Chapter 22: Taxes on Savings

Intertemporal Choice Model

The main model for understanding savings, which frames the choice of how much to save as a choice about how to allocate one's consumption over time. Savings is the residual (the excess of current income over current consumption).

Intertemporal Budget Constraint

The measure of the rate at which individuals can trade off consumption in one period for consumption in another period. For example, the opportunity cost of $1 of consumption today is (1+r) dollars of consumption in the future

Life-Cycle Model / Dissaving

(Based on the Intertemporal Choice Model) A simplified model where an individual lives for two periods: a working life (Period 1) where they earn income Y, and a retirement (Period 2) where they earn nothing.

• Saving: Occurs in Period 1 when consumption is less than income (S = Y - c^W)

• Dissaving: Occurs in Period 2, when the individual consumes their savings plus interest (c^R = (1+r))

Precautionary Savings Model

Models of savings that account for the fact that individuals save to smooth consumption over future uncertainties, not just to smooth consumption between work and retirement. This saving serves as a "buffer stock".

Self-Control Models

Models based on the idea that individuals may not be able to save as much as they would like due to self-control problems. These models suggest retirement accounts act as "commitment devices" because they are hard to access until retirement.

Liquidity Constraints

Barriers to credit availability that limit the ability of individuals to borrow. This makes precautionary savings more important, as individuals cannot easily borrow during "tight times".

Capital Income Taxation

The taxation of the return from savings.

Nominal Interest Rate

The interest rate earned by a given investment (e.g., 10%). The U.S. taxes nominal interest income

Real Interest Rate

The nominal interest rate minus the inflation rate. This measures an individual's actual improvement in purchasing power from their savings.

Inflation and Taxes

Because taxes are levied on nominal interest, inflation reduces the real after-tax return on savings.

income tax

This is a tax that governments impose on the income earned by individuals and businesses. This income can come from various sources, including wages, salaries, business profits, and interest from a bank account.

Optimal Income Taxation,

the study of how to set income tax rates across different income groups to balance the goals of raising government revenue (equity) and minimizing economic inefficiency (efficiency).

Capital Gains Tax

• This is a tax on the profit (the "capital gain") you make when you sell an asset for more than you originally paid for it.

• Assets: This applies to capital assets like stocks, bonds, real estate, and other investments.

• Key Distinction: The tax is only on the profit (the gain), not the total amount you receive from the sale.

Substitution Effect (on Savings)

• A tax on savings lowers the after-tax interest rate (the "price" of current consumption). This makes consuming today cheaper and saving less attractive.

• The substitution effect causes first-period consumption to rise and savings to fall.

Income Effect (on Savings)

• A tax on savings lowers the after-tax interest rate, which reduces the lifetime value of an individual's income (they are poorer).

• This causes first-period consumption to fall and savings to rise (assuming a "target savings" goal).

Ambiguous Effect of Taxes

Because the substitution effect (save less) and income effect (save more) move in opposite directions, the theoretical impact of taxes on savings is ambiguous.

Pension Plan

An employer-sponsored plan where employers and employees save on a (generally) tax-free basis for the employees’ retirement.

Defined Benefit (DB) Pension Plan

A pension plan where the firm pays a retired worker a benefit that is a function of their tenure and earnings.

Defined Contribution (DC) Pension Plan

A pension plan where the employer sets aside a proportion of a worker's earnings in an investment account. The worker receives the investment and any earnings upon retirement.

401(k) Accounts

• Tax-preferred retirement savings vehicles offered by employers. Employers often match employee contributions.

• (Note: 403(b) accounts are similar but for non-profit/public sector employees, though not explicitly defined in the text).

Individual Retirement Account (IRA)

A tax-favored retirement savings vehicle, primarily for low- and middle-income taxpayers, where individuals make pre-tax contributions and are then taxed on future withdrawals

Roth IRA

A variation on traditional IRAs where individuals contribute after-tax dollars but can then make tax-free withdrawals later in life.

SEP (Simplified Employee Pension) IRA

Retirement savings accounts specifically for the self-employed, which function similarly to 401(k)s (without matching).

Tax Subsidies (for Savings)

Policies that increase the after-tax return to savings, such as tax-deferred retirement accounts (like IRAs and 401(k)s). These subsidies can have ambiguous effects due to the income and substitution effects.

Low Savers

For individuals who save little, a tax incentive has an ambiguous effect on savings, depending on whether the income or substitution effect dominates.

High Savers

• For individuals who save more than the contribution cap (e.g., $6,000 for an IRA), the incentive has only an income effect.

• They may simply "reshuffle" assets from non-tax-advantaged accounts to the IRA, causing their total savings to fall.

Private Savings

Total savings by individuals. Tax incentives may not increase total private savings if individuals just reshuffle existing assets.

National Savings

The sum of private savings and the government's budget balance. If a tax incentive (which costs the government money) fails to increase private savings, it will lower overall national savings.