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Tuesday, August 30, 2005

Progressive Tax Reform Democrats Can Support?

The tax reform issue is about to heat up – when congress reconvenes in September tax reform will be at or near the top of the administration’s agenda and, given the outcome of Social Security reform efforts to date, we can expect this to be undertaken with an eye towards success at most any cost. Thus, Democrats have a choice to make.  Should they try to block GOP proposals for tax reform or get out in front of the issue, if it’s not too late already, with a proposal of their own?  Given that the status quo with respect to tax burdens, shifting income distributions, and other changes is not acceptable to Democrats, and that the GOP reform proposals are not acceptable either, serious consideration should be given to a counter tax reform proposal that embodies principles of equity Democrats wish to promote.

For this reason, when my dissertation adviser from long ago, whose opinion I value, sent me a link to an article from Economist’s Voice (no relation, they voice, I view) saying I should consider posting it, it caught my attention.  I’m hoping it will catch yours as well as a means of opening this conversation.  The article deals with two important problems, the low saving rate and progressive tax reform. Interestingly, the article sees rising income inequality and the pressure to “keep up with the Joneses” as a source of low U.S. saving, something I'm not entirely sold on, but fortunately that mechanism is not required for the proposal to address saving and tax reform issues.  The tax reform proposal involves progressive taxation on income after saving.  The proposal progressively raises the price of current consumption relative to future consumption to encourage more saving, e.g. if I save a dollar this year and spend it next year, taxes are avoided.  And, importantly, the tax would be relatively easy to implement since it is structured much like the current tax system.  The major difference is that the tax is calculated based upon income after saving rather than just income:

Robert H. Frank (2005) "Progressive Consumption Taxation as a Remedy for the U.S. Savings Shortfall", The Economists' Voice: Vol. 2: No. 3, Article 2: The American savings rate, always low by international standards, has fallen sharply in recent decades. One in five American adults now has net worth of zero or less, and more than half of all retirees experience significantly reduced living standards when they stop working. … I argue here that low U.S., savings rates are in large part a result of pressures to keep pace with community spending standards, pressures that have been exacerbated by rising income and wealth inequality. Replacing the income tax with a progressive consumption tax would stimulate additional savings by reducing the price of future consumption relative to current consumption as compared to its price under the current income tax. Perhaps more important, a progressive consumption tax would stimulate savings by altering the social context that shapes spending decisions.

Why Do Americans Save So Little? Although numerous factors contribute to our savings deficit, I will mention only two and focus on one. First, we often find it difficult to summon the willpower to save. And second, we often confront pressures to keep pace with community spending standards. The self-control problem can be remedied by individual action. But the problem of keeping pace requires collective action.

The Self-Control Problem Although the pain from reducing current consumption is experienced directly, the pain from diminished future consumption can only be imagined. So the act of saving requires self-control. If the temptation of current consumption were the only important source of our savings shortfall, individuals could solve the problem unilaterally—for example, by signing a contract to divert some portion of future income growth into savings until a target savings rate was reached. Thus, if a family’s income grew by three percent each year, it could commit itself to divert, say, one third of that amount—starting next year—into savings.

The Collective-Action Problem Our savings shortfall also stems from a second source, one that is much harder to address by unilateral individual action. The following thought experiment illustrates the basic problem: If you were society’s median earner, which of these two worlds would you prefer?

A. You save enough to support a comfortable standard of living in retirement, but your children attend a school whose students score in the 20th percentile on standardized tests in reading and math; or

B. You save too little to support a comfortable standard of living in retirement, but your children attend a school whose students score in the 50th percentile on those tests.

Because the concept of a “good” school is inescapably relative, this thought experiment captures an essential element of the savings decision confronting most middle-income families. If others bid for houses in better school districts, failure to do likewise will often consign one’s children to inferior schools. ... The choice posed by the thought experiment is one that most parents would prefer to avoid. But when forced to choose, most say they would pick the second option. Context influences our evaluations of not just schools but virtually every other good or service we consume. To look good in a job interview, for example, means simply to dress better than the other candidates. It is the same with gifts:

In a poor country, a man proves to his wife that he loves her by giving her a rose but in a rich country, he must give a dozen roses.

The savings decision thus resembles the collective action problem inherent in a military arms race. Each nation knows that it would be better if all spent less on arms. Yet if others keep spending, it is simply too dangerous not to follow suit. Curtailing an arms race thus requires an enforceable agreement. Similarly, unless all families can bind themselves to save more, those who do so unilaterally will pay a price. They risk having to send their children to inferior schools. Or they may be unable to dress advantageously for job interviews. Or they may be unable to buy gifts that meet social expectations. Temptation and collective action problems may explain why Americans save too little, but why do we save less than other nations, which themselves confront these problems?

How Income Inequality Exacerbates the Savings Shortfall Inequality in income and wealth has always been more pronounced in the U.S. than in other industrial nations. That fact helps explain why our savings rate was lower to begin with. And the fact that inequality has increased in recent decades helps explain why the savings gap has grown. Inequality is linked to savings because of its effect on community consumption standards. This is a controversial claim because, according to the reigning economic theories of consumption, the distribution of income has no effect on individual spending decisions. These theories predict that consumption in the various income categories will rise in proportion to the corresponding changes in income. … In contrast, models that incorporate positional concerns predict that sharply increased spending by top earners will exert indirect upward pressure on spending by the median earner. When top earners build larger houses, for example, they shift the frame of reference that defines the aspirations of others slightly below them. And when they build bigger houses, they in turn shift the frame of reference for others just below them, and so on. This explains why the median size of a newly constructed house … had risen more than 30 percent to over 2100 square feet by 2001—roughly twice the increase predicted by traditional theories ... Additional evidence supports the view that expenditure cascades in housing and other areas, and the implied reductions in savings rates, are at least in part a consequence of increased income inequality...

Stimulating Additional Savings A law requiring that each family save a portion of its income growth each year would attack the self control and collective action problems simultaneously. A less intrusive approach would be to make consumption less attractive by taxing it. Shifting to a progressive consumption tax would change our incentives in just this way. Because the amount a family consumes each year is just the difference between the amount it earns and the amount it saves, a system of progressive consumption taxation could be achieved by making savings exempt from tax. A family would report its income to the IRS just as it does now, but would then deduct the amount it had saved during the year.  ... The marginal tax rate on low levels of taxable consumption would start low—say, at 20 percent. Maintaining the current tax burden across income levels would ... require that marginal tax rates rise steadily with taxable consumption ... The objection that higher marginal tax rates on income discourage investment does not apply to higher marginal tax rates on consumption. Indeed, because a progressive consumption tax exempts income from taxation until it is spent, the tax would shift incentives in favor of savings and investment.

It might seem that steep marginal tax rates at the highest consumption levels would severely compromise the ability of many wealthy Americans to support the standard of living to which they have grown accustomed. But what sorts of sacrifices, exactly, would this tax entail? … an American CEO “needs” a 30,000 square-foot mansion only because others of similar means have houses that large. ...  if all CEOs were to build smaller houses, no one would be embarrassed ... many CEOs might even prefer to have smaller houses. It is a nuisance, after all, to recruit and supervise the staff needed to maintain a large mansion. ... A progressive consumption tax would increase savings not only by reducing the price of future consumption ..., but also by changing the frame of reference that shapes spending. ... If people at the top built smaller mansions, those just below the top would be influenced to spend less as well, quite apart from any change in relative prices. Their cutbacks, in turn, would influence others just below them, and so on, ... Given the importance of context, the indirect effects of a progressive consumption tax promise to be considerably larger than the direct effects...

Concluding Remarks … there is little question that Americans save too little. Evidence suggests that we do so in part because we face pressure to keep pace with escalating community consumption standards. To solve this collective action problem, we must change incentives. A progressive consumption tax would directly increase the incentive to save for individual families at all income levels. And the resulting changes in spending would alter social frames of reference in ways that would further increase savings. Is there any prospect that a progressive consumption tax might actually be adopted? Many conservatives have long advocated that we move from income taxation to consumption taxation. Their preferred form of consumption tax, the flat tax, has drawn fire on distributional grounds. ... If the flat tax fails to attract political support, pro-growth conservatives might be willing to consider a progressive consumption tax in its place. Indeed, just such a tax—the so-called Unlimited Savings Allowance Tax—was introduced in the Senate in 1995 with bipartisan sponsorship. This proposal is ripe for another look.

One final comment to reinforce something said in the introduction.  While I like the proposal, and the idea is simple, tax income minus saving at a progressive rate to make current consumption relatively expensive and encourage saving, I'm not sure I buy into the "keep up with the Joneses" explanation for the low saving rate given in the article.  However, it is not necessary to believe this hypothesis in order to support the other merits of the tax reform proposal such as its progressive nature and its ability to provide incentives to increase saving by changing the intertemporal price of consumption.

    Posted by on Tuesday, August 30, 2005 at 01:08 AM in Economics, Income Distribution, Saving, Taxes | Permalink  TrackBack (1)  Comments (9)

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