Economics 101: Taxes, Deadweight Loss and Savings

In the comments to this post there seems to be a problem with understanding the basic problem with taxes. The commenter ken writes the following,

Taxes are the lowest now than have been for a generation. That includes taxes on savings. Further lowering these taxes, either in general or specifically on savings will not work.

Increase the return on savings untill it is above the percieved value of some additional bling blings and savings will increase.

The problem is that this is precisely what lowering taxes would do, raise the return on savings. When a tax is levied on some good it has two effects. From the perspective of the demand side it raises the price. From the perspective of the supply side it lowers the price. The impact is to lower the equilibrium output. These effects are going to happen irrespective of who the tax is levied on (generally speaking). The following graph shows what happens,

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Now, for savings the price is the rate of return one earns on their savings. People, firms, etc. who save are the suppliers and those who borrow are the demand side. So, a tax lowers the rate of return for those who save, and thus lower the amount of savings. By the same token lowering the tax rate or even abolishing the tax rate on savings would increase savings. Would it be enough to put the savings rate back at where it was in say 1991/92? I don’t know, that is an empirical question and is beyond the scope of this post. There is also the consideration that lowering the tax and not raising another tax elsewhere to offset the decline in revenues could be worse than doing nothing.

Another thing to consider are the two triangles that are pointed out with the arrows in the picture. Those two triagnles comprise what is known in public finance circles as the deadweight loss of taxes. It represents transactions that would take place, but for the imposition of the tax. That is, the tax prevents some people from engaging in what they percieve as mutally beneficial transactions. The upper triangle is the loss to the consumers and the lower triangle is the loss to the producers. Together, these two triangles represent a loss to society that is not recovered.

Now, taxes are not the only thing that can affect the savings rate. There could be other things that could cause either the demand or the supply curve to shift and thus either raise or lower the amount of savings. It might be easy to blame the low savings rate on the budget deficit, but the problem with that story is that the decline in the savings rate started in 1992 and continued throughout the years where there was a budget surplus. In fact, the impact of deficits on interest rates and savings is hard to nail down. For example, there is what is known as the Ricardian Equivalence Theorem in macroeconomics. The idea here is that individuals in the economy realize that the budget deficit simply means higher taxes in the future so they buy the bonds the government sells and holds them until the tax rate goes up, then they sell the bonds to pay the taxes. In this case, the deficit has zero impact on the interest rate. Another issue is foreign investors. People in other countries might decide to invest their savings in the U.S. and hence could lessen the impact of a budget deficit on the interest rates and possibly allow the savings rate in the U.S. to decline.

The problem with the low savings rate in the U.S. is that if the foreign investors decide to stop investing or invest at a lower rate, then to continue running a deficit the individuals in the U.S. will have to save more, and to do that interest rates would have to rise. Further, people would be saving money vs. consuming it and current welfare and output might decline. Also, if the deficit spending is not adding to the nations capital (i.e., plant, machine, equipment, etc.) then it could result in lower production in the future as well.

This is not right-wing economics. It is not “supply-side” economics. It is pretty much standard bland neo-classical economics. Note that it does not exonerate Bush for letting the budget deficit get so out of hand. It does not say, “Ignore it; be happy,” but instead says, “We might want worry about this.” This is not an attempt to gloss over a problem, but and attempt to explain why the budget deficit and trade deficit might be serious problems. Dragging in partisan rhetoric simply clouds the issue.

FILED UNDER: Economics and Business
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. ken says:

    Steve, taxes have already been lowered on savings to no effect. The rate of savings kept falling. What makes you think (other than textbook theory) that all you have to do is keep pushing on that string for it to work?

    My points (made in the previous thread) are that firstly the low rate of savings has nothing to do with tax policy. The big savers (baby boomers) are retiring or cutting back savings outside of already maxed out 401ks. The following generation has never been a big saver outside of employer sponsered plans.

    And secondly, to increase savings people need to get more than a 2% CD return in a 3% inflationary environment. This cannot be achieved by tax reduction. Cut the tax to zero on the 2% interest and you are still below the rate of inflation.

    It’s like those pennies people leave on the counters of convenience stores. Ever wonder why nobody just picks them up? Same reason why people won’t bother to chase the pennies in a low return savings environment. Notch up the interest rates to 8 to 10 percent and people may start to give up their bling blings and put that money away for a rainy day. You are not going to achive that with a tax cut.

    Your repeated claim that reducing taxes on savings will increase savings in the face of counterfactual evidence that this is not happening earns you a place of honor among right wing nuts. Yeah, in theory it should work. But then in theory a bumblebee shouldn’t be able to fly.

    Economic theory is neutral. It is your partisan use of it that gets you in trouble. Like the administrations focus on the possibilities of WMD led them to lie to us about their actually being WMD you focus on the possibility (in some possible worlds) of a tax cut working to increase savings and ignore the reality that (in this world) it hasn’t.




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  2. ken says:

    ..the Ricardian Equivalence Theorem in macroeconomics. The idea here is that individuals in the economy realize that the budget deficit simply means higher taxes in the future so they buy the bonds the government sells and holds them until the tax rate goes up, then they sell the bonds to pay the taxes. In this case, the deficit has zero impact on the interest rate….

    As an institutional bond trader for over ten years why did no one ever tell me that was why my bank, credit union, insurance company, money manager, municipal, and other institutional customers were buying UST notes from me?

    And all this time I thought it was because of my charming personality.




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  3. Steve says:

    ken,

    You are a moron. First the Left bitches about the budget deficit. I post on why it might be a problem (i.e., I agree) and point to a possible solution and you have to drag in your partisan biases and try to read partisanship into eveyrthing. Get help, get medicated.




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  4. bryan says:

    I have to agree with the rate of return on simple savings being a major drawback. Even with a CD, you get basically squat return on bank savings. That doesn’t give a lot of incentive to keep money in the bank.




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  5. ken says:

    You are a moron. First the Left bitches about the budget deficit. I post on why it might be a problem (i.e., I agree) and point to a possible solution and you have to drag in your partisan biases and try to read partisanship into eveyrthing. Get help, get medicated

    Steve, if conservatives had any other solution to any economic problem, including the budget deficit, besides futher cutting taxes I might take you guys more seriously.

    As it is your single minded solution appears driven by idealogy rather than by facts and circumstances.

    And you think this makes me moronic? What is they say about people who keep doing the same thing over and over again each time hoping for a different result?




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  6. Steve says:

    Sure, a low interest CD is likely to offer a positive return. However, taxing what returns there are makes the situation worse, not better. Lowering that tax specifically makes the situation better not worse.

    What is so damn hard to understand about this? This can be proven quite simply:

    (1-t)*r < r, whenever t is in (0,1). Don't they teach about inequalities in 4th grade anymore? ken keeps harping about the low taxes. Well look at the data in the link in the other post. It looks like the decline in the savings rate moderated some around 2000/2001. Was it due to the tax cut? Maybe...maybe not. I don't know, but it is a possibility. I never said cutting taxes would result in a huge surge in savings, but that it would act to increase savings. Given basic economic theory this is a very reasonable assertion. Further, note that ken has offered not one single alternative policy. He says, "raise interest rates so that the return is more attractive than bling blings." Great...how the fuck do we do that? Can't cut taxes because ken doesn't seem to think that will do any good. So what is left? Government fiat? Yeah, price controls are a really great method of solving a problem. What other policies are their? Reducing the deficit? I'm not sure I see how that will work? American's simply aren't saving enough, it isn't of question of how they are saving. ken is emblematic of what is wrong with the Left. They have zip on ideas, generally speaking. All they know is that if somebody who is ideologically different than them offers a possible solution it must be bad because of ideology. That is just plain vanilla stupid.




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  7. Steve says:

    No ken you are a moron because you can’t address the issues I raise in my post. For example, like the moron you are you ignored this part of my post,

    There is also the consideration that lowering the tax and not raising another tax elsewhere to offset the decline in revenues could be worse than doing nothing.

    See, I note that cutting taxes alone might not be a good idea. Yet in your moronic partisan blindness you keep insisting that I have only one goal and that is cutting taxes. Clearly I indicated that making the tax cut revenue neutral (i.e., cut taxes on savings, but raise taxes elsewhere) might be the best course. It is for reasons like this that I think you are a low grade moron and that it is a minor miracle that your drool hasn’t shorted out your keyboard.




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  8. ken says:

    Steve, I have better things to do than trade insults with you all day long, not that it hasn’t been fun.

    Seriously though what solution do you see to our economic problems, whether they be low rates of saving, deficit spending or whatever that does not include or rely exclusively on cutting taxes?
    And when does cutting taxes become a problem rather than a solution?

    Having spent a great deal of time investing municipal money I can tell you first hand the problem caused when tax reciepts fall year after year: streets not swept, parks not maintained, libraries closed, schools shut down, police not hired, etc. Life for the residents of these municipalities become grimmer in a manner not considered by idealogues whose only purpose is to deny the public sector money.

    That is a view from the personal level. On the larger level though we have tax cuts adding huge amounts to our borrowing needs. I don’t need to go through all the potential problems that presents from a weakening dollar (and it’s replacement by the Euro as a reserve currency) to the potential for economic blackmail.

    I presented a solution in a previous thread that called for a restoration of fiscal responsibility. It is not an immediate cure but over the long run I believe it is our only hope.




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  9. Steve says:

    Seriously though what solution do you see to our economic problems, whether they be low rates of saving, deficit spending or whatever that does not include or rely exclusively on cutting taxes? And when does cutting taxes become a problem rather than a solution?

    What is your problem? I never said that the only answer is cutting taxes. That is a creation of your own fevered imagination. I noted cutting taxes for one particular problem. Taking that suggestion and applying it to other topics other than the one I was discussing is at the very least dishonest.

    Cutting taxes becomes a problem when it leads to more problems than it solves. I have actually posted on this before, but like a blithering jackass with blinders firmly in place you assume that I’d never actually do something like that.

    The problems with taxes are manifold, and this post tried to point out a few of them. I have posted more extensively on this over at my blog and I’m not going to repost them all here simply for your benefit.

    As for the rest of your post, I find it boring. You seem to be operating under some sort of delusion that I think deficits are just hunky dory. You couldn’t be more wrong…which by now is something you must be intimately familiar with.




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Economics 101

Matt Yglesias takes issue with his boss’ assertion that people will always choose $1.60 gasoline over $2.60 gasoline:

You’ve got an Exxon station selling gas at $1.50 a pop and I own the Gulf place across the street and set my price at $2.00 — am I crazy? Maybe not. Sure, “everyone” will go to your station, except that once everyone’s there, you’re going to have a very long line. People who are willing to spend more in order to save time will go to my station. You’ll have higher volume, but I’ll have higher profits-per-unit.

It could well be. Almost daily, I pay $5 in tolls to take a road that saves me a few minutes each way on my commute, bypassing a “free” road that is more congested.

As to gas prices, they fluctuate wildly–by 15 to 20 cents a gallon–on the five miles along Route 7 between my office and where I turn off to access I-66. And all of those stations are a few cents cheaper than the gas stations where I live. There seem to be a plethora of cars at all of the stations.

FILED UNDER: Economics and Business
James Joyner
About James Joyner
James Joyner is a Security Studies professor at Marine Corps University's Command and Staff College and a nonresident senior fellow at the Scowcroft Center for Strategy and Security at the Atlantic Council. He's a former Army officer and Desert Storm vet. Views expressed here are his own. Follow James on Twitter @DrJJoyner.

Comments

  1. Jeremiah says:

    I guess in a congested area this might be true, but I know where I live, I go for the cheapest gas, even if I have to drive to a station that’s farther away from the one I’m driving by.




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  2. Boyd says:

    I was thinking about this recently. I was driving down Algonkian Parkway and needed to fill up. I noticed that the Mobil was selling Regular for $1.79. When I got to the Shell about a mile down the road, I saw that they were charging $1.83. I pulled a U-turn and went back to the Mobil.

    On the way, I was thinking, “I need about 20 gallons, so at 4¢ a gallon, I’m saving 80¢. Why am I bothering?”

    Then it occurred to me that I prefer to “punish” the Shell station for having their price so high by withholding my patronage.

    Especially if it’s owned by some liberal punk like Matt.

    Note for the humor impaired: The Matt part is a joke.




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  3. Paul says:

    Setting aside gasoline prices and focusing on the larger point, the very existence of Wal-Mart proves Matt’s boss correct.




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  4. James Joyner says:

    Paul: Sure, in general, people flock to low prices. I prefer low prices for commodities and will even put up with the crappy service of WalMart for some of it. But WalMart also offers convenience–one stop shopping–that helps offset some of its service drawbacks. And the existence of stores that sell what WalMart does but at higher–soemtimes much higher–prices proves Matt is right: Price isn’t everything.




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  5. Jim says:

    I am sure that Jim knowns the Wall-Mart at Fairlakes. Before I moved to the DC area, I enjoyed shopping at the super-Walmarts. They were large, clean and had decent service. The ones in the DC area are small, dingy, cramped andquite horrible service. I am now a Target shopper: the prices are simular but the service and store layout beat Wall-Mart in every respect. So price isn’t everything. If that was the case everyone would eat at McDonalds and every restraunt would be out of business.




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  6. James Joyner says:

    Yep. The Wal-Marts here are absolutely awful. I don’t get it. I know this is a more affluent area but there are still a lot of people (including myself) who want low prices on commodities.




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  7. rammer says:

    this happened to me on 9/12/01. i had an 8:00 meeting and when i hopped into the car, she was empty. i went to the local place, but it was jammed with everyone topping off. rather than wait, i drove down the street to the “rip-off” station that is always higher. that day it was 30 cents a gallon more. but no one was waiting, so i filled up, went to work and was happy about it.




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