Are lower taxes on "savings" good for the economy? Heritage, CRS and the "Matthew Effect"

[Hat tips to Ann Murphy (for pointing out the Heritage release to the tax prof listserve) and to Calvin Johnson, Edward Kleinbard, and Martin McMahon for permitting me to build a post around their contributions to the interesting exchange on the listserve.  I hope they will forgive any error I may have made in those instances where I paraphrased rather than using direct quotes.]

The Heritage Foundation put out a press release just a few days ago contesting the results of a Congressional Research Service study about the benefits from lowering tax rates.  See Curtis Dubay, Congressional Research Service Wrongly Implies Lower Tax Rates Don’t Strengthen Economy, Heritage Network “The Foundry” (Sept. 17, 2012).  The idea–clearly implied by the title of the release–is both to discredit the CRS, a long-admired non-partisan research organization funded by Congress, and to bolster the right’s longstanding argument that tax cuts are almost always good for the economy.

The attempt to skewer the CRS focuses on the correlations the CRS report uses between top marginal income and capital gains rates and economic growth rates, from which the study concludes that lower rates do not in fact correlate with stronger economic growth.  (See extensive work in this area, looking at the correlation between rates, growth and party administrations, in Presimetrics, a book by one of my fellow Angry Bear bloggers.) 

 Heritage claims that the correlations “prove nothing” because of “the economy is more complicated”.  To make any analysis, Heritage seems to be saying, you have to take the entire gamut of potentially influencial factors into account, and then you have to also be aware that no two eras are ever the same.  In short, Heritage seems to be arguing that there is no way to do an analysis, and therefore the rough correlations shown by the CRS study should be disregarded.  Even if that were true, it would amount to a pretty flimsy claim on the other side–i.e, it would amount merely to the claim that Heritage thinks the problem is so overwhelming that the conclusion that tax cuts have a harmful effect on the economy can’t be considered completely substantiated.  A pretty flimsy excuse for a release with the title provided.

But Heritage goes further with its own statements. 

Of course, if you tax income, investment, and savings less you’ll get more of them and the stronger growth that comes with the increase in these activities.  And if you raise tax rates on those most able to react, then the reactions will be that much more pronounced.  Upper-income taxpayers have the most capacity to adjust their behavior; by shifting the composition of their labor income to avoid tax, to shift the composition of their investments to avoid tax, or to shift away from work effort toward leisure.

It is vital that the public, the media, and, most importantly, policymakers don’t fall for misleading analysis. … the economy is in bad shape and will remain that way unless and until it gets better policy from Washington.  One of those policy improvements would be lower tax rates through tax reform.  Id.

Note that Heritage hasn’t shown that the CRS conclusions are wrong, nor has it shown that the CRS methodology is so deficient that the conclusion isn’t a useful, “rough justice” conclusion based on the emprical data that exists, even though it does not (and cannot) consider the entire universe of factors at play in the economy and even though no study can compare a tax year with such tax cuts to the same tax year without such tax cuts.  As Edward Kleinbard, Professor at USC’s Gould School, notes, “The alternative to the ‘weak’ correlation that [Heritage] criticizes is no correlation at all. Why is that useful?” (quoted from an email exchange with permission). 

Calvin Johnson, the Andrews & Kurth Centennial Professor of Law at the University of Texas, notes that there are really only four reactions to cutting taxes on capital income (the main way generally proposed for reducing taxes on savings): 

1) reductions in savings as people hit their targeted fund levels for things like retirement, purchases, emergencies sooner;

2) increases in borrowings to fund investments that benefit from the cut taxes on investment income;

3) moving capital from other investments to the tax-advantaged forms of investment; and

4) saving more because of the tax incentive.

Heritage, Johnson says, wants to claim that item 4 is the typical response, but the evidence suggests it is mostly the first three.  And because of that, the economy goes “in the wrong direction”–”the private reaction is close to zero or negative” and “the deficit is dissavings dollar for dollar”, so that “the overall impact is strongly negative.”  Calvin Johnson (paraphrased and quoted from an email exchange with permission) .  Johnson has been writing about needed reforms to the tax system for some time, including comments on overly generous incentives for savings, through the “Shelf Project”, a series of articles in Tax Notes that discuss potential ways that Congress could adjust the federal income tax laws to create a simpler, fairer and more efficient tax system and still raise the much-needed revenues for infrastruture and other programs.

There is pretty good evidence that Johnson’s first item–targeted savings for precautionary needs and for targeted purchases and retirement–covers the main reason that people save.  The Federal Reserve underwrites a triennial survey of consumer finances.  The most recent study is reported in Bricker, et al, Changes in U.S. Family Finances from 2007- to 2010: Evidence from the Survey of Consumer Finances, Federal Reserve Bulletin Vol. 98, No. 2 (June 2012). 

The study shows that saving for “liquidity” (emergency expenditures, illness, etc.) ranked first in 2010,at 35.2% and saving for retirement ranked second, at 30.1%.  Saving for specific targeted purchases, homes, and education amounted to another 17.1 %.   In contrast, saving for investment was a piddling 1.2% and saving for “no particular reason” (which may be the kind of savings we would expect from high income families with more money to spend than they can easily spend) garnered only 1.4%.   Id. at 16 (Table 3).

Note, too, that Heritage only offers in substitute to the CRS’s study the same tired and untrue economic theory it has always relied on (like the infamous Laffer-curve, a theory that essentially speculates about the great benefit from lower taxes based on “free market” assumptions).  Heritage is left with merely asserting a claim that “lower tax rates” in and of themselves will lead to a better economy.

Martin McMahon, the Stephen C. O’Connell Professor of Law at the University of Florida, notes that this is “poor theoretical economics at best.”   Ed Kleinbard adds that these types of theoretical arguments are “like a biologist studying the mating rituals of butterflies along a highway median–likely as not, the new dance you observe is just a downdraft from a passing tractor-trailer.”  (quoted with permission).

McMahon goes on to say:

[The Heritage release] incorporates only the substitution effect, and ignores the income effect.  It is based largely on what I refer to as an ‘attractive nuisance’ in tax policy analysis.  That [attractive nuisance] is a model of a commodity tax on which the purchaser is indifferent between apples and oranges until a tax is levied on one and the preferences shift because prices shifted.  The proponent then trades ‘apples and oranges’ in the model for ‘consumption and savings’ and ‘leisure and work’ [to reach] the conclusions that are reflected in the paragraph above [i.e., the first quoted paragraph from the Heritage release]. … But in the translation, the income effect is ignored as are exogenous constraints on substituting consumption for savings and leisure for labor.  The data bears out the CBO and has for decades.

Heritage’s real gripe is that the real world does not behave the way the model that it prefers to believe is true [says it should].  (quoted from email exchange with permission) 

Marty McMahon has also been writing about this topic for some time.  A good place to start your reading is “The Matthew Effect and Federal Taxation,  45 Boston College L. Rev. 993 (2004) (available on SSRN, here), for which the abstract notes:

This article first examines in detail the increasing concentration of income and wealth in the top one percent, and particularly within much narrower cohorts near the top of the top one percent, that has occurred over the past twenty-five years. It demonstrates the strong Matthew effect in incomes in the United States over that period. The super-rich are pulling away from everyone by so much and at a rate so fast that the fact that incomes of many households at the bottom and in the middle have stagnated, or even fallen in constant dollars, has been obscured by ever increasing per capita income.

The article then examines changing effective federal tax rates over the last two decades of the twentieth century. By the close of the twentieth century the tax system was not raising revenue as fairly and was doing less to mitigate inequality than it had in the middle of that century. Tax legislation in the twenty-first century continued this trend by providing tax cuts very disproportionately in favor of those at the top of the income pyramid with very small tax cuts going to everyone else.

The article then demonstrates that economic theory does not support the argument that the tax cuts were necessary to spur incentives to save and invest and to work, and that the empirical evidence of the effect of tax cuts on savings and investment clearly contradicts the claims made by supporters of the tax cuts. It examines the rapidly growing body of economic literature supporting the thesis that economic inequality impedes economic growth rather than fostering it, and concludes that because the tax cuts increase inequality, they probably impede economic growth.

This is worth repeating:  tax cuts to spur savings (such as preferential rates for capital gains and other tax programs that reward investment) don’t really work.  They tend to increase inequality.  Inequality tends to impede economic growth.  So tax cuts to foster savings tends to do more harm than good. 

In fact, in a review of the research literature and empirical studies regarding taxes and savings (see id. at 1080-89, in particular 1084-89 on savings), McMahon shows that “an increased yield to capital might actually decrease household savings.  Over the long term, the United States personal savings rate has varied inversely with the yield to capital.”  Id. at  1086 (emphasis added).  And even investment increases from tax cuts only help the US economy if they are invested domestically–a proposition that is highly uncertain given today’s international financial markets; otherwise “the benefits of increased wealth … would inure only to savers, the owners of capital” and not to U.S. workers.  Id. at 1087.