New York Times
February 11, 1999

ECONOMIC SCENE

Thinking Twice About Tax Breaks

By MICHAEL M. WEINSTEIN

The Democrats, trying to blunt furious tax cutting by Republicans, are flocking to limited tax proposals aimed at promoting individual saving.

President Clinton's budget proposes tax subsidies to underwrite the cost of setting up private accounts for workers. Sen. Robert C. Torricelli, D-N.J., this week proposed, along with Sen. Paul D. Coverdell, R-Ga., tax breaks on interest, dividends and capital gains. Though politically deft, these plans are economically suspect.

The administration hopes its plan will deflect attention away from Republican proposals to create private retirement accounts as part of Social Security and to achieve a huge 10 percent across-the-board tax cut. Large tax cuts, say the Democrats, are fiscally reckless because budget surpluses are only temporary Besides, the Democrats argue, across-the-board tax cuts only sound fair. Instead, they overwhelmingly reward the high-income families who pay the bulk of taxes.

But if tax-subsidized savings accounts are a sound political device, they are a shaky economic device. Clinton's plan purports to increase the savings of America's many nonsaving families, but no one knows how to make the idea work in practice. Sen. Torricelli's plan, many economists argue, would provide little more than a consumption holiday for higher-income families and do virtually nothing to achieve its stated goal of rebuilding the nation's low savings rate.

Even Jonathan Skinner of Dartmouth College, whose research backs the use of targeted tax breaks to increase savings, describes the Torricelli-Coverdell plan as the "wrong means to achieve a laudable goal."

In the United States, the personal savings rate is pathetically low, hovering in recent months around zero. Low personal savings pose two important threats.

For the economy at large, a low savings rate can lead to a low investment rate, leaving the future economy bereft of the factories, equipment and technologies it needs to create high-wage jobs. Low wages would intensify the burden on workers of supporting the growing ranks of retirees. But Skinner warns that tax-based savings incentives can do little to solve this problem.

Consider, he says, what would happen if, magically, tax subsidies encouraged every household to save an additional $1,000. Under that implausibly rosy scenario, national savings would rise by about $100 billion, or 1.5 percent of aggregate income. That, says Skinner, would "hardly make a dent in returning the personal savings rate to around 7 percent, the level it hit in the 1970s."

The second problem posed by low saving rates is distributional. Half the population lacks an employer-based pension plan. Perhaps 40 percent have no financial assets to fall back on during retirement. Skinner points to studies that show for many of these families, consumption plummets by 40 or 50 percent once they retire.

Clinton's plan does at least address the plight of low-saving families with modest incomes. He would create $100 savings accounts for workers. In addition, the government would match a portion of each extra dollar that workers voluntarily add to these savings accounts. Low-income families would receive a higher government contribution than would middle-income families.

William Gale of the Brookings Institution applauds its potential. "One hundred dollars invested every year for, say, 40 years could amount to $10,000 by the time a worker retires," Gale said. "If the worker contributes another $100, matched by government, the nest egg at retirement could total $30,000."

But Gale warns against undue optimism. How would the government prevent families from borrowing on their credit cards to deposit money into the tax-advantaged accounts? Would Congress let people invade their retirement accounts for pressing needs like a medical catastrophe or college tuition? If so, would retirement saving rise at all, or would the proposal act as a trigger for one claim after another on the accounts, including the money the government contributed?

What's worse, Torricelli's proposal shows how quickly the impulse to subsidize savings can go haywire. The plan, among other things, would provide a tax exemption for the first $500 of interest and dividend earnings and for the first $5,000 of capital gains.

But Alan Auerbach, a professor at the University of California at Berkeley, says it would backfire. The plan cuts taxes on the initial amounts of interest, dividends and capital gains that people earn. In other words, it rewards families for their existing levels of saving.

But because the tax savings do not rise as interest, dividend and capital gains earnings rise, the proposal does nothing to persuade people to save more than they already are.

"The full benefit of the Torricelli plan goes only to those above the 15 percent bracket and who already have substantial investment earnings," Auerbach said. "Those least in need would benefit the most."