The Effects on Consumption and Saving of Taxing Asset Returns

The aim of this study is to review what we know about how consumption and saving choices respond to tax incentives, and in particular to those taxes that change the interest rate. Whether and how much we should tax the return to saving, and whether different assets should be taxed in the same way, has been a topic of debate for both academics and policy makers. The material that we review provides a useful input to this debate by describing the likely consequences of policies that affect returns on assets. Understanding whether and how changing the tax regime for savings is likely to alter saving behaviour requires a clear conceptual and theoretical framework. With that in mind we devote the bulk of this chapter to setting out and developing the basic model of saving over the life cycle that is the key tool economists use in thinking about why and how people save. This framework allows the analyst to specify the different incentive effects that alter saving when the return on assets changes, and to describe when the forces that increase saving will outweigh those that reduce it. A general summary of our findings is that given the basic structure of the model - and the best information we have on people\u2019s willingness to shift their consumption and the way their needs and resources change over the life cycle - it is unlikely that changes in interest rates (including those brought about by tax changes) will have a big impact on the level of saving. This is consistent with our (controversial) reading of the literature on how people have responded to past changes in the taxation of assets. That is not to say that there are no behavioural effects coming from such tax changes - the empirical literature has shown that individuals do seem to respond to changes in relative interest rates by altering the mix of assets they hold. A note of caution is that while we have been as realistic as possible in our analysis, the framework was still relatively stylized. In Section 7.3 of the chapter we outline a set of extensions to the framework that would add to its realism and to its usefulness as a tool for policy analysis. These extensions include allowing people to alter their labour supply; allowing people to hold multiple assets, perhaps including housing, other durable goods and pensions as well as a saving account; and exploring issues of habits, temptation, and procrastination that cannot be captured in the simple view of people\u2019s preferences over the life cycle. In spite of the limitations of our analysis, we believe that our discussion illustrates why the life-cycle model is a useful - indeed, we would say essential - tool for the analyst who wants to know how behaviour and welfare will be affected by changes in the return to saving. We hope that the simulations that we present are a useful early step for understanding how to use the model to analyse these issues