Arnold Kling  

Income Volatility

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Robin, Radon, and Regulation... Math and Economics...

The Los Angeles Times reports


In the early 1970s, the inflation-adjusted incomes of most families in the middle of the economic spectrum bobbed up and down no more than about $6,500 a year, according to statistics generated by the Los Angeles Times in cooperation with researchers at several major universities. These days, those fluctuations have nearly doubled to as much as $13,500, the newspaper's analysis shows.

...Families in the economic middle saw their incomes, adjusted for inflation, climb by almost one-quarter to an average of nearly $50,000 between the early 1970s and the beginning of this decade, the newspaper's analysis shows. At the same time, middle-class families saw their average net worth grow 40% to $86,100 in the last decade alone, according to the Federal Reserve.


The basic theme is that as overall incomes have risen, volatility has gone up, also. Some economists (Brad Delong, Bob Shiller) are convinced that this provides a rationale for more government intervention in the economy, to protect people from unfavorable swings in income.

My first thought is that people ought to save more in today's economy. I call this the Millionaire Next Door mindset.

My worry about the risk-mitigation wonks is that their ideas will be translated by Congress into piecemeal programs to protect middle-class families from all of the major contingencies. The net result would be to lull people into a sense of security and entitlement, with all the moral hazard that results.

I think that the least harmful approach to paternalism would be to encourage more saving. For any given family, more saving ultimately might be used to deal with an employment interruption, a large health expenditure, a divorce, or some other common financial setback. But generically learning to save to protect against risk seems better than generically learning to treat government like a rich uncle who will indulge you no matter what.

For Discussion. What would be the most effective ways to encourage more personal saving?


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CATEGORIES: Income Distribution



COMMENTS (24 to date)
Nate Grover writes:

Simple. Raise the amount of money that can be put into an IRA. I would go farther and make all IRAs tax-free on the way out too.

Perhaps a compromise would be to tax distributions as income at the lowest rate when it comes out, regardless of other incomes you may have at the time.

Also, include unemployment as another exemption that allows pre-retirement age distributions.

By making it incredibly attractive, IRA contributions will soar. Obviously.

Nate Grover

Mark Horn writes:

Arnold, I like one of your other suggestions. By taxing consumption instead of income people will have greater incentive to save.

James writes:

I like this "class": the "teacher" gives out the answer to all the questions before he starts lectures. "If you want more of something, subsidize it...", so subsidize savings. Tax-exemption for certain types of savings (like IRAs) is one way to go, but howsabout something a bit more revolutionary: kill the outdated and reviled IRS, and start drawing all your revenue from taxing consumption. Saving instead of spending means you "keep" more money.

Want to make it progressive? Tax only goods/services that cost more than, say, $100 (how many individual items do low-income families buy that are more than a hundred bucks?). Or just exempt a few "necessities" like clothes, food, and shelter. Or, just refund low-income people's tax paid at the end of the year -- that is, if the poverty line is $25,000, refund (federal sales tax rate * 25000) to any low-income persons. Tax capital gains, or don't, but don't tax original share purchases, since stocks can be considered a type of savings.

Is this crazy?

dsquared writes:

Here's an alternative "Question for discussion": how can small risk pools possibly be more efficient than big ones?

Bob Knaus writes:

I'm Mr. Income Mobility, having inhabited every income quintile in my adult life, plus a few negative income years. Oh yeah, and when I worked as a sharecropper for my dad (in my teens) I got paid all of my income once a year.

Savings is a great vehicle for getting you through the ups and downs of income. So is credit, if you use it wisely. And, credit is far more available to the young than is savings.

Thinking of credit as a privately negotiated wealth transfer between generations (the old save & lend, the young borrow & repay) helps. The old are better at saving, it's their area of expertise, their competitive advantage so to speak. The young have bright futures ahead of them, they are excellent credit risks and represent a good investment opportunity for the old.

Then, when the old die, the not-so-young inherit their remaining capital and the cycle starts over.

That is, presuming the government doesn't take out a huge slice beforehand, or get involved too much in the credit/savings allocation decisions.

Individual savings is over-rated. Particpation in the inter-generational credit cycle is key.

Capt. Bob Knaus
S/V PELLUCID

Max Sawicky writes:

What about the welfare losses from saving too much?

Mcwop writes:

My division manages large and mid sized company retirement plans (e.g. 401ks). We have struggled with this for the past decade. Only now are we starting to get those last holdouts into their plan. Here is what we find works best:

- Education. Show employees the benefits of automatically setting aside money from each paycheck. Once people start doing this they usually do not stop. This is best accomplished through personal communications. Maybe the SSA can add something to the social security statement showing the benefits of opening an IRA in addition to SS.
- Automatic plans. Many companies now automatically start taking money from employee paychecks to go into their retirement plan (a result of better regulations). There is a default investment option set up as well. Again, once this starts it usually does not stop.
- Better regulations (more on this below)

People want to save, but procrastination is a big issue.

In cases where employers do not offer a company sponsored retirement plan, maybe set up rules that make it easy to automatically divert an employee's pay to an IRA. Many smaller employers do not offer retirement plans because the regulations are very onerous and discrimination regulations do not make it worthwhile for the owner.

Tax incentives to accomplish this goal are not necessarily needed. Many of the problems are regulations that make it onerous for employers to offer plans, and get employees into those plans. Restructuring the regulations could encourage more automatic employer sponsored plans.

Lastly, a nice development is automatic rollovers to an IRA upon an employee leaving their job. Previously, regulations prevented this. Now there will be less cash outs when people leave their jobs.

Randy writes:

Have people ever saved? It seems to me that up until about 100 years ago most people worked until they could no longer work and then relied on extended family. The idea of the independant nuclear family is fairly recent - and even that is breaking down. I question the premise, that it is good to insist that the aged be self reliant.

As I see it, my primary responsibility is to ensure that my children get a good start - education, a car, help with a new home. My secondary responsibility is to enjoy life - a new Jeep, vacations, a variety of toys, etc. After these are taken care of, I'll worry about saving for retirement. Saving is for people who make enough to accomplish the above and still have money left over - not for me. How do you encourage someone like me to save? You don't. Though if the government would stop taking 30% of every dollar I make, it might help.

Randy writes:

P.S. And where am I supposed to save? Mutual funds are risky and the management fees eat up the returns. Bank accounts don't keep up with inflation. Social Security is a forced loan to the government that the government has no obligation to repay. In my opinion, the idea of "Savings" is overrated. The only real investments are family, health, education, and willingness to work.

Matt writes:

Nate, I hope you are smarter than you sound. A lot of real research goes into the question of the savings effect of IRAs and 401(k)s. The net effect on personal savings is estimated variously between 0 and 50 percent (more people think it's close to 0 for reasons I'm sure you can imagine). The effect on public savings is -100 percent, leaving a nasty negative effect on national savings. Please try harder.

Other than forced savings, the only way I see to encourage people to save more is by tricking them, though that may be an uncharitable characterization because I'm all for it. Automatic enrollment in deferred compensation plans, etc.

Michael H. writes:

One reason poor people might not want to save more is because of the income volatility you mentioned. People might prefer to risk bankrupcy and let others pay their debts. Bankruptcy could be viewed as a sort of social insurance. Only problem is, the risk of bankruptcy raises borrowing rates especially for those in the highest risk group (the poor).

JT writes:

A follow-up question is whether income volatility leads to the appearance of income inequality if the inequality is measured over small spans of time.

Dsqaured writes: "how can small risk pools possibly be more efficient than big ones?"

What do you mean by "efficient"?

Bob DObalina writes:

Mcwop-- you wrote that Lastly, a nice development is automatic rollovers to an IRA upon an employee leaving their job. Previously, regulations prevented this. Now there will be less cash outs when people leave their jobs.

Plan sponsors can do automatic rollovers now? Wow. What about loss of ERISA protection? And why would a money management firm want to make it easier for assets to leave their product? Any background you can give would be nice.

Mcwop writes:

Bob,
Yes they can do this now. The DOL has set the parameters.

Here is a nice ERISA blog (there is a blog for everything) with the info:

http://www.benefitscounsel.com/erisaarchive/cat_automatic_rollovers.html

If the provider also does IRAs (like we do), then you get to retain the assets. It is a better alternative for the Under $5,000 auto cash out.

Lawrance George Lux writes:

I am an oldtime reactionary who doesn't see all the benefits of modern economic policy that is touted. Low Interest rates did not generate relatively high economic expansion--or prevent contraction. They did constrict Seniors' spending, and reduce the use of Bank deposits--CDs, etc.

401(k)s and IRAs etc. plus business tax credits for investments have overfunded the Financial Paper market. Funds heavy money has overinflated Crisises by Profits Taking--consider the Price of Crude Oil, where heavy Money has maintained the price of Crude $7-14/barrel over most economic model simulations.

Give me a Fed Overnight rate of 3.75% constant, with a standard Bank CD rate of 4.25%, and I would be happy. Real Truth: I would call for elimination of all Tax credits, including IRAs, 401(k)s etc., if I had a Voice in Tax Reform. lgl

jan writes:

I think letting people put social security in private accounts would increase the amount of savings.
Income maybe fluctuating more because of the use of bonuses has increased. People getting bonuses know this money is at risk and hopefully don't take on debt that would require the same bonuses year after year, but use it for big item purchases such as a car. If bonuses are the reason for the fluctuation, a law passed to alleviate the loss of the bonus would be counter-productive, since the bonus is there to give employees an incentive to work harder.

Randy writes:

Arnold,

Re; But generically learning to save to protect against risk seems better than generically learning to treat government like a rich uncle who will indulge you no matter what.

Rich Uncle - interesting analogy, because the choice really is between govenment and family. But a rich uncle is not an accurate characterization of the government. Rich uncles don't first steal the money they hand out. By taking 30% of my wages, the government has made it difficult if not impossible for me to be self-reliant. They have forced me into a position of dependancy and themselves into a position of responsibility. Given this environment, beyond my control, how is it illogical for me to demand that the govenment accept its responsibility? I think it would have been better had such an environment never been created, but it has. In a society of free riders, only a fool tries to be self reliant.

Roger D. McKinney writes:

The down payment for a house used to be a major incentive to save. Today it's easy to get a no-down mortgage. Lacking that, I vote for taxing consumption and not savings or capital gains.

Nate Grover writes:

Matt, perhaps I am stupid. I don't understand why savings wouldn't go up if tax law made it more attractive to do so. Specifically, if IRA and 401K contributions were made even more advantageous, I would like to know why contributions would not go up. Thanks.

Nate

Matt writes:

Nate, I apologize if I was dismissive or condescending - not my intent. There are two good reasons why the effect on savings is low or negative:

1) The tax deduction method ensures that those with the strongest incentive to save in a tax-preferred account are those who earn more (and are in a higher marginal rate bracket) - the incentive is close to nothing at modest income levels. Those with high income are usually just shifting existing assets from taxed to untaxed accounts, not increasing saving.

2) The government pays for the shifting of this income to IRAs by way of a tax expenditure. Gene Steuerle at Urban recently wrote about how the annual tax expenditures of retirement accounts now exceed the net personal savings rate.

Then there is the problem of efficacy - only 5 percent of 401(k) contributors are at the maximum, so increasing the max only affects them, and they are the ones most likely to be doing additional saving (and thus asset shifting) anyway.

This all brings me back to my opinion that we should be tricking or forcing people into saving more, or stop complaining about the personal saving rate. Ending public dissaving would help, too, of course.

Boonton writes:
Simple. Raise the amount of money that can be put into an IRA. I would go farther and make all IRAs tax-free on the way out too.

1. Many people fail to max out their 401K's today. This despite the tax incentives plus the fact that many employers do a 50-100% match!

2. If income volatility hurts the poor most then what good is raising IRA limits? It doesn't matter to someone making only $24K per year that they could put $30K rather than $10K in their IRA.

Here's a suggestion, mandate a 2% contribution to an IRA-like account. Also state that money from this account can be withdrawn at any time provided it is 3 or more years old. The typical person will have at least 6% of a years income (3.12 weeks) in their account. If they don't withdraw the maximum. After the first 3 years gradually increase this to 5% or 10%.

In effect you would have delaying 5-10% of income for 3 years (plus interest earned on it). If people experience five great years and then three horrible ones they will be able to withdraw 5-10% of their 'great income' during the lean years.

Randy writes:

Boonton,

Interesting concept. But we are already forcing the working poor to "save" 15% of their pay towards Social Security and Medicaire. We are also charging them roughly 10% for the use of public services. Twentyfive percent of $20k is a huge hit for a family already struggling to make ends meet. The problem with this type of paternalism is that it is disconnected from reality. It isn't designed to help the poor. It is designed to keep them from being a burden on our collective conscience. It is pretend charity.

Nate Grover writes:

"If income volatility hurts the poor most then what good is raising IRA limits? It doesn't matter to someone making only $24K per year that they could put $30K rather than $10K in their IRA."

Boonton, income volatility means it goes up and down. So in the fat years people would be more likely to save an IRA. When they drop to $24K, they would be less likely.

The question was how to increase savings, not how do we best shield the poor from income volatility.

Also, IRA limit is $4k, not $10k (and not everyone has a 401(k) option). Increasing that IRA limit would certainly increase savings, at least somewhat.

Now, would it increase savings among the very poor? No, nothing will. The very poor are never going to save anything. They can't.

But it would increase savings among the middle class. Most households have room to save 5 to 10K per year if they're smart about it. Median income in 2003 nationwide for a four person household was 65K. http://www.census.gov/hhes/income/4person.html

They can save more than 4K and a strong tax incentive would likely cause many to do so.


Nate

Boonton writes:

Boonton, income volatility means it goes up and down. So in the fat years people would be more likely to save an IRA. When they drop to $24K, they would be less likely.

IRA contribution limits are relevant only if income volatility is severe. Typically volitile income may be between $12K and $24K per year, it is not typical to see people cycle between $12K and $120K.

The question was how to increase savings, not how do we best shield the poor from income volatility

Even here the answer is not as obvious as you depict. There are two motives for savings. One is to earn returns and another is to achieve a certain amount. If you want to earn returns then you might indeed save more if the rewards for savings are increased (higher interest rates, more tax subsidies/benefits). However if your goal is to achieve a certain goal then increasing the rewards for savings will cause you to cut savings. After all, if I had $5M in my 401K I would immediately drop my contribution to 0%!

I do agree that an IRA contribution limit should be more along the lines of $10K per year rather than $4k.

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