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. Distributed to the Trade by National Book Network, 15200 NBN Way, Blue Ridge Summit, PA 17214. To order call toll free 1-800-462-6420 or 1-717-794-3800. For all other inquiries please contact the AEI Press, 1150 Seventeenth Street, N.W., Washington, D.C. 20036 or call 1-800-862-5801. ISBN 0-8447-7071-X 1 3 5 7 9 10 8 6 4 2 © 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.