The Savings Rate Problem

Jon Henke has an informative post on one of the problems facing the U.S., the dismal savings rate.

By all accounts, the US is drowning in the Twin (Budget and Trade) Deficits. The effect on the dollar has already become obvious, and Paul Volker has suggested there is “a 75% chance of a currency crisis in the United States within five years“. Heightened interest rates, recession, and the fall of the dollar as a world currency are being discussed as anything from distinct possibilities to probabilities.

In looking at the chart, the savings rate started to decline in 1992, and declined throughout the rest of the 1990’s at a pretty consistent pace with periodic swings in each direction. Around 2000 it leveled off somewhat but it still looks like there is a downward trend. Why? I don’t know.

One possible solution is to stop taxing income and in particular interest income from savings. To some extent this happens with 401k plans that have deferred taxes (yes I know the taxes are deferred not eliminated). This would raise the after-tax interest rate to be equal to the pre-tax interest rate. This would induce both more people to save and those who are already saving to save more.

Another policy response is a consumption tax. However, the consumption tax provides a tax break only for new savings. Income that is spent from “old” savings would still be taxed. Thus, the asset value of existing savings is eroded away. Think of it this way, suppose you have $10 in your savings account. You withdraw it and spend it. Under an income tax you pay no taxes. With a consumption tax you’d pay taxes on the $10 you want to spend and in effect you couldn’t spend the $10, but something like (1 – t)$10 (where t is the consumption tax).

Thus, there could be a problem in making a swicth from the income tax to the consumption tax. The person with that $10 in the bank would have an incentive to withdraw it prior to the implementation of the consumption tax and spend it. Thus, prior to the implementation of the consumption tax, the savings rate could drop even lower. Another consideration is that a consumption tax would pretty much have to get rid of the interest deduction. The deduction for things like home mortgage interest acts as an incentive to spend (buying a house) and the idea here is to promote savings, not spending.

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. Alex Knapp says:

    A consumption tax is also horribly, horribly regressive, because those people who can’t afford to save very much money (ie, poor families with young children) now have to use still more of their disposable income on taxes. What’s worse, since most people in those demographics work in retail service and restaurant trades, a consumption tax provides a double whammy of decreasing revenues in those industries, resulting in job losses.

  2. The Twin Deficits gave Me an 80s flashback. I remember constant “news” stories and editorials.

  3. ken says:

    The biggest reason why savings rates have fallen is because the biggest savers, the baby boomers, are starting to retire. Those still working are not saving as much, because quite frankly, there is no point in putting money into a 2% CD at the bank when inflation is running 3% or higher. The boomers lived through high inflation before and know how it kills savers and rewards spenders.

    Younger generations have never been savers outside of tax favored 401k plans, TSAs, SEPs and IRAs.

    Your solution to reduce taxes on savings is a joke, right? Taxes are are the lowest point in a generation. Further pushing on that string will not work. You are not going to get a generation Xer to give up current bling bling consumption for a miniscule spif in favor of savings.

    There is a real solution however and it is called fiscal responsibility. Taxes could be raised on the wealthiest 2% of taxpayers and if the money is used to reduce deficit spending it will have a similiar effect as increased savings with the added advantage that it would actually work.

  4. Steve says:

    Your solution to reduce taxes on savings is a joke, right? Taxes are are the lowest point in a generation. Further pushing on that string will not work. You are not going to get a generation Xer to give up current bling bling consumption for a miniscule spif in favor of savings.

    Do you have to work at being this dishonest ken? I didn’t say reduce taxes, but reduce taxes on savings. Nice job at shifting the sands there.

    There is a real solution however and it is called fiscal responsibility. Taxes could be raised on the wealthiest 2% of taxpayers and if the money is used to reduce deficit spending it will have a similiar effect as increased savings with the added advantage that it would actually work.

    Now who is the joker? Ever heard of Friedman’s Permanent Deficit hypothesis? Basically it states that politicians have a tolerable deficit. That is they’ll accept a deficit that is say x% of GDP. Thus, there is an incentive on the part of politicians to run a deficit.

  5. Teri says:

    What year did they phase out the credit-card interest deduction? I wonder how much of the savigs dip is from people paying more on their credit cards because they didn’t get any benefit from racking up the interest?

    (Not that I am suggesting that is a good idea – but as a 20-year tax preparer I know that people will do insanely stupid things to get a tiny tax deduction.)

  6. ken says:

    Steve, you are using, poorly I might add, the typical conservative talk show rhetorical trick of misrepresenting a small detail in order to misrepresent the point someone is making. Your hope is that the detail is small enough that no one focuses on the misrepresentation.

    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.

    If you don’t want to be criticized for right wing nuttery don’t engage in it.

    Friedman has no credibility. He is a right wing hack. Clinton proved that politicians could balance budgets and actually run down the accumulated debt using budget surpluses. If you want to claim they are helpless victims of their own ideology please be sure to point out that it is the conservative ideology that they are the victims of. Democrats have proven it is possible to do what Republicans are incapable of doing.

  7. Steve says:

    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.

    That is precisely what cutting the tax (or even eliminating it) on interest would do! Are you being this dense on purpose or what?

    Reducing the deficit is likely to have little impact, IMO, since the decline in the savings rate started when there was a surplus.

    Your complete inability to take of your political blinders has left you unable to look at a situation without trying to pin the blame on conservatives and/or Bush in particular.

    Friedman has no credibility. He is a right wing hack. Clinton proved that politicians could balance budgets and actually run down the accumulated debt using budget surpluses.

    Robert Rubin admits that a large part of it was luck. Granted he (and Clinton) get some credit, but a large part of what occurred that allowed for the surpluses was out of the President’s hand.

    As for conservative/right-wing nuttery, WTFAYTA? Raising taxes on something raises the price for buyers and lowers the price for sellers. This is called: Standard Economic Theory. There is nothing right-wing about it. Here look at this picture and study it real hard

    http://www.steveverdon.com/archives/image001.gif

    You can find pictures like that in just about any decent public finance book (e.g. Atkinson & Stiglitz–and by the way Stiglitz is a liberal).

    In the case of savings, people are the suppliers (by and large). Hence a tax on interest income reduces the interest rate (i.e., the price) and reduces supply. It also increases the price from the demanders perspective and that decreases demand by the same amount.

    Why don’t you try to familiarize yourself with basic economic theory instead of advertising your ignorance of said topic…repeatedly.

  8. Dave Schuler says:

    I wonder what the secondary effects of an increase in the savings rate would be. Since an increase in savings would mean a reduction in consumer spending, wouldn’t a substantial increase in the national savings rate cause a radical re-alignment of the economy from consumer goods to things purchased by businesses? And wouldn’t this in turn have very serious implications for foreign economies?

  9. ATM says:

    Clinton proved that politicians could balance budgets and actually run down the accumulated debt using budget surpluses.
    No the only thing he proved was that it was possible to balance the budget and run surpluses at a time when transistor size and thus transistor performance and count per chip made robust, easy to use computers with enough memory and processing power to run relatively quickly relatively affordable. It also made high speed wireless communications and wired broadband networks possible. The budget was balanced because of increased tax revenue from corporate profits and capital gains from the booming stock market which was largely driven by growth in the tech sector. These technologies would not have been possible any sooner because the transistor densities and performance levels would not have been achieved any sooner than the 90s for the simple reason that the improvement in the fundamental trait of a transistor that determines all of the above follows Moore’s law. Had the transistor and the integrated circuit been invented ten years later, there would have been no boom under Clinton (assuming Clinton was president during the 90s) like we saw in the 90s, and likely no balanced budget.

    The other thing he proved was that it was easy to balance the budget in the short term when the stock market and dollar spirals upward rapidly, encouraging overseas investors and central banks to push our currency up even higher while they dump money into a stock market bubble, all the while slowly poisoning American manufacturers by making their products more expensive abroad and less competitive at home, thus reducing the profits that would be the basis of a high stock market valuation. Unfortunately the bubble also encouraged Americans to invest large portions of their savings in a bubble market, which was destined to burst. The good news is that we managed to swindle some foreign investors out of their money while generating some good technology in the process. The bad news is that a lot of useless stuff was also created, Americans lost some of their savings, and foreign competition became entrenched because it was quite profitable to export to the US due to the relative weakness of their currencies while American companies were forced to squeeze costs by cutting profit margins or sourcing labor and components from overseas. The increased competitiveness of foreign competion and decreased profitablity of American companies naturally meant the stock market would have to correct itself as P/Es were sky high, and that the dollar would have to become weaker before companies would start having pricing power here and abroad and finally see profits increase.

  10. ATM says:

    A consumption tax is also horribly, horribly regressive, because those people who can’t afford to save very much money (ie, poor families with young children) now have to use still more of their disposable income on taxes. What’s worse, since most people in those demographics work in retail service and restaurant trades, a consumption tax provides a double whammy of decreasing revenues in those industries, resulting in job losses.

    Only if you replace the income tax completely and tax all types of consumption and suddenly switch taxation schemes. I would prefer to see a consumption tax that was ramped up slowly while income tax brackets were ramped down, with lower brackets decreased more. The consumption tax ought to be aimed at higher value goods and services, and the final rate should be no more than 5-10%.

    It is true that people in the lower income brackets tend to work in the retail and restaurant sectors. It is also true that these sectors don’t generally generate much wealth and often export wealth. If the shift towards more consumption taxation increased savings and investment rates in domestic manufacturing industries, then higher paying manufacturing jobs could be created. In the absence of increased consumption taxes, it is likely that we will see an increase in our trade deficit and a drop in our currency. This will hurt the buying power of lower income people anyway. A consumption tax may be the best way to maintain the strength of our currency and our economy.

    Since an increase in savings would mean a reduction in consumer spending, wouldn’t a substantial increase in the national savings rate cause a radical re-alignment of the economy from consumer goods to things purchased by businesses? And wouldn’t this in turn have very serious implications for foreign economies?

    Yup. They have built their economies around our consumption. They use the proceeds to invest in more advanced industries using knowledge and technology they buy from us.

  11. ken says:

    Clinton proved that politicians could balance budgets and actually run down the accumulated debt using budget surpluses.

    No….blah, blah, blah…..

    No? Better look again.

  12. 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 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.

    But right now, spending money, particularly on housing, is the smart choice.

  13. Steve says:

    Those still working are not saving as much, because quite frankly, there is no point in putting money into a 2% CD at the bank when inflation is running 3% or higher. The boomers lived through high inflation before and know how it kills savers and rewards spenders.

    First, the above probelm with a 2% CD and 3% inflation means it makes little sense for anybody to save, let alone the boomers. Second, there are other saving vehicles that have better rates of return. Third, 3% inflation is not high inflation.

    It is amazing you can go through life with such a bad grasp of facts or history.

    There is a real solution however and it is called fiscal responsibility. Taxes could be raised on the wealthiest 2% of taxpayers and if the money is used to reduce deficit spending it will have a similiar effect as increased savings with the added advantage that it would actually work.

    No, it will not have the same effect as raising savings. Lowering the deficit would remove part of the problem with low savings rate and the budget deficit, but it isn’t clear what it would do for the trade deficit. Further, raising taxes by a sufficient level to eleminate the deficit would most likely cause a recession (unless done slowly). Recessions are probably not good for savings. Further, raising taxes on income will acutally raise taxes on interest income and create even less incentive to save than there currently is.