Federal Tax Reform and Its Potential Effects on Saving

Federal Tax Reform and Its Potential Effects on Saving

Order Code RS22367
January 26, 2006
CRS Report for Congress
Received through the CRS Web
Federal Tax Reform and Its Potential Effects
on Saving
Gregg A. Esenwein
Specialist in Public Finance
Government and Finance Division
Summary
It is often argued that the saving rate in the United States is too low. Many
observers suggest that the federal tax system can provide an effective way of increasing
the U.S. saving rate. Indeed, one of the major directives to the President’s Advisory
Panel on Federal Tax Reform was to recommend modifications to the tax system that
would provide simple and straightforward ways for Americans to save free of tax,
which, they argue, would increase saving in the United States. The panel recommended
two reform options, one based on the current income tax system and the other based on
a hybrid income/consumption-based tax. The panel considered, but did not recommend,
a pure consumption-based tax.
Two observations can be drawn from the analysis contained in this report with
respect to the effects of tax reform on the level of saving. First, public dissaving in the
form of federal budget deficits reduces net national saving. So, if tax reform adds to the
federal budget deficit, then, everything else being equal, tax reform would reduce net
national savings. Second, even if tax reform is revenue neutral, the offsetting nature of
income and substitution effects reduces the chances that changes to the tax system alone
will increase saving. Indeed, because economic theory is not clear and because of the
lack of compelling empirical evidence, it cannot be determined conclusively whether
moving to a pure consumption tax would significantly increase the level of saving in the
economy. This report will be updated as legislative action warrants.
Recommendations of the President’s Advisory Panel
The President’s Advisory Panel on Tax Reform was tasked to issue a report with
revenue-neutral policy options for reforming the federal Internal Revenue Code.1 Another
major directive to the advisory panel was to recommend modifications to the tax system
1 U.S. President (Bush), “President’s Advisory Panel on Federal Tax Reform,” Executive Order
13369, Federal Register, vol. 70, no. 008, Jan. 12, 2005.
Congressional Research Service ˜ The Library of Congress

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that would provide simple and straightforward ways for Americans to save free of tax,
which, they argue, would increase saving in the United States.
In its November 2005 report, the President’s panel presents two major options for
reforming the federal tax system. The first option is the Simplified Income Tax Plan
(SIT).2 This plan basically starts with the current federal income tax system and makes
incremental changes (albeit significant changes in some areas) to achieve its stated goals
of making the tax system simple, fair, and more conducive to savings and growth. Under
this plan, the various incentives for saving under current law would be replaced by three
new and expanded saving programs (Save at Work, Save for Retirement, and Save for
Family) and a refundable savers tax credit. This plan would also “introduce a more
consistent treatment of savings held outside of tax-preferred accounts.” The plan would
exclude 75% of the capital gains on sales of stock in U.S. corporations and eliminate the
taxation of corporate dividends earned in the United States.
The advisory panel’s second reform option is a hybrid income and consumption tax
called the Growth and Investment Tax Plan (GIT). Basically, it contains the same three
new savings programs as under the simplified income tax and the refundable savers tax
credit. (Contributions under the Save at Work program under the GIT plan would be
made on an aftertax basis rather than on a pretax basis, as would be the case under the
SIT plan.) Unlike the first option where capital income from the corporate sector would
be tax exempt or taxed at reduced rates at the individual level, the GIT plan would
impose a 15% flat tax on all capital income from savings outside of these three new
accounts.
As described in the panel’s report, the Growth and Investment Tax Plan deviates
from a pure consumption tax by imposing this 15% tax on the return to savings on income
earned outside of the three savings programs. Although the panel considered a proposal
for a pure consumption tax, which it called the Progressive Consumption Tax Plan, that
option was not included in the panel’s final recommendations to the President.
Nevertheless, some observers, including several panel members, believe that adopting a
pure consumption tax would be the best way to increase private saving.

What Is the Saving Rate?
Sometimes there is confusion over what actually constitutes the saving rate in the
United States. There are many different rates of saving and alternative means of
measuring them. As a result, some discussions of the U.S. saving rate essentially end up
comparing apples and oranges.
In the National Income and Product Accounts, total saving in the economy is
composed of two major parts: private saving and public saving.3 Private saving can be
further broken down into its components, personal saving and business saving. Personal
2 Simple, Fair, & Pro-Growth: Proposals to Fix America’s Tax System, The President’s Advisory
Panel on Tax Reform, Nov. 2005.
3 For a more detailed discussion of saving as defined in the National Income and Product
Accounts and for a discussion of saving as a policy goal, see CRS Report RL32119, Can Public
Policy Raise the Saving Rate?, by Brian W. Cashell.

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saving represents household aftertax income not used for consumption. Gross business
saving represents the portion of aftertax profits retained after distribution of dividends and
the funds set aside to replace plant and equipment that has worn out (depreciated). Net
business saving is calculated by subtracting depreciation (the portion of gross savings that
is applied towards replacing facilities and equipment that has worn out) from retained
earnings.
Net private saving is the sum of personal saving and net business saving.
The second major component of total saving is public sector saving (government
saving). Public sector saving includes government at the federal, state, and local levels.
If the net budget position of the public sector is in surplus, then the public sector is a net
saver. If the net budget position of the public sector is in deficit, then the public sector
is a net dissaver.
Net national saving is the sum of net private saving and public saving. It is
important to note that net national saving can change (increase or decrease) if either net
private saving or public saving changes.
Tax Reform and Revenue Neutrality
As outlined in the preceding paragraphs, if there is an increase in the federal deficit
then, absent any offsetting changes, net national saving will go down. Therefore, the
effects of tax reform on federal revenue will have a direct bearing on the level of saving
in the economy. If, under tax reform, federal revenues fall and the deficit increases, then
net saving will decrease. Conversely, if federal revenues rise and the deficit decreases,
then net saving will increase.
How do the advisory panel’s proposals affect federal revenue? The panel was tasked
to issue a report with revenue-neutral policy options for reforming the federal Internal
Revenue Code. However, the executive order establishing the advisory panel specifies
neither the baseline nor the time horizon for achieving revenue neutrality.
The Congressional Budget Office (CBO) produces baseline projections of the budget
semi-annually so that policymakers have a common starting point from which to debate
policy changes. The purpose of the baseline is to project revenues and outlays under
current law over the next 10 years. CBO describes the baseline projection as
a benchmark for measuring the budgetary effects of proposed changes in federal
revenues or spending.... By statute, CBO’s baseline projections must estimate the
future paths of federal spending and revenues under current law and policies. The
baseline is therefore not intended to be a prediction of future budgetary outcomes;
instead, it is meant to serve as a neutral benchmark that lawmakers can use to measure
the effects of proposed changes to spending and taxes. So for that reason and others,
actual budgetary outcomes are almost certain to differ from CBO’s baseline
projections.4
4 CBO, The Budget and Economic Outlook: Fiscal Years 2006 to 2015, Jan. 2005.
[http://www.cbo.gov/showdoc.cfm?index=6060&sequence=0]. Instructions for creating the
baseline estimates are contained in the Budget Enforcement Act (BEA), as amended.

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In other words, the CBO baseline is a projection of revenues and outlays under current
law, absent any changes, over the next 10 years.5
The advisory panel report, however, indicates that its reform plans meet the goal of
revenue neutrality when compared to the Administration’s revenue baseline rather than
the CBO baseline. The Administration’s baseline assumes that the 2001/2003/2004 tax
cuts will be made permanent and that all of the Administration’s FY2006 budget
proposals affecting federal revenues are enacted. The CBO baseline, on the other hand,
assumes that the 2001/2003/2004 tax cuts will expire at the end of 2010, as is specified
under current law. In addition, the CBO baseline does not include the Administration’s
FY2006 budget proposals affecting revenues.
As a result, when compared to current law as defined in the CBO baseline, the
Administration’s baseline projects lower federal revenues over the next 10 years. So,
when compared to the CBO revenue baseline, the reform proposals will result in a
significant reduction in federal revenue over the next 10 years. Some analysts have
calculated that the reform plans would reduce federal revenues by almost $1.4 trillion
compared to the revenues under CBO current law baseline over the next 10 years.6

The Effects of Tax Policy on Private Saving
It is often argued that tax policy, through incentives for saving or disincentives for
borrowing, can be used to influence the level of private saving. This line of reasoning
argues that saving incentives in the tax code will increase the aftertax return to saving and,
as a result, taxpayers would be willing to substitute future consumption (saving) for
present consumption. This substitution effect would cause aggregate private saving to
rise.
There is an additional effect, however, that occurs simultaneously with this
substitution effect that might actually cause the level of saving to decline. An increase
in the aftertax rate of return would mean that an individual could actually save less and
still achieve the same level of consumption in the future. In other words, in addition to
the substitution effect, there is an income effect which makes an individual richer and
could induce him to consume more in the present.
To fully appreciate the income and substitution effects associated with tax incentives
for increased saving consider the following example. Assume that an individual has a
28% marginal tax rate and invests $100 in an account paying 10% interest. After five
years, the account will have grown to $141.57 ($100 investment earning 7.2% interest,
after taxes, for five years).
Now consider what would happen if the tax on interest earnings were eliminated.
In this case, the aftertax rate of return would increase from 7.2% to 10%. As a result of
5 Also see CRS Report RS22045, Baseline Budget Projections Under Alternative Assumptions,
by Gregg Esenwein and Marc Labonte.
6 See “A Preliminary Evaluation of the Tax of the Tax Reform Panel’s Report”, Tax Notes, Dec.
5, 2005, p. 1349.

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this increase in the aftertax rate of return, the taxpayer might be expected to increase his
savings (and his future consumption) by reducing current consumption.
However, the taxpayer may only be concerned with accumulating $141.57 in his
savings account at the end of five years, a characteristic of a target saver. In this case,
since the aftertax rate of return on saving has gone up, the taxpayer need only save $87.90
to reach his goal ($87.90 at 10% interest would grow to $141.57 after five years).
Because the income effect associated with the tax incentive has made the taxpayer richer,
the taxpayer can actually reduce his savings by $12.10.
This example brings to light an important point with regard to the ultimate effects
of tax incentives on the level of saving, a point which applies to incentives targeting both
personal and business saving. If a tax incentive to promote private saving is deficit
financed (the revenue loss from the tax reduction on saving is not recouped by raising
other taxes), then the income effect may well dominate and the level of national saving
could drop. Depending on how the tax incentive is designed, the reduction might
manifest itself directly as a reduction in private saving or as a reduction in both private
and public saving. (For a deficit financed tax incentive to increase total saving each dollar
of tax reduction (public dissaving) would have to be matched by more than a dollar
increase in private saving.)
Only if the tax incentives for saving are fully tax financed (the revenue loss from the
saving incentive is made up by raising other taxes) will the income effects be eliminated.
Even under these conditions, however, the overall effectiveness of the tax incentives on
the level of savings is unclear.
For example, even if one switched from an income- to a consumption-based tax, the
overall effect on the level of saving cannot be determined a priori. Life-cycle models tend
to predict an increase in saving in response to changing from an income to a consumption
tax. These models show an increase in savings for two main reasons.7
First, under a consumption tax the old (retirees who are dissavers because they are
drawing down their accumulated capital to finance consumption) would pay higher taxes
and the young would pay lower taxes compared to what they would pay under an income
tax. In fact, for young taxpayers, a consumption tax is the equivalent of exempting the
rate of return on all savings from tax. As discussed in the preceding paragraphs, for the
young, this results in a substitution effect and an income effect with the net effect of these
two forces uncertain.
Because of their higher taxes, however, retired workers would have to reduce their
consumption in order to pay what amounts to a double tax on their accumulated assets.
(That is, the income on their assets was taxed first when it was earned under the income
tax and now both the income and the principal will be taxed again when spent under the
consumption tax.) So while the effects on young taxpayers are uncertain, retired
taxpayers have to reduce consumption (increase saving) and the overall effect would tend
to increase aggregate saving in the economy. It is important to note, however, that any
7 For a more detailed discussion see CRS Report RL32603, The Flat Tax, Value-Added Tax, and
National Retail Sales Tax: An Overview of the Issues, by Gregg Esenwein and Jane Gravelle.

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transition rules enacted to mitigate these increased taxes on the elderly would dampen the
stimulus to new saving.
Second, the life-cycle models which show an increase in saving from switching from
an income to a consumption tax tend to rely on somewhat idealized assumptions. For
example, they assume that all taxpayers have perfect information and the sophistication
to map out their consumption choices over a long period of time. They also assume that
taxpayers believe that the tax system will not change over their lifetimes. If these
idealized assumptions are relaxed, then the effects on saving of switching from an income
to a consumption tax are inconclusive.
In addition, the empirical evidence regarding the effect of tax incentives on saving
is inconclusive. For instance, The Economic Tax Recovery Act of 1981 reduced marginal
income tax rates, expanded the availability of individual retirement accounts (IRAs), and
accelerated depreciation deductions. Life-cycle models would predict that these changes
would increase private savings, but that did not happen.8
Because of the inconclusive empirical evidence and the theoretical ambiguities, it
cannot be determined definitively that even switching to a pure consumption tax would
significantly increase the level of saving in the economy.

8 See CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales Tax:
Overview of the Issues, by Gregg A. Esenwein and Jane G. Gravelle. Additional information on
the empirical studies regarding the effect of tax policy on the level of saving can be found in CRS
Report RL30255, Individual Retirement Accounts (IRAs): Issues and Proposed Expansion, by
Thomas L. Hungerford and Jane G. Gravelle, specifically footnote 18.