Arnold Kling  

Consumption Tax?

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Pejman Yousefzadeh makes the case for a consumption tax.


A consumption tax such as the one contemplated by H.R. 25 and S. 1493 will reduce transaction costs to a minimum, eliminate the need for concerns about loopholes and exemptions, and save people the time and expense of having to consult tax experts for the payment of taxes -- or lawyers for advice on how to defend against audits. This, in turn, will dramatically reduce the need for an expanding bureaucracy in the IRS, thus allowing for a dramatic reduction in the size of government through the elimination of unnecessary government personnel positions, along with substantial savings to the economy...compliance costs could be reduced by as much as 95% via the implementation of a consumption tax.

I also suggested a consumption tax in Bleeding-Heart Libertarianism.

For Discussion. Typical sales taxes do not tax "consumption" as defined by economists. For example, the economic definition of consumption includes the consumption of housing services, in the form of rent paid on apartments as well as the implicit rent on owner-occupied housing. Also, the consumption of durable goods, such as cars, is spread out over time rather than expensed as purchased. Would taxing consumption by the economic definition give rise to new problems of lack of clarity in the tax code, new potential for loopholes, and so forth?


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CATEGORIES: Tax Reform



COMMENTS (36 to date)
Joe Kristan writes:

As long as politicians have the ability to dun the many for the benefit of the motivated few, tax laws will always tend to become more complex over time. See Buchanan and Tullock.

The 20%+ sales tax rate in HR 25 makes it a non-starter; it would move many transactions off the books and create irrestistable pressure for loopholes.

An economic consumption tax has a better chance of being enacted (not a great chance, mind you); with a broad enough base, it could come in at a low rate, and existing information reporting tools would make it more or less self-enforcing.

I think low rates are the most important issue; if the rates are kept low enough, loopholes matter less. Even our income tax would be serviceable if ruthless simplification were combined with lower rates.

Eric Krieg writes:

Just wondering how you would structure a consumption tax to really tax consumption?

Wouldn't an income tax with credits for ALL savings (not just retirement savings) be, in effect, a consumption tax.

Boonton writes:

Which leads me to ask why should savings be 100% exempted from taxation?

Another question, exactly how is a consumption tax less beaurcratic and less expensive to enforce than income taxes? While most 'regular people' probably never have to worry about sales taxes because they are automatically added onto our bills its not like there is no work for the merchant. Its also not like enforcement of sales taxes is a trivial matter.

Bernard Yomtov writes:

"Would taxing consumption by the economic definition give rise to new problems of lack of clarity in the tax code, new potential for loopholes, and so forth?"

Yes.

The complexities in the income tax are due to the difficulty of defining "income." So if you define consumption as income minus savings you have the original problem: defining income, plus a new one: defining saving.

And if you try to calculate consumption directly you face huge problems. Consider just the rental value of a house, mentioned by Arnold. There's huge scope for disagreement. And what about people living in a house they've owned for 30-40 years, which has appreciated greatly, and whose rental value is now a large fraction of their cash income? Going to force them to sell, as a good libertarian would?

Whatever the merits of a consumption tax, the notion that it is an easy way out of the complexities of the income tax is pure fantasy.

Bernard Yomtov writes:

Just read the article at TCS. Yousefzadeh really just makes a bunch of unsubstantiated claims. He doesn't describe how hs proposed tax would work, or why compliance costs would drop.

As Boonton mentions, enforcement of and compliance with current state and local sales taxes is not free. Imagine how much more enforcement effort would be needed if the tax were in the neighborhood of 20%.

Lawrance George Lux writes:

A Consumption Tax will always deliver first impact Inflation to the Production of Goods; inevitably reducing realizable Production schedules. It is not really a solution, but another added Cost to Full Production.

Many Economists claim taxing Business Profits will only pass such Taxes unto Consumers. They use this rationale to claim such Taxes should not be implemented. It can be proven, though, that substitution of Business taxes for Income, Sales, or Consumption taxes actually increase Short-run Household Discretionary Income along the entire Curve; this meaning while Long-run Discretionary Household Income is decreased by the full measure of the Taxation on Business, Household Purchasing power is increased by the switch to Business taxes. Most of the arguments for reduction of Tax collection costs would be served by a Tax base paid solely by Business taxes, which could more viably regulate Consumer Demand; inside of cheaper Tax Collection costs. lgl

Eric Krieg writes:

>>Whatever the merits of a consumption tax, the notion that it is an easy way out of the complexities of the income tax is pure fantasy.

I agree. Those arguing for the consumption tax feel that it is "simpler" only because businesses will have to deal with the complexity, not individuals.

And you are also right that the complexity of the income tax derives from the difficulty of defining income, not the complexity of the code itself. A flat tax is just as complicated as today's income tax, unless the definition of income becomes very broad.

That wasn't the case with Steve Forbes' flat tax. He wanted to make dividends exempt from income taxation.

Ronnie Horesh writes:

What about the Lifetime Expenditure Tax? I remember being convinced by advocates of this years ago, on grounds of its simplicity and apparent justice. If I remember rightly it taxes net withdrawals from registered assets [savings etc].

Monte writes:

>>Which leads me to ask why should savings be 100% exempted from taxation?>Another question, exactly how is a consumption tax less beaurcratic and less expensive to enforce than income taxes? While most 'regular people' probably never have to worry about sales taxes because they are automatically added onto our bills its not like there is no work for the merchant. Its also not like enforcement of sales taxes is a trivial matter.

Monte writes:

>>Which leads me to ask why should savings be 100% exempted from taxation?

Boonton writes:

"Our personal savings rate has been abysmal, which, according to most retirement professionals, will ultimately develop into a national epidemic if serious measures aren’t taken to reverse this trend."

Why should we believe this? Because retirement professionals, who typically sell savings products on commission, tell us so? I'm sure new car salesmen will tell us our rate of new car purchases are also abysmal & creating tax exempt 401K_Car accounts will solve the problem.

Why is the market unable to provide the necessary incentives to adaquate savings? If our rate is abysmal then one should expect the market to greatly reward savers, enough so as to encourage them to forgo consumption.

"Switching to a consumption tax and permitting unlimited pre-tax contributions to IRAs and 401ks would certainly encourage more savings and investment, which I’m sure all would agree are the primary catalysts for long-term economic growth"

Encourage more savings possibly, whether that results in more investment is a rather large question mark. Investment, from a GDP point of view, is not savings accounts or 401K's but the production of capital goods...goods used to produce other goods...think robots in factories, computers, machines etc. It is quite possible for savings to go into savings accounts and end up fueling not more investment but higher prices for paper (aka stocks), credit card consumption spending & more.

So the question that I think is especially relevant for free market types is why is the market unable to generate the 'correct' amount of savings when the market is trusted to produce the correct amount of just about everything else.

Bernard Yomtov writes:

Boonton,

Just as a technical matter, net economywide savings must equal investment. (I'm leaving govt out of the picture for now)

Suppose you put money into a savings account, and the bank uses this to finance credit card based consumption by someone else. Looks like your savings weren't invested at all. But that's because there was no NET savings. By borrowing for consumption the credit card spenders were "dissaving," engaging in negative saving.

Speaking in somewhat simplified terms, net savings are invested, and it is the interest rate (more accurately, the financial markets) that is the equilibrating mechanism. If savings exceed desired investment the rate drops, which increases investment and decreases savings, and vice versa.

The US savings rate may well be too low for our long-run well-being (or not), but the level of savings/investment determined by the market is a reflection of how willing we are as individuals to defer consumption, and how attractive the investment opportunities available to us are.

Boonton writes:

Bernard, I agree about the 'dissaving' of using credit cards to fund consumption. However, nothing about making 401K's even more attrative tax wise would prevent just such a scenero. Gov't tax policy cannot force 'savings' into true investment unless you are talking about a command economy like the old Soviet Union, which I think we all would agree would be highly counter productive.

Likewise 'savings' channelled into the stock and bond markets may have no effect on investment. As you pointed out, such 'savings' may be countered by dissavings from those cashing out of the market (every share brought is by definition also a share sold). Even greater tax advantages to savings may accomplish little more than a consumption bing indirectly financed through a stock market bubble.

There is the other question of whether increasing the rewards for savings will actually encourage people to save more. Obviously people would like to earn a better return on their savings accounts or retirement accounts. The flip side, though, is that if you are saving up for something (like a retiremnt) then improved returns means that you can accomplish the same goal by saving less. This is indirectly what happened when people talked about the 'wealth effect' of profitable 401K's fueling consumer spending.

My fundamental question, though, is why the supposed need to encourage savings? Why are so many conservative, free market types, willing to so lightly assume that the gov't must encourage savings by granting it tax advantages? If we are really suffering a shortage of savings, why doesn't the market simply adjust the rewards to savers to resolve the problem?

Eric Krieg writes:

>>Why are so many conservative, free market types, willing to so lightly assume that the gov't must encourage savings by granting it tax advantages?

Because we're not giving savings an advantage. We are simply taking away the disadvantages, things like double taxation due to corporate taxes.

But Boonton is probably right on some level. Economists have been prophesizing for decades that the low US savings rate was going to be the cause of our decline, and it hasn't happened yet.

And the Japanese have an enviable savings rate that hasn't done much for them.

Boonton writes:

"Because we're not giving savings an advantage. We are simply taking away the disadvantages, things like double taxation due to corporate taxes."

This isn't a disadvantage. In a free market all prices adjust accordingly. If the stock market is hampered by 'double taxation' then the prices of stocks will be lower making it easier for the saver to seek his returns there. Likewise, the saver could turn to corporate bonds. Interest payments are deductable from a corporations taxable income therefore the double taxation problem is resolved.

Even more important, who says you have to apply your savings towards corporations at all? Savers can invest in non-incorporated companies. They can purchase physical assets (gold for example) and so on.

The case that saving is being hampered by the tax system to any extent greater than any other activity is pretty hard to make in my opinion.

Eric Krieg writes:

>>In a free market all prices adjust accordingly.

Not just prices, right?

Prices, in this case interest rates...

Demand, in this case savings rates...

Supply, in this case investment rates...

...will ALL adjust.

So if you want to increase savings, increase the return to savings by decrease the REAL AFTER TAX interest rate.

B, I think your problem is that you aren't looking at the REAL, after tax interest rate. THAT is what motivates people to save, not the nominal, before tax rate.

Monte writes:

>>Why should we believe this? Because retirement professionals, who typically sell savings products on commission, tell us so? I'm sure new car salesmen will tell us our rate of new car purchases are also abysmal & creating tax exempt 401K_Car accounts will solve the problem.>Why is the market unable to provide the necessary incentives to adaquate savings? If our rate is abysmal then one should expect the market to greatly reward savers, enough so as to encourage them to forgo consumption.Encourage more savings possibly, whether that results in more investment is a rather large question mark. Investment, from a GDP point of view, is not savings accounts or 401K's but the production of capital goods...goods used to produce other goods...think robots in factories, computers, machines etc. It is quite possible for savings to go into savings accounts and end up fueling not more investment but higher prices for paper (aka stocks), credit card consumption spending & more.

Monte writes:

Boonton,

It’s difficult for me to picture Fed/BEA officials straightening their ties and approaching me with out-stretched hand to sell me on the fact that our national savings rate is abysmal (dipping below 1% in 2000). It’s a matter of public record, not a sales pitch.

Americans have clearly demonstrated their ineptness with respect to personal finance & retirement planning. Many workers do not participate in their employer’s retirement plans, contribute very little of their wages, and make questionable investment and distribution choices.

Retirement security for many Americans has, as a result, been severely compromised. In the absence of adequate retirement savings, SSI will remain the primary means of income for most senior citizens, and we’re all familiar with the long-term prognosis there.

The incentive to save is not a market-driven phenomenon so much as it is a personal choice. But that choice can be positively influenced by increased efforts to educate the public and by creating stronger incentives to invest through more favorable treatment of pre-tax dollars.

Younger generations have been conditioned by too many years of advertising and easy credit to buy now and pay later. And the government has been a poor steward, as evidenced by a federal deficit that continues to scale up with the ushering in of each new administration.

Domestic savings (along with savings invested in the U.S. by foreigners) provides the funds that businesses use to engage in investment. This ultimately translates into capital stock. Less saving means less investment, less investment means less growth of capital stock, less growth of the capital stock means less growth of output and labor productivity, and less growth of labor productivity means less growth of real wages.

Savings invested in stocks is generally a good thing. Savings used for consumption (or credit financing) would be taxed.

Lawrance George Lux writes:

Savings are not really affected by any rate of taxation currently. Working households (One or Two Income employed)treat Savings as a Fixed Cost in Budgeting, utilized only where there is sufficient Discretionary Income after Expenses. The major component, therefore, is not even 'after-Tax' income; it is the percentage disparity between necessary Expenditures and Discretionary Income. Savings always suffers when Prices are rising faster than Wages, always gains when Wages advance faster than Prices. Almost no tax, except for Income tax itself, and Sales taxes, have any impact at all.

The actual worst operating tax found consistently operating against Savings remains unrestrained Utility and Communications costs; Economists would not call this a Tax, but it drains set aside Discretionary Income for Savings. Utilities and Communications join forces with Construction to throw the Costs of expansion on the current Client base. An estimated seven percent of Household savings is lost to such 'above the Curve' costs.

There is some evidence expressing limited Tax credits for Investment, and Capital Gains taxes actually increase Investment among wealthier Investors; this in order to achieve desired Investment schedules. lgl

Boonton writes:

"It’s difficult for me to picture Fed/BEA officials straightening their ties and approaching me with out-stretched hand to sell me on the fact that our national savings rate is abysmal (dipping below 1% in 2000). It’s a matter of public record, not a sales pitch."

Isn't it true that the 1% figure does not include 401K contributions as part of the savings rate? Does it include building equity in home ownership?

"Americans have clearly demonstrated their ineptness with respect to personal finance & retirement planning...."

Let's try to imagine this statement applied to anything else that is usually decided by the market:

"Americans have clearly demonstrated their ineptness with respect to paying a fair wage for low skilled labor"

"Americans hae clearly demonstrated their ineptness with respect to providing for a decent education for their kids, therefore vouchers are unworkable..."

"Americans have clearly demonstrated their ineptness with respect to health insurance therefore the country should adopt a single payer system..."

It's really hard not seeing most people on this list objecting to the above statements on the groudns that the market is better suited to make these decisions. Yet as far as savings is concerned you all think nothing of ignoring the market. How do you know that the reason the savings rate is 1% isn't because that's what people want it to be?

Eric Krieg writes:

>>How do you know that the reason the savings rate is 1% isn't because that's what people want it to be?

Because that number is low by historical standards as well as low by international standards.

It is logical to ask if there are any government policies that are causing the number to be so low.

Boonton writes:

"So if you want to increase savings, increase the return to savings by decrease the REAL AFTER TAX interest rate.

B, I think your problem is that you aren't looking at the REAL, after tax interest rate. THAT is what motivates people to save, not the nominal, before tax rate."

Eric, I'm not questioning whether you can increase savings through gov't policy. You certainly can. You can also increase domestic sugar production through gov't policy by enacting a set of protectionist policies as well as providing tax advantages for producing sugar. The question is why is this a good policy?

Economists will all pretty much agree that the economy is not suffering from any sugar shortage, the market does fine at providing sugar...they will admit that policies that support sugar production are simple payoffs to sugar producers (and inefficient ones at that).

I understand that people will look at their after tax savings returns. I still see no case that savings is an activity that is hampered by the tax system any more than any other activity. In fact, when you consider how many ways there are to save in either a tax free or tax advantageous form you have to ask yourself whether savings is being given an unfair advantage by the tax code.

Lawrance George Lux writes:

The Savings rate could be advanced far greater than through elimination of Capital Gains type taxation. A very favorable increase in Savings would be initiated by a law prohibiting internal financing of Production operations by Corporations; insisting such capitalization must come through the central banking system and financial instruments. Corporate leadership would be compelled to distribute Profits immediately, thereby increasing the ability of private Investors to invest.

The law would not significantly limit the speed of Investment, insure proper Investment procedures were utilized in Capitalization, and begin a trend to limit Corporate salaries and Stock Options. Growth rates would be a shade slower, but with less failure of Production operations; this due to observable greater Profitability of externally financed Production operations. lgl

Bernard Yomtov writes:

We confuse two notions when we talk about the national savings arte being "too low."

The first is simply the aggregate of individual and household savings. This, as Boonton, says, is what people want it to be given the economic environment. It may well be imprudently low, but the market does not enforce prudence, it reflects preferences.

The second is some vague idea of a savings rate that would be "good for the country," regardless of individual preferences. The market will not produce such an "ideal" rate. There is no reason to expect it to do so.

Boonton writes:

If the motive for increasing savings is that individuals tend to be inprudent, then the best policy would not be unlimited 401K contributions or repealed capital gains taxes. If someone isn't utilizing the $3-$5K that you can easily put away tax deferred per year then why would they change their behavior if you made that $15K-$45K? That wouldn't help the inprudent but the people who are already pretty prudent (or wealthy enough to asorb the cost of being foolish with their money).

If you are beginning with the position that people cannot be trusted to allocate for their own retirements the the conclusion is the most efficient policy would be forced savings. Even more interesting, if this is the position you want to adopt then why is it reasonable to assume the savings would be invested wisely? In that case you leave the world of 401K's and arrive at social security as the ideal savings policy.

I guess many here did not take that into account when they decided American's just don't want to save as much as they should.

Monte writes:

“Isn't it true that the 1% figure does not include 401K contributions as part of the savings rate? Does it include building equity in home ownership?”

National savings = private savings + government savings (or GNP – C - G). Private savings = DI – C, so 401k contributions are included in national savings. Equity is a component of wealth, and wealth (I believe) is included in any calculation of the national savings rate.

"Americans have clearly demonstrated their ineptness with respect to paying a fair wage for low skilled labor"

The fair wage argument generally falls short in both theory and practice. There may be isolated instances where raising the minimum wage results in a pareto improvement, but, on balance, it’s counter-productive. This is particularly the case regarding the living wage. It may help those who are currently employed, but hurts those who are seeking employment.

"Americans have clearly demonstrated their ineptness with respect to providing for a decent education for their kids, therefore vouchers are unworkable..."

Vouchers are the market’s response to the inferior good of public education, not a result of poor choices by Americans. If anything, the public school system has demonstrated it’s ineptness to provide a quality education for our children. It’s because of this that Americans have resorted to vouchers and home schooling.

"Americans have clearly demonstrated their ineptness with respect to health insurance therefore the country should adopt a single payer system..."

I have some serious concerns about the single payer system. Consider the following study recently conducted by economists in Oregon, whose legislators have proposed this type of initiative:

http://www.aahp.org/Content/NavigationMenu/About_AAHP/News_Room/Press_Releases/Oregon_Single_Payer_System_Could_Increase_Health_Care_Costs_by_30%25_%2810_14_2002%29.htm

“It's really hard not seeing most people on this list objecting to the above statements on the groudns that the market is better suited to make these decisions. Yet as far as savings is concerned you all think nothing of ignoring the market. How do you know that the reason the savings rate is 1% isn't because that's what people want it to be?"

Savings is not a good or service provided by the market so much as it is a result of human behavior modulated by things like lifestyle, incentives, education, and experience. I’m not sure we necessarily want our savings to be low. Credit and debt financing have enabled us to get into the nasty habit of consuming beyond our means. And I think it’s going to take a concerted effort at every level to break this habit.

“I understand that people will look at their after tax savings returns. I still see no case that savings is an activity that is hampered by the tax system any more than any other activity. In fact, when you consider how many ways there are to save in either a tax free or tax advantageous form you have to ask yourself whether savings is being given an unfair advantage by the tax code.”

I don’t think the issue is whether or not savings activity is hampered by the tax system. I think the issue is how to encourage more savings activity. And the tax system can certainly be used to do that.

Bernard Yomtov writes:

"Savings is not a good or service provided by the market so much as it is a result of human behavior modulated by things like lifestyle, incentives, education, and experience. "

I don't think you can distinguish savings that way.

Savings are deferred consumption. The saver gives up consumption today in exchange for consumption tomorrow. The rate of exchange - the price of consumption tomorrow - is set by the market just as surely as the price of potatoes is. The price of potatoes, remember is also heavily influenced by lifestyles, incentives, personal tastes, etc. The difference is that we have some notions about an optimal amount of savings which might differ from that produced by the market, but not about an optimal amount of potatoes.

Monte writes:

Bernard,

“Savings are deferred consumption. The saver gives up consumption today in exchange for consumption tomorrow.”

Agreed. In an economic sense, this is the ideal definition of savings.

“The rate of exchange - the price of consumption tomorrow - is set by the market just as surely as the price of potatoes is.”

Yes, but the market mechanism is not going to influence savings in exactly the same way. For instance, if the PV of the dollar were to greatly exceed its FV, people aren’t going to spend all (or most) of their DI today. Conversely, if FV>>PV, people wouldn’t set aside all (or most) of their DI for future consumption. The same cannot be said of normal goods and services.

“The price of potatoes, remember is also heavily influenced by lifestyles, incentives, personal tastes, etc. The difference is that we have some notions about an optimal amount of savings which might differ from that produced by the market, but not about an optimal amount of potatoes.”

Another major difference is that an optimal amount of potatoes isn’t nearly as critical to our future prosperity as an optimal amount of savings.

Boonton writes:

"Another major difference is that an optimal amount of potatoes isn’t nearly as critical to our future prosperity as an optimal amount of savings. "

Tell that to Ireland during the potatoe famine.

Bernard Yomtov writes:

"For instance, if the PV of the dollar were to greatly exceed its FV, people aren’t going to spend all (or most) of their DI today. Conversely, if FV>>PV, people wouldn’t set aside all (or most) of their DI for future consumption."

Not sure I see your point here. By the "PV exceeding the FV" I assume you mean real returns are negative. Then poeple will spend more, especially on durable goods, because the value of savings is declining. Sure, they'll save some anyway, but at the margin, when it's a close call whether to buy that new car or not, they'll buy it. And vice versa when real returns are high.

Monte writes:

Boonton,

“Tell that to Ireland during the potatoe famine.”

If you’re concerned we may suffer the same fate, I recommend you invest heavily in potato futures.

Bernard,

“Not sure I see your point here. By the "PV exceeding the FV" I assume you mean real returns are negative. Then poeple will spend more, especially on durable goods, because the value of savings is declining. Sure, they'll save some anyway, but at the margin, when it's a close call whether to buy that new car or not, they'll buy it. And vice versa when real returns are high.”

My example was a poor one. Obviously, an appropriate discount rate fixes the time value of money. The point I failed to make is that consumers aren’t as rational about money as you suggest.

Increases in DI are typically spent, in spite of how favorable the outlook for future returns may be. In this particular case, tax policies designed to improve the personal savings rate (an increase in pre-tax contributions for retirement) are much more effective than reliance on the market.

Boonton writes:

Unless you are going to mandate forced savings, aren't tax policies to 'promote savings' simply altering the market rate of return that a consumer faces for choosing saving over consumption? If you trust individuals to make what you deem to be the correct savings choices by responding to tax incentives then there is no reason to assume individuals wouldn't respond to market incentives. Which brings me back to my original question; what justifies assuming the market just doesn't work in allocating the correct amount towards savings?

Monte writes:

Easing restrictions on the amount individuals are allowed to contribute to retirement plans doesn’t alter the market’s rate of return. It simply makes saving more attractive than spending. And while I‘m generally a strong advocate of free markets and consumer choice, I think some form of forced savings model (similar to that of the UK or Chili) will be necessary to avert the crisis we’re sure to face if we continue to hold out hope that SS can satisfy our retirement needs.

The fact that savings is at an all time low is evidence enough for me to conclude individuals aren’t making the right savings choices. But this doesn’t mean they don’t make the right choices in most other respects. Again, I think it goes back to poor money management skills and a desperately needed sense of urgency among future retirees.

Boonton writes:

I think we may be talking past each other, you are assuming that individuals will respond to *their* rate of return for saving. So, for example, if you improve the tax advantages of savings people will respond by increasing their savings.

So if people do respond to rational incentives to save, then they should respond to market incentives as well. If 'poor money management' was causing people to save less than they should, the predictable result should be that bank, financial institutions & other players will respond with increased returns for savings.


Here's my other point, savings does not result in investment. Whether tomorrow's retirees are paying for their consumption with gov't checks or with retirement account disbursements, their standard of living will be determined by tomorrow's economy. Tomorrow's economy will be determined by tomorrow's labor force and capital stock. If savings today increases tomorrow's capital stock, you may be able to provide for tomorrow's retirees today by savings. However this effect is subject to diminishing returns. Adding a second unit of capital today will have less impact on 2030's GDP than adding the first unit today.

Keynes's insight was correct, 'saving' is meaningless on a society wide basis. What counts is investment. Do you have any evidence that the economy is suffering from a shortage of investment? I don't see the evidence for this assertion.

Boonton writes:

Here's a simple thought experiment that may help explain my points:

Suppose population & GDP remain constant but the distribution of older people to younger increases:

Intially let's say 10% of the population is retired and 90% are workers and GDP = $100. No matter what method is used to fund the retired population, the distribution is 9 workers to 1 retired.

Let's say in the future 40% of the population is retired but GDP remains at $100. This is excellent productivity growth because each worker is now producing $1.50 in GDP for every $1 each worker produced in the past. However, the fact remains that now each retired person has only 1.5 people working.

IF GDP remains constant, it is mathematically impossible to increase (or even maintain) the standard of living of the retired people without decreasing that of the working people. Notice this little example makes no assumptions about how the retired standard of living is funded...whether through 'savings' or direct taxation or even just the workers giving their parents gifts to support them.

You may try to argue that GDP won't remain constant if the economy increases their savings, but this only holds true as long as savings is channelled into additional investment. Even then, the investment must be productive yet diminishing returns dictates that there's a limit to how much faster you can make an economy grow by adding any additional resource, including investment.

It may very well be that the 'market' is factoring things into account that the professional retirement savings sales community is missing. For example, if people expect to work longer & have a retirement income that is less than their work income (I notice that many 401K brochures assume that people will retire at 65 and fund 20 years of retirement at levels near 100% of their work income) then they do not need to save as much.

Another example of what the market may be taking into account is what Arnold has been talking about in a few of his posts; if the economy is poised for a productivity boom fed by 'miracle breakthroughs' in nanotech, super-super-computers & more then additional savings is not needed.

Arnold has speculated that we may see an end to mortality in this generation. In other words, if science learns to stop our body's from aging then what does that do to a lifetime consumption/savings model? If you will never age (like a vampire) then it is silly to put money into a 401K for a retirement because you'll never have a retirement...just maybe a 20 yr long vacation.

I'm not as optimistic about some of these things as Arnold, my point is that the market is a very powerful mechanism even if the individuals that make it up are very dumb. Its one thing to say you want to use the gov't to change the results of the market because you think they are morally wrong (example, outlawing prostitution, welfare for the poor etc.) but it is quite another to suppose you can 'beat the market' and allocate resources more efficiently.

Monte writes:

Boonton,

“…you are assuming that individuals will respond to *their* rate of return for saving. So, for example, if you improve the tax advantages of savings people will respond by increasing their savings.”

People will save when it’s advantageous to do so. At issue is whether or not they save enough, and the evidence suggests they don’t. That’s why I believe some form of forced savings plan may be needed to secure an acceptable level of retirement assets for future retirees.

“So if people do respond to rational incentives to save, then they should respond to market incentives as well. If 'poor money management' was causing people to save less than they should, the predictable result should be that bank, financial institutions & other players will respond with increased returns for savings.”

You’re talking about the risk-return tradeoff, which isn’t really a function of the demand for or supply of investment dollars. My point is that working Americans aren’t adequately planning for their retirement needs, due to a combination of dissaving and a lack of money management skills.

”Here's my other point, savings does not result in investment. Whether tomorrow's retirees are paying for their consumption with gov't checks or with retirement account disbursements, their standard of living will be determined by tomorrow's economy.”

I disagree. First, the national savings rate constrains the rate of investment, where low levels of national savings ultimately lead to low levels of investment. Indeed, NBER’s Feldstein (1992) argued that government measures aimed at raising a country’s savings rate approaches a one-for-one increase in its long run investment rate. Second, our standard of living (excluding cross-country comparisons) is largely determined by the level of income we earn or the personal assets we own, not by any measure of how well the economy is doing in general.

“If savings today increases tomorrow's capital stock, you may be able to provide for tomorrow's retirees today by savings. However this effect is subject to diminishing returns.”

I would argue that we have a long way to go before we start experiencing any diminishing returns effect.

“Keynes's insight was correct, 'saving' is meaningless on a society wide basis.”

Keyne’s Paradox of Thrift has pretty much been dismissed by the mainstream. It’s an interesting conversation piece, but it doesn’t square with the empirical evidence regarding savings, output, and employment.

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