For years, policymakers have worried that America's
savings rate is too low. International comparisons often show that
the United States has one of the lowest savings rates in the world.
These numbers generate widespread anxiety, and for good reason.
Savings are the key to capital formation, and every economic
theory--even Marxism--teaches that capital formation is necessary
to raise wages and stimulate long-term economic growth.
To
some degree, the low rate of savings has been overstated.
Comparisons between the United States and other nations, for
example, sometimes are based only on personal savings rates. Such a
comparison does not provide an accurate picture of total savings,
however, since it does not include the reinvested earnings of
companies. Another common mistake occurs when observers focus
solely on the percentage of income that is saved in any given time
period. This measurement of "flow" ignores changes in the existing
"stock" of savings. Yet increases in the value of stores of wealth,
such as stocks and bonds, are just as important to the economy as
the additional amounts of savings generated out of annual
income.
Nonetheless, there is a strong case to be
made that America's savings rate is lower than it should be. Some
believe that Americans are too consumer-oriented and that corporate
management ignores long-term needs by placing too much emphasis on
quarterly profits. As it turns out, the major culprit is misguided
government policy. The tax code and various spending programs
combine to depress the savings rate and discourage savings. More
specifically:
-
The tax code, by imposing multiple
layers of taxation on capital, reduces the incentives to save and
invest and creates a bias toward consumption.
-
Government programs, especially Social
Security, eliminate or reduce many of the traditional reasons that
motivate households to save.
In
other words, government policy has undermined the incentives to
save. The tax code is heavily biased against savers. Taxes on
interest, dividends, capital gains, and estates raise the cost of
savings versus consumption and drain capital from the economy.
Government spending is equally hostile to
savings. Individuals used to save for their retirement; now the
government forces them to participate in Social Security. They used
to save for health care expenses; now they rely more and more on
Medicare, Medicaid, and other government health programs. Families
used to save to buy a home or send their children to college;
government programs now subsidize those activities as well. Workers
used to save in case they lost their jobs; government now has an
unemployment insurance program.
American consumers and businesses are not
foolish and shortsighted. They are responding logically to the
perverse incentives created by politicians. If anything, it is a
tribute to the American people that the nation's savings rate is
not even lower. Instead of blaming others, lawmakers who want to
boost the savings rate should work to change the policies that
undermine the reasons to save. In particular, savings would
increase if legislators would:
-
Eliminate the bias
against savings in the tax code, preferably by scrapping the
Internal Revenue Code and replacing it with a simple and fair flat
tax. A flat tax would abolish the present system's multiple
taxation of capital.
-
Replace the bankrupt,
low-return Social Security system with a system that allows
individuals to build up retirement nest eggs in privately managed
accounts. If Australia, Britain, Chile, Hungary, and Mexico can do
it, so can the United States.
-
Reform health care
entitlements and other government spending programs that weaken
incentives for individuals to plan and control their own lives by
saving for the future.
HOW TO MEASURE SAVINGS
Savings is a store of wealth and usually
can be converted into cash without great difficulty. A traditional
bank account is probably the first thing that comes to mind, but
there are many types of "savings." These include stocks and bonds,
retained business earnings (the profit not distributed to
shareholders), and any income that is invested rather than
consumed.
Savings and investment are different sides
of the same coin. Savings typically can be converted quickly to
cash, though certain types of savings, such as pension funds, and
individual retirement accounts (IRAs), are designed to foster
long-term savings. Savings usually generate income for the saver.
Some people, however, invest in gold, land, and collectibles in the
belief that traditional forms of savings are too risky or that
these assets will increase in value.
There is no consensus about how to measure
savings. Is it the value of all financial assets? Should it include
the value of land, collectibles, owner-occupied housing, and
consumer durables? The savings rate measures how much income is
saved in any given period. This is a "flow" measure. Chart 1 shows the personal
savings rate and the gross savings rate (which includes business
savings).
Interestingly, the personal savings rate
data released by the government are not based on an estimate of
actual savings. Instead, the rate is calculated by subtracting
consumption from income. One problem with this measurement is that
it cannot include unreported income earned in the underground
economy. This means that the actual savings rate is certainly
higher than officially reported.
Another way to measure savings is to
calculate the "stock," which is the value of all existing savings.
Chart 2 shows how the value
of financial assets has increased over time and also provides a
measure of the equity people have in their homes. Financial and
household assets are an important store of wealth and are part of
national savings.
WHY DO PEOPLE SAVE?
People who save are making a decision to
consume in the future rather than today. This allows them to build
wealth and protect against unforeseen expenses. Income that is
saved becomes an asset. Often that asset earns income, primarily in
the form of interest and dividends. Sometimes the asset goes up in
value, meaning that the individual benefits from a capital gain. If
the individual re-invests earnings, the asset increases in value
and the saver benefits from compounding. Ultimately, however,
people save because it will allow them to consume significantly
more tomorrow than they could today.
Individuals save for both the short term
and the long term. A youngster mowing neighborhood lawns may save
during the summer to buy a new bicycle. A young couple may save for
a few years to come up with the down payment for a new house. A
family may save for a decade to put a child through school. A
worker may save for 40 years to ensure a comfortable retirement. An
elderly couple may choose to live frugally in order to pass their
savings on to their children and grandchildren. In each case, the
act of savings results in consumption at some future point.
HOW THE TAX CODE PUNISHES SAVINGS AND HOW
TO FIX IT
A
neutral, fair tax system would not impose a higher burden on income
that is saved and invested than on income that is consumed. Doing
so reduces savings. Yet, as Chart 3 illustrates, that is
exactly what happens under current law.
The
most obvious bias in the tax code is the double tax on savings. A
taxpayer who spends his after-tax income incurs little or no
federal tax liability. The taxpayer who saves and invests the money
is not so fortunate. Even though the income was taxed when first
earned, any interest or other earnings generated by that income is
subject to an additional tax. To make matters worse, because of
capital gains taxes, double taxation of dividend income, and death
(estate) taxes, some income is taxed three or four times.
This
bias against savings and investment should be eliminated. For
income that is saved, this can be accomplished in one of two ways.
The first would be the traditional IRA approach, which allows the
taxpayer to defer taxation on income that is saved until the money
is withdrawn, at which time the tax is applied to both the original
income and any returns. The second approach, known as the
back-ended or Roth IRA, would tax all income the year it is
earned--including income that is saved--but all subsequent
withdrawals, including any interest or other earnings, would be
spared the second layer of tax.
A
neutral tax code also would require the elimination of the capital
gains tax and the death tax. The capital gains tax is nothing more
than a tax on the change in the value of an asset purchased with
after-tax dollars. Taxing that gain penalizes those
who save and invest rather than consume. The death tax is a levy
imposed on the transfer of assets that have been accumulated with
after-tax dollars. Like the capital gains tax, the death tax
punishes the act of savings and drains capital from the
economy.
The
double taxation of savings can be eliminated by adoption of a flat
tax that treats all taxpayers and all income equally. Such
fundamental reform would repeal all provisions of the current tax
code--including the capital gains tax, the death tax, and the
double tax on dividends--that tax income twice.
Finally, no discussion of the tax code's
impact on savings would be complete without mentioning the
aggregate burden of taxation. According to the Tax Foundation, the
average family now works until May 10 to earn enough income to
satisfy the demands of federal, state, and local tax collectors.
Forty years ago, "Tax Freedom Day" was April 9. Losing an
additional month of income to taxes has forced families to cut back
in other areas. Since spending on food, shelter, and other
necessities cannot be eliminated, families have had little choice
but to save less.
HOW SOCIAL SECURITY PUNISHES SAVINGS AND
HOW TO FIX IT
One
of the primary reasons workers save is to build a nest egg for
retirement. Social Security significantly reduces this reason to
save by giving all seniors a monthly payment from the
government.
The
negative impact of Social Security on savings has been confirmed by
numerous scholars. A global study conducted by the World Bank found
that government systems undermine savings, and this conclusion is confirmed
by the American experience. Analysis of household behavior in the
United States indicates that every dollar of perceived Social
Security benefit reduces private savings by 60 cents. Even a study
co-authored by a researcher at the Social Security Administration
confirms that "a dollar of Social Security wealth substitutes for
about three-fifths of a dollar of fungible assets."
Privatization would reverse this corrosive
effect, replacing a system that drastically reduces savings with an
approach based on real savings. Unlike the current system, which
takes payroll taxes from workers and immediately transfers them to
retirees, a private system is based on the principle that workers
must set aside a certain percentage of their income every year.
Countries that have privatized their
retirement systems have seen their savings rates skyrocket. In
Chile, for example, the savings rate increased by at least 150
percent during the 1980s. As Chart 5 shows, total savings in
the newly privatized Australian system already has reached more
than AUS$300 billion, and the government expects the savings rate
to climb by about 3 percent of gross domestic product (GDP) by
2020.
Britain's private pension pool--which
already is worth over £650 billion (over $1 trillion in U.S.
dollars)--is rapidly approaching the value of the country's annual
economic output. (See Table
1.) In fact, it is larger than the private pension funds of all
other European countries combined. Singapore, which never made the
mistake of creating a government system in the first place, has the
highest savings rate in the world. There is every reason to think
the same thing could happen here; one recent study, for example,
estimates that privatization would boost the U.S. savings rate by
2.6 percent of GDP by 2010.
THE IMPACT OF OTHER GOVERNMENT PROGRAMS ON
SAVINGS
Social Security may be the government's
biggest anti-savings program, but it is not the only one. Many
other programs provide subsidies that reduce or eliminate the need
for savings. Policymakers may believe that benefits from these
programs offset the damage to savings rates, but such benefits do
not change the fact that the subsidies undermine savings.
Consider:
-
Health Programs. Medicare, Medicaid, and other programs
provide large subsidies to consumers. These subsidies in many cases
reduce or minimize the need for households to engage in
precautionary savings for unexpected expenses. These programs also
have supplanted private insurance, which is based on savings since
companies invest premiums.
-
Education Programs. Subsidies for higher education reduce or
minimize the need for certain households to save for education
expenses. Government grant and loan programs either replace savings
with direct subsidies or replace savings with debt. Indeed, some of
these programs undermine savings even further since students may be
ineligible for handouts if the family has too many assets.
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Housing Programs. Through the Federal Housing Administration,
the Farmers Home Administration, and the Department of Veterans
Affairs, the federal government runs mortgage insurance, direct
loan, and loan guarantee programs that have the effect of reducing
the down payment requirement for home purchases. This increases the
default rates (since owners have less to lose if they walk away
from a mortgage) and the cost to government; it also gives people
less reason to save.
-
Unemployment
Insurance. Workers traditionally
had an incentive to set aside a portion of their income to tide
them over during unexpected periods of unemployment. Often, they
would participate in mutual aid societies that collected and
invested premiums. The government's pay-as-you-go system
discourages these savings-based approaches by providing benefits
for the unemployed.
Although it is clear that these government
programs undermine savings, exactly how much they do so is not
clear. Unlike tax policy and Social Security, these programs have
not been subject to a great deal of research attempting to quantify
their impact on the savings rate. This lack of research can be
explained by the perception that the impact is relatively small
compared with the effect that taxes and Social Security have on
savings.
QUESTIONS AND ANSWERS
Q. Why do
savings matter?
A. Savings are important
because they are the key to capital formation, and capital
formation is necessary for economic growth and rising wages. This
is recognized by every economic theory, even Marxism. Without
savings, it would be impossible to build factories, purchase
equipment, conduct research, and develop technology. It is savings
that allows an American farmer to buy advanced equipment to
increase the productivity of his farm, and therefore the income he
earns. It is savings that allows a business to purchase equipment,
and it is the new equipment that allows a factory to produce
more--thereby raising the income of workers and owners. (See Chart 6.) It is savings that
allows venture capitalists to take risks and invest in the
Microsofts of tomorrow.
President Clinton's Council of Economic
Advisers may have explained it best in the 1994 Economic Report of
the President:
The
reasons for wanting to raise the investment share of the GDP [gross
domestic product] are straightforward: Workers are more productive
when they are equipped with more and better capital, more
productive workers earn higher real wages, and higher real wages
are the mainspring of higher living standards. Few economic
propositions are better supported than these--or more important.
Q. Does
more savings mean more investment?
A. Yes, but increasing
the savings rate is only part of the investment picture. A nation
can have a very high savings rate, for instance, but if high taxes
on capital encourage savers to invest their money overseas, workers
will not be able to reap the benefits of increased investment. It
is important not only where savings are invested, but also how
savings are invested. The former Soviet Union had very high rates
of saving and investment, but the people did not benefit because
government planners, rather than market forces, decided how savings
were invested. Similarly, Singapore has a mandatory system of
saving for retirement, but the government controls how the funds in
the individual retirement accounts are invested. As a result, the
accounts earn lower returns and the workers do not benefit as much
as workers in countries with privatized Social Security systems
that allow professional pension fund managers to direct the
investment.
Q. Is
consumption bad?
A. Not at all. Indeed,
the purpose of savings is to increase consumption over time.
Countries with high levels of private capital formation have higher
levels of per capita income. This translates into higher levels of
consumption. High savings rates, it should be noted, simply are a
measure of when the income is being consumed.
Although consumption is not bad,
government policies that penalize savings clearly are ill-advised.
Such policies may increase short-term consumption, but only at the
expense of savings and future consumption. Over time, the lack of
savings and investment in an economy will reduce income growth and
lead to significantly lower levels of consumption.
Q. What
role do interest rates play?
A. Interest rates are a
measure of the return on savings. Interest rates also reflect the
value individuals place on future consumption versus current
consumption. An individual may choose to save $100 if this will
allow him to consume $105 one year from now (a 5 percent return).
Or he may choose to consume today if the return on savings is only
3 percent (meaning $100 of savings will give him only $103 for
consumption one year from now).
Interest rates help determine whether
investments are viable. If a new factory is expected to earn a 10
percent after-tax return, investors may be willing to provide debt
financing (bonds) or equity financing (stocks). At a 5 percent
return, however, investors may choose to place their funds
elsewhere. Interest rates also help adjust for risk. Risky loans
command higher interest rates to protect the lender from the risk
of default. Safe investments like U.S. Treasury Bills, by contrast,
earn relatively low returns. Venture capitalists understand that
many of their investments will be complete busts, but the
investments that do pay off generate such high earnings that the
losses elsewhere are offset.
Some people complain at times that
interest rates are too high, thereby discouraging investment.
Others complain that interest rates can be too low, thereby
discouraging savings. There is no right interest rate, however.
Interest rates are simply market prices that help allocate credit
based on risk, taxes, and individual preferences for current and
future consumption.
Q. Are
budget deficits bad for savings?
A. Government borrowing
is believed to be counterproductive because the programs upon which
the money is spent consume savings that could be used for
productive investment. It is important to realize, however, that
budget deficits are a symptom. The real problem is that government
spending diverts resources from the private sector. Whether the
spending is financed by taxes or borrowing, the damage occurs
because politicians do not have incentives to use the money wisely.
Replacing debt-financed spending with tax-financed spending simply
trades one ill-advised policy for another. Indeed, because real
interest rates on government debt are so low and foreign savings
can be relied upon to finance the deficit, it is almost certain
that raising taxes to reduce government borrowing will reduce
America's growth rate. (See Chart 7.)
CONCLUSION
The
United States is not suffering from a savings crisis. There is no
question, however, that Americans would be better off if the
national savings rate increased. The problem is clear: Government
tax and spending policies simultaneously penalize savings and
remove the incentives to save. The two biggest culprits are the
current tax code and the Social Security system. Fortunately,
solutions are readily available.
First, a low-rate, consumption-based tax,
such as the flat tax, would remove the tax code's bias against
savings and investment. Second, Social Security reform should
include a system of individual accounts to allow workers to invest
a portion of their payroll taxes privately. Not only would these
accounts boost the savings rate, but they would enable workers to
retire with more income than they would have received from the
actuarially bankrupt Social Security system. These tangible, wise
decisions would correct some of the government's current policies
that most discourage savings in America.
Daniel
J. Mitchell, Ph.D., is McKenna Senior Fellow in
Political Economy at The Heritage Foundation.
Endnotes