Incentives to work and spend

[19 April 2007]

By Rob Horning

As someone who has groused about the negative savings rate in America (it seems indicative of competitive consumption for its own sake that yields little in well-being, and signals a muted lack of faith in the future), I feel obliged to present a contrary view. Writing at Slate, Henry Blodget makes the case that a rational response to the American tax system is to spend as much as possible.

The problem is how we tax investment gains. Over the past 80 years, the average annual return on Treasury bills (a proxy for savings accounts) has been 3.7 percent per year. Inflation, meanwhile, has averaged 3.1 percent per year. This combination has produced a “real return” of a paltry 0.6 percent per year. If you got to keep that 0.6 percent, you might still have an incentive to save: A $616 real gain on $10,000 in 10 years wouldn’t be much, but it would at least be $616 more than you have now. Unless you’re so poor that you’re exempt from taxes, however, or so flush that you can afford to lock up cash for decades in a tax-deferred annuity or retirement account, you won’t be keeping that 0.6 percent. You’ll be giving all of it—and probably more—to the government.

Blodget proposes making savings taxfree, which makes some sense if you think about middle class folk building up little nest eggs. But you have to consider who would really benefit from tax free savings—those with massive estates or inherited wealth. If we stop taxing interest and dividends, more tax dollars would have to come from levies on income—what John Edwards is talking about when he complains that we tax work instead of wealth. Such a tax scheme would create incentives to elude work as much as possible, or at least disguise work as some other form of income (say, stock options).

The other alternative is to tax consumption instead of income—through a sales tax or VAT. But then you run into the problem that such taxes are typically regressive (the burden of them is proportionally heavier on those with less income). Perhaps that complaint becomes less ignificant when we consider that our current system is getting more regressive as we speak.

Nonetheless, if one believes that consumption has negative externalities, as Robert Frank argues here, and one accepts the economists’ prescription of taxes to rectify externalities, then the policy course is plain. Writes Frank:

In Luxury Fever, I suggested that we scrap our current progressive tax on income in favor of a far more steeply progressive tax on consumption. Because total consumption for each family can be measured as the simple difference between the amount it earns each year (as currently reported to the IRS) and the amount it saves, such a tax would be relatively easy to administer. And if the tax were coupled with a large standard deduction (say $7,500 per person) and had low marginal tax rates on low levels of consumption, it would be even less burdensome for the poor than our current income tax.

More important, it would provide top earners with strong incentives to save more and limit the rate at which they increase the size of their mansions. Their doing so would reinforce the incentives on those just below the top to do likewise, and so on all the way down. Phased in gradually, this tax would slowly reduce the share of national income devoted to consumption and increase the corresponding share devoted to investment. Total spending would continue at levels sufficient to maintain full employment, and greater investment would lead to more rapid growth in productivity.

Of course, taxing consumption (which people associate with rewards, pleasure, etc.) is never going to be as politically feasible as taxing work (which people all too often associate with drudgery, humiliation, subservience, and boredom). And it seems doubtful that changes in our attitude would follow from changes in the incentives generated by tax policy. The same problem seems to beset any potential tax on carbon consumption—our attitudes toward gasoline consumption won’t change as fast as our attitudes toward the politicians who levied the tax—they have everything to lose and nothing to gain. (but the respect of future generations grateful to still have an inhabitable coastline. But then, what’s that worth now?)

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