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Tax system blamed for Americans not saving enough

STANFORD -- American taxes discourage savings for the future, which is bad for the individual and the country, three Stanford economists said at an Alumni Reunion Weekend forum sponsored by the Center for Economic Policy Research.

Income taxes also discourage people from working as hard as they might otherwise, and do less than they once did to protect individuals from the negative chance aspects of the economy.

Given the intense political pressure on elected officials surrounding any tax proposal, however, the speakers agreed that only modest reforms to fix the worst aspects of the tax system are likely in the short term.

The United States has one of the lowest total tax burdens in the advanced world. Nevertheless, taxes have taken an increasing portion of income since World War II, said Professor Kenneth Arrow, a Nobel laureate who has been on the Stanford faculty since 1949.

The smaller size and broad base of American taxes translate into high compliance with tax laws compared to other countries, Arrow and others said. But still, there are cheaters, and the system could be more efficient and do a better job for households and for the economy.

Baby boomers don't save enough

A typical member of the baby boom generation is saving only about one-third of what he or she needs for retirement, and the current tax system discourages saving, said Professor B. Douglas Bernheim, who recently returned to the Stanford faculty from Princeton. Bernheim is the author of the Merrill Lynch Baby Boom Retirement Index and a new study on "financial literacy" among people born between 1946 and 1964. In the latter, he found a majority of Americans have difficulty understanding the benefits to them of compounded interest.

The net national saving rate - the combination of government and private savings minus debt - dropped dramatically in the 1980s from its historical pattern of 7 to 9 percent and is hovering at about 2 percent of net national income in the 1990s, Bernheim said. "About one-half of the decline is attributed to a decline in private savings" and half to government deficits, he said.

He listed these macroeconomic disadvantages to the decline in saving:

From the individual's perspective, he said, insufficient savings also mean a "steep decline in standard of living after retirement."

Bernheim would "tinker" with the existing tax system and launch a program of workplace education for Americans to encourage more adequate saving.

Professor and Hoover Institution Fellow Robert E. Hall instead would replace personal and corporate income taxes with a "flat tax" of 19 percent on income, after personal deductions that would be substantially larger than the ones available in the current tax law.

Hall and Alvin Rabushka of the Hoover Institution first proposed their flat tax system in 1981. They update their calculations annually to demonstrate its advantages, which include better compliance because it is simpler than existing taxes and more private saving because it taxes consumption, eliminating what amounts to a "double tax" currently on most forms of saving, Hall said.

The flat tax, however, is unrealistic politically, Hall said he has learned over the years, because too many people have vested interests against major reform. Politicians of both parties and from other countries get excited about the proposal, Hall said, only to "call in the middle of the night seeking help" when they discover the extent of political opposition to the proposal.


Both Hall and Arrow said they favor taxes that somewhat redistribute income to aid the poorest households in society. The flat tax, Hall said, "was designed specifically to get around the objection of taxing poor people's consumption," as is done with European-style value-added taxes and with American-style sales taxes. Currently, he said, his calculations indicate that the United States could afford to exclude from the flat tax the first $20,500 spent annually by a family of four.

His proposal "is not progressive in a less important way," Hall said. "It does not try to soak the rich, because it doesn't work to soak the rich."

The income tax reform of 1986 has made that tax less effective at redistributing income from the wealthiest to the poor, Arrow said, even though the redistribution was "modest" before 1986 as well.

While economists don't uniformly agree that taxes should redistribute wealth, Arrow said he favors that function to counteract "the forces of the economy [that] generally lead to tremendous inequalities" of income, partly as the result of chance.

Economists can explain only roughly half of the variation in income by such factors as education, Arrow said. Much of the variation is chance, "especially if you include genetic chance - the chance of where you were born, so the kind of educational system you have, the chances about your family background and a lot of things we don't even understand."

Double-taxing savings

The idea that taxes discourage saving by taxing saved income twice dates back to John Stuart Mill in 1848 but is more self-evident with modern tools of economic analysis, Arrow said.

"If I invest some of my post-tax income, I don't get any pleasure out of it now. I invest it and then receive a return, which is itself taxed. I've in effect been taxed twice on the enjoyment I'm going to get in the future or that my heirs are going to get."

As a result, he said, theorists and tax reformers of different political persuasions have been advocating eliminating the double tax since the 1930s.

The government has gone part of the way by setting up various programs to defer taxes on income that individuals or corporations put into various types of saving or investment, Bernheim said. In recent years, however, many of those preferences have been eliminated or reduced, and the remaining ones are under attack.

Since 1987, for example, companies are not allowed to project retirement benefit increases for their employees when calculating liabilities for the purpose of determining their deductible contributions to defined-benefit retirement plans. Work by Bernheim and Stanford economist John Shoven, dean of the School of Humanities and Sciences, indicates that this change in the rules has led to reduced employer contributions, Bernheim said, and has had "a significant effect on overall national saving."

But tax policies designed to encourage individual saving have come under fire, he said, partly because some economists doubt they actually promote saving.

To help the economy as a whole, he said, "it's not enough to stimulate private saving. It must rise by more than public sector saving falls," he said, unless the government is willing to cut its expenditures.

Added to that concern, he said, is one by some economists who "believe that saving responds little at all, in fact, may even decline, when the after-tax rate of return rises."

Bernheim gave the example of a person 35 years old who intends to retire at age 65 and wants to finance a real retirement income of $50,000 a year through the age of 90. For simplicity, he assumed the individual had no separate pension plan.

"If the real after-tax rate of return is 4 percent, this individual needs to save $14,250 a year. If the rate of return is 6 percent - 2 percentage points higher - the individual only needs to save $8,220 a y

same target."

An individual's savings target "should rise when you increase the after-tax rate of return, because essentially you are making retirement consumption cheaper in terms of what you have to sacrifice today to get a given level of [future] consumption," he said, but that is not the way many financial advisers counsel their clients.

In addition, he said, there are concerns about the limits the government imposes on savers in 401k plans.

"If I am at the limit, if I have maxed out, then the existence of these accounts does not change the rate of return that I earn on my marginal - or last - dollar of saving, and therefore it does not affect my incentives to contribute an additional dollar to saving," Bernheim said.

The 401k plan is also under fire because studies show that individuals are managing plans too conservatively, which will reduce their retirement income from them. People also tend to "binge" by cashing them out when they change jobs, he said.

Bernheim would modify retirement saving incentives by providing floors instead of ceilings on tax-favored investments. "For someone earning $30,000 a year, the first dollar of saving might be eligible for contribution to a tax-favored account. Someone earning $100,000 might be required to save $10,000 before becoming eligible."

The effect of such a proposal would be to "reduce the revenue impact [on the government] of the tax incentives while better targeting the financial incentives at the marginal dollar of saving," Bernheim said. "My research has indicated that such a proposal could roughly double the cost effectiveness of tax incentives."

He also suggested the government encourage financial education in the workplace because "my recent research has shown that financial illiteracy is very closely tied to failure to save." The workplace is the logical place to educate people about how to use their opportunities to invest in 401k plans, he said.

"Education in the workplace has been held back primarily by concerns of liability" among employers under federal laws, he said. In the recent survey of baby boomers, "we found that as a source of information and advice on financial matters, employers ranked behind prayer."

A smaller scale reform that Hall recommended would be for the government to tax non-wage income at its source rather than at its destination.

"If you are like me, at the end of the year in January, you get a bunch of 1099 forms from all over the place and the IRS tries very hard . . . to make sure every 1099 actually made it onto my 1040 [income tax form]. That is the most ridiculous procedure because if you did it the way we [propose to] do it, you wouldn't have 1099s, the tax would have been already collected."

The idea was considered in Congress in 1986, he said, but did not pass because it generated "an incredible firestorm of opposition" from “the people who had figured out ways not to pay the tax on their 1099s."

There are so many entrenched interests dedicated to the 1099 . . . that at least $100 billion of taxable income leaks out in the current system," Hall said.



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