Economics 101: Taxes, Deadweight Loss and Savings
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,
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.