To Save Or To Spend: That Is The Tax Question?

Abstract

While the effects of interest rates on consumption and savings has always been a concern to economists, there is still a great debate regarding the magnitude of the after-tax interest rate effect on savings. The response of consumption and savings to such changes in after tax interest rates potentially alter the United States private savings rate, which may influence our economic growth. While the Federal Reserve has executed the most aggressive expansionary monetary policy in history by lowering the Federal Funds interest rate by more than 10 times in the past year in an attempt to increase consumption to rebound from the current recession, this may ultimately reduce savings.  If savings fall, it potentially reduces our ability to spend in the future? In Solow's Growth model, the biggest determinant of future growth in an economy is the savings rate. The current savings rate in the US is at an all time low and is much lower than that of other nations, such as Germany and Japan. So, how can policy makers increase savings in the US? Can the U.S. increase savings by lowering the capital gains tax rate, which changes the after tax return on capital investment? If so, how effective will President Bush's proposed capital gains tax cut be on altering our savings rate?  To better understand after-tax interest rate effects on savings, one needs to discover the interest elasticity of savings to different types of taxes, such as capital gains and consumption taxes. If the private savings rate is sensitive to the after-tax interest rate return, then a capital gains tax, income tax, and sales tax will have very different effects on savings. The more sensitive the savings rate is to the after tax interest rate, the more an increase in the after tax interest rate will cause an increase in savings.  To assess the current interest elasticity of consumption/savings on the after tax real return of interest, I build on Boskin's (1978) model with a simultaneous equations model and more recent data. Specifically, I estimate the log of consumption on wealth, unemployment, interest rates, and disposable private income, and the after tax return of the Moody's AAA Bond Rate. To avoid the potential endogeneity bias between these variables, I use a simultaneous equation approach. Results will help determine if the U.S. can increase its savings by lowering the tax rates on investment. In general, this paper finds that the elasticity of substitution is close to .2, which suggests that the elasticity of substitution is quite small and stable. As Feldstein suggests this shows that a reduction in an income or sales tax will generate greater savings than a reduction in the capital gains income tax.