental Security Insurance and Medicaid are designed to assist the elderly who have lim­ ited assets and income. Encouraging people to contribute money into IRAs and 40l(k)s could save the government money in the long term by reducing the numbers ofpeople who qualify for means-tested welfare programs (see Hubbard, Skinner, and Zeldes 1995). It is difficult, how­ ever, to place a value on the incremental reduction in fu­ ture government expenditures because people today par­ ticipate in IRAs or 40l(k)s. One other problem with this HUBBARD AND SKINNER 27 explanation for saving incentives is that the programs are typically voluntary rather than mandatory. Those most likely to end up on welfare at retirement are prob­ ably those least likely to contribute to any pension or sav­ ing program.

Myopia and Self-Control. To this point, we have re­ stricted our attention to individuals facing well-defined, dynamically consistent utility functions. As Bernheim (1996) emphasizes, there is considerable evidence that people stumble through their planning for retirement with little idea of what they require at retirement and little motivation to meet those requirements. For example, in earlier work Bernheim (1994b) suggests that saving rates on average are only one-third what they should be for households to consume during retirement at levels com­ mensurate with their preretirement consumption pat­ terns. Ifhouseholds make dynamically inconsistent plans (in the sense ofLaibson 1994), there may be an intrinsic value to retirement saving programs that assist them in "self-control," the ability to plan ahead for retirement without the temptation of spending that money in the near term. Similarly, Posner (1995) distinguishes between one's "young self' and "old self," where the younger self does not care sufficiently for the older self to provide the latter with a retirement nest egg. In this case, encourag­ ing people to forgo consumption today for consumption during retirement could well yield substantial social ben­ efits, at least from the perspective of one's old self. The difficulty or inability ofmanyAmericans to save enough for their retirement is the most persuasive justi­ fication for encouraging saving incentives. The problem is that such benefits are difficult to quantify. Ifwe cannot write down preferences in a dynamically consistent way, it makes it harder still to attach dollar equivalent varia­ tion measures to capture the benefits ofdeferred consump­ tion. 28 EFFECTIVENESS OF SAVING INCENTIVES

One problem with viewing IRAs and 40l(k) plans as the cure to problems with self-control, however, is that such programs are voluntary. Many households experi­ encing difficulty saving for retirement are unlikely to en­ roll in IRA programs. As noted above, only 18 percent of households aged fifty-five to sixty-four and with income less than $20,000 actually contributed to an IRA account by 1985. While 401(k) contribution rates are much higher among lower-income employees, few such employees are offered the option of 40l(k) contributions. It is hard to justify the design of 40l(k) and IRA plans as policies to ensure that myopic households save enough for retire­ ment if these same households are the ones least likely to sign up.

Conclusions

In this analysis, we have three objectives: (1) to evaluate empirical studies of how targeted saving incentives af­ fect private saving; (2) to estimate the increase in net capital accumulation per dollar of revenue cost under plausible assumptions; and (3) to assess whether saving incentives are good public policy. We find that, even un­ der conservative assumptions about the effect oftargeted saving incentives on saving behavior, they generate sub­ stantial net capital accumulation per dollar of forgone revenue. Demonstrating that saving incentives are wel­ fare enhancing, however, is more difficult. We know too little about the social benefits, for example, ofincreasing capital accumulation. Probably the best rationale for sav­ ing incentives is myopia or dynamic inconsistency in households' saving decisions. The problem comes in plac­ ing a numerical value on saving incentives, since in these models there is not a well-defined utility function with which to evaluate the benefits of increased saving. This review in this volume has focused primarily on short-term effects of IRA and 40l(k) programs. It is the HUBBARD AND SKINNER 29 long-term effects, however, once all the temporary shuf­ fling has occurred, that are arguably relevant in assess­ ing the desirability of a permanent targeted saving pro­ gram. Engen and Gale (1993) and Engen, Gale, and Scholz (1994) attempt to quantify the magnitude of IRA and 40l(k) programs on the long-term capital stock. They find the benefits of increased private capital stock per dollar of lost revenue (or, in their case, per dollar of increased government debt) to be very high-$5 per dollar of rev­ enue loss associated with expanding IRA contribution lim­ its and $17 per dollar of revenue loss associated with ex­ panded 40l(k)s. These researchers are careful to qualify their long-term predictions-noting, for example, that the period of transition is quite lengthy, taking nearly fifty years before IRAs yield long-term benefits. 18 Neverthe­ less, their exercises emphasize the importance of focus­ ing on the long-term effects of these saving programs, which might be quite different from their short-term or transitory effects. Economists have more than a decade of data on the effect of targeted saving incentives on saving behavior, so it is perhaps surprising that they still disagree about whether such incentives work. One reason why disagree­ ments remain is that economists are just beginning to realize how little is understood about consumption and saving behavior, and in particular about the wide varia­ tion in saving behavior among people who are of similar age, education, and income. The active research on sav­ ing incentives offers an opportunity to understand more about how they influence saving behavior and provides a better picture of why households save.

Notes

1. See, for example, Hubbard and Judd (1987); Engen and Gale (1993); Engen, Gale, and Scholz (1994); and Hubbard, Skinner, and Zeldes (1994, 1995). 2. Another way to see that IRAs tend to provide marginal in­ centives in the long term is the insight from Feldstein and Feenberg (1983). They noted that, given the low levels ofhousehold holdings of financial assets, it would not take long for most households to exhaust their ability to contribute ifcontributions were drawn ex­ clusively from existing (taxable) assets. 3. Of course, this result does not prove that the $2,000 contri­ bution represents new saving; it could have been shuffied saving. In a pure life-cycle model, however, taxpayers should not need the prodding ofa check due to the IRS in order to shuffie their saving; they should have done it anyway! 4. Freenberg and Skinner (1989) also noted the prevalence of "falsely constrained" IRA contributors: households that could have contributed $2,250 or $4,000 but in fact only contributed $2,000. They attribute this behavior to the psychological effect of IRA ad­ vertising, which at the time focused on the $2,000 limit. Engen, Gale, and Scholz (1994) have shown that the corrected number of "falsely constrained" married households is 19 percent in a given year, rather than the 39 percent reported in Feenberg and Skin­ ner, and that some of the households included in the 19 percent had contributed to the legal limit in other years. 5. Poterba, Venti, and Wise (1996) suggest that their estimated parameters are very sensitive to the selection criterion of the sample and exclusion restrictions. 6. The Venti and Wise studies, like that of Gale and Scholz, compare limit contributors versus nonlimit contributors to iden­ tify the saving effect oflRAs.

31 32 NOTES TO PAGES 12 TO 29

7. See Poterba, Venti, and Wise (1996) for further discussion of the Gale and Scholz results. 8. As noted above, Poterba, Venti, and Wise (1996) could not replicate the Gale and Scholz (1994) results exactly because ofsmall differences in the sample size. So one cannot conclude that the Poterba, Venti, and Wise-replicated saving coefficient for the $90,000 and $110,000 limits would be exactly the same as those that would arise from a similar exercise using the Gale and Scholz computer code. 9. A more detailed analysis of data from the Survey of Income and Program Participation by Venti and Wise (1994) using panel data yields similar results. 10. Engen, Gale, and Scholz (1994) also used a specification simi­ lar to Joines and Manegold (1995) to estimate the effect of IRAs. Their estimated coefficients of how raising the contribution limit would affect saving range from -0.71 to 0.31, although most coeffi­ cients are estimated imprecisely, and there is considerable vari­ ability in the predicted average propensity to save across sample periods and estimation methods (see Hubbard and Skinner, 1995). Also see Poterba, Venti, and Wise (1996) for an analysis of the Joines and Manegold estimates. 11. See Hubbard and Skinner (1995) for a detailed discussion of these issues. 12. More recently, Papke (1995) has estimated that there is no substitution of 40l(k) for defined contribution plans among large firms but that among smaller firms, the introduction of a 40l(k) plan increased the chance of termination of a defined benefit pen­ sion plan by about nine percentage points. The aggregate effects, however, would be small, given that small firms account for fewer than one-quarter of all employees with 40l(k) plans. 13. We have assumed that individual saving behavior is unaf­ fected by whether the government issues debt or pays for the IRA through increased taxation. To the extent that Ricardian equiva­ lence holds, private saving would rise by more when IRAs are fi­ nanced through debt. 14. Assuming the contributor plans to smooth withdrawals be­ tween age 65 and 80, age 72 is a midpoint. 15. Because ofthe higher return on stocks, the share ofstocks in the portfolio rises over the life of the IRA. 16. The marginal tax rate at retirement is assumed to be 24 per­ cent; the assumed equity share is 50 percent; and the average tax rate on interest, dividends, and capital gains is 26 percent. 17. We have already included the tax "wedge" between the gross and net-of-tax rate of return in our revenue cost measures. 18. See Hubbard and Skinner (1995) for a detailed discussion of these simulation estimates. References

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About the Authors

R. GLENN HUBBARD is Russell L. Carson Professor of Eco­ nomics and Finance, Columbia Univeristy; research as­ sociate, National Bureau ofEconomic Research; and vis­ iting scholar, AEI. He received his Ph.D. from Harvard University and has been a visiting professor at Harvard University and the University ofChicago. He was deputy assistant secretary ofthe U.S. Treasury Department from 1991 to 1992.

JONATHAN S. SKINNER is professor ofeconomics, Dartmouth College; senior research associate, Dartmouth Medical School; and research associate, National Bureau of Eco­ nomic Research. He received his Ph.D. from the Univer­ sity ofCalifornia at Los Angeles and taught most recently at the University of Virginia.

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AsSESSING THE EFFECTIVENESS OF SAVING INCENTIVES R. Glenn Hubbard and Jonathan Skinner

FUNDAMENTAL ISSUES IN CONSUMPTION TAXATION David F. Bradford