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November 06, 2008

Saving and taxes

I hope you will excuse me for trading in a bit of old news, but I’ve been thinking about a post by Greg Mankiw from last week. Titled “My Personal Work Incentives,” the item takes published details of the McCain and Obama tax proposals. The essence of the post was to point out how these details impact the return to working for higher-income individuals, assuming that a marginal dollar earned is a marginal dollar saved (for the children, of course):

“Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:

(1-t1){[1+r(1-t2)(1-t3)]^T}(1-t4).

“For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years…

“Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

“Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario.”

Since the election is over, I trust that fact will keep the focus on the essential economic point, which is that tax policy does indeed affect incentives.

Which brings me to my point. Using Mankiw’s interest rate assumption, the present value of McCain’s $4.81 is $0.17 (which is implied directly by the 83 percent marginal tax rate). The comparable figure for Obama’s $1.85 is $0.07.

Mankiw’s point is that these sorts of numbers would substantially change his incentives to work. If the whole point is to leave a little nest egg for the kids, that is surely true, but there is another choice.

Here is another possibility: Suppose I forgo provisioning for the children altogether and simply consume that extra dollar of income. That way I avoid the corporate tax, dividend and capital gain tax, and the estate tax altogether. Under the McCain plan I get to enjoy $0.65 worth of extra consumption, or $0.57 worth under the Obama plan. I would have to value my children’s consumption an awful lot to trade $0.65 (or $0.57) of my own for $0.17 (or $0.07) of theirs.

As I think about this example, I am naturally drawn to the fact that savings rates in the United  States are, in an historical context, pretty darn low.

Personal Saving as a Percent of Disposable Income

There are almost certainly multiple reasons for the pattern shown in this chart. It would be tough to make the case that tax policy is the only culprit, but it would be equally tough to argue that it is irrelevant.

The distortion on saving from capital-income taxation could be eliminated, of course, by simply eliminating taxes on saving, but doing so would have exactly the sort of distributional consequences that account for a good deal of difference in the Obama and McCain tax plans in the first place. My training as an economist gives me no special expertise in determining how to value the trade-off between “fairness” and efficiency—and beware of any economist who pretends otherwise. But as you contemplate the distortions presented by your favorite tax proposal—a required step in any complete analysis—you might consider putting disincentives to save fairly high up on the list.

 

November 6, 2008 in Saving, Capital, and Investment, Taxes | Permalink

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Comments

I know this was not your point, but can you literally post Mankiw's analysis without discussing how few estates are actually subject to the inheritance tax? Is there any data that suggests that even if this extremely small sliver of the population subject to the estate tax actually does work less because of "disincentives," that overall output is lower (i.e., that those not subject to the estate tax do not "pick up the slack")? Is there any data that suggests that the money sent to the government via taxation does *nothing* to benefit this hypothetical worker's children? Do the taxes paid over to the government simply go into a hole? Is it impossible that any portion of those taxes actually benefited the children? Is it impossible that some high earners take pride in paying taxes while knowing that at least some small portion of the taxes are being used to build the communities in which their children will live? Do people have absolutely no incentive to help their communities unless they get a hospital wing named in their honor? With all due respect, let's admit that the incentives argument is usually far, far more complex than any blog post will ever be able to relate.

Posted by: Anonymous | November 06, 2008 at 04:50 PM

Except that the top tax rate from 1936-1981 was 70% or higher.

Corporate tax rates were 46% or higher from 1951-1986.

I can't find convenient numbers on estate and capital gains rates, but even Obama's proposals are at historically low levels.

But just with those two rates, his return would only be $1.89 in the 1970's. Factoring in 15% cap gains, and 15% estate taxes, and you get $1.22 for a 1970's investor vs. $1.85 for Obama's plan.

I'd speculate that 5-year CDs rates under 3% had something to do with the savings rate in the 2000's. Somewhat risky investments, like stocks, weren't doing significantly better.

And you could borrow money at single digits (in some cases low single digits).

And assets were increasing generating apparent wealth for everyone.

But I don't think it has to do with our (historically) relatively low tax rates.

Posted by: SKG | November 06, 2008 at 06:43 PM

Also, for example, a plumbing company entrepreneur with after tax NI of 250K plus would save more in taxes by hiring another worker at his newly purchased firm under the Obama than the McCain plan Since the deduction amount is higher against a higher marginal rate.

Furthermore the new worker pays payroll and income taxes which do not get dynamically scored, which means raising taxes raises employment rates AND total tax revenues. I'm sure the WSJ opinion page will cover this anomaly extensively.

Posted by: VennData | November 06, 2008 at 08:52 PM

Very interesting, as was the original.

However, wouldn't the analysis need to consider the implications of the two candidates' tax and spending plans on future deficits (and therefore, taxes for the children)?

In other words, I could propose a plan where we cut taxes to zero and borrow the entire federal budget. According to this analysis, that would yield a bigger inheritance and provide a greater incentive to work. But the kids doing the inheriting are going to have to pay that back through higher taxes. I worked hard, but it was a shell game. The kids just got taxed more later.

I think this analysis misses something that is missing from our political system as a whole - a clear distinction between a tax cut and a tax deferral.

Posted by: Chris | November 06, 2008 at 10:16 PM

Mankiw's math is suspect.

Why would he pay capital gains/dividend tax on 100% of his gross investment return every year? This implies 100% turnover of his investments every year. Why does he assume the entire investment will be taxed at the estate tax rate? Why does he assume that tax rates 35 years from now will be set by either 2008 Presidential candidate?

His boldest assumption is that the long-term value of r is invariant with respect to t1..t3. In a low-tax environment in which the National Debt increases geometrically over time, it is not obvious to me that r will stay constant or increase over time. It is plausible that the long-range value of r would be higher in a moderately higher tax rate environment.

Following Mankiw's logic, Warren Buffett would have never started investing.

Posted by: OreGuy | November 06, 2008 at 11:43 PM

For the life of me I can't understand any discussion dealing with tax reductions when I see the real issue as being over spending by the federal government. It seems as if this particular issue is never addressed by the media or elsewhere.

When was the last time the white house or members of Congress actually owned a company that hired people and put them to work verus talking about job creation that they have nothing to do with!!! any thoughts would be appreciated.

Norm

Posted by: norman | November 10, 2008 at 08:30 AM

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