Evolving views of the taxation of saving

Date: 22 May 2015
Publisher: Institute for Fiscal Studies

The 125th anniversary of the Economic Journal provided an opportunity to look back on several of the journal’s important papers and reflect on how these papers altered our thinking about important economic issues and laid the groundwork for further progress in economic research. One such contribution was the 1980 paper by Anthony Atkinson and Agnar Sandmo, “Welfare Implications of the Taxation of Savings,” written at a time when the most commonly held objective of tax reform was the achievement of a broad-based income tax, i.e., a comprehensive tax on all forms of income, applied to a base not eroded by deductions, exclusions, or favourable rates of tax, all of which could influence taxpayer behaviour and require higher tax rates on the remaining tax base. Apparently at odds with this objective, even then, was the basic theory of optimal taxation, which by viewing saving as a vehicle for future expenditure suggested that the taxation of income from saving – capital income – was an implicit tax on future consumption, and further implied that only the objective of taxing individuals’ future consumption, as in retirement, more heavily than their consumption earlier in life could one justify any taxation at all of the income from saving.

A recording of the session, 'The taxation of savings', at the RES conference

Confronting these opposing views, and reflecting a growing appreciation of the importance of dynamic considerations, in particular the influence of the taxation of saving on wealth accumulation and the distribution of well-being across generations, Atkinson and Sandmo (hereafter AS) reconsidered the desirable mix of different taxes, including taxes on labour income, taxes on capital income, and taxes on consumption expenditures. A key lesson from their analysis was that the influence of concerns about intergenerational equity on tax design depends on the range of instruments available to government.

In considering the appropriate combination of labour and capital income taxation, AS showed that having national debt available as a policy instrument allows the government to choose tax rates without regard to concerns for intergenerational equity. Instead, it can adjust the rate of debt accumulation to influence the relative well-being of current and future generations, borrowing more to shift burdens more onto future generations and borrowing less to shift burdens to the present. On the other hand, to the extent that debt policy lacks such flexibility (as it would if there were limits on the range of debt accumulation imposed by budget rules or the discipline of financial markets), varying the tax mix between labour income and capital income must serve two functions simultaneously: providing suitable incentives for saving by individuals within particular generations and (because labour income accrues to younger cohorts than capital income) distributing the tax burden among generations. As a consequence, capital income taxation may be called for to shift greater burdens of the cost of government activities onto older generations if reductions in national debt cannot be used to accomplish that objective.

Thus, AS provided a potential justification for capital income taxation, even through the lens of optimal tax theory, with the additional consideration of intergenerational equity taken into account. But this justification was very different from the one underlying the traditional argument for comprehensive income taxation, which might be summarized as a view that the source of income should be irrelevant to the rate at which the income is taxed. Moreover, even in the environment considered by AS, the addition of another tax instrument, in the form of a tax on consumer expenditures, largely eliminates the argument for using capital income taxes for generational equity. This is because consumption taxes, like capital income taxes, fall more heavily on older generations, while not discouraging individual saving. While this conclusion is largely implicit in the paper by AS, it follows directly from their analytical framework and helped contribute to an array of subsequent contributions, including in the two recent volumes of the Mirrlees Review, putting forward and evaluating alternative methods of implementing consumption taxation. Another motivation for relying more on consumption taxes is that they do not require one to distinguish between labour income and capital income, the difficulty of doing so being perhaps the only remaining potential justification for taxing labour and capital incomes at the same or similar rates.

While much has been learned about the taxation of saving in the years since the AS contribution, many issues remain for future research. One such issue is the integration of taxes on capital income and taxes on intergenerational wealth transfers within families. Both affect incentives for individual saving, but with different saving objectives and different implications for the intergenerational transmission of inequality through the persistence of wealth concentration. A second issue is the design of policies toward retirement saving, which for most households represents the primary reason for long-term saving. The UK, like other countries, provides substantial tax incentives specifically for retirement saving, and yet the justification for such targeted tax incentives requires further consideration, as does the design of such schemes and the consideration of alternative policies aimed at ensuring adequacy of resources among the elderly.

Alan Auerbach presented a paper at the special session, which was chaired by IFS Research Director, Richard Blundell. Richard is also director of the Centre for the Micoeconomic Analysis of Public Policy at IFS, which sponsored the session.

See all papers and sessions involving IFS staff at the RES conference 2015.