Tax Breaks and Household Savings Rajnish Mehra Arizona State University NBER and NCAER INDIA POLICY FORUM New Delhi July 10th 2018
I enjoyed reading this thought provoking paper. It is an empirical contribution to the literature on capital taxation and savings. Historically, savings for retirement was not a major public policy issue, especially in developing countries as life expectancy and the working life span largely coincided. Increases in life expectancy have increased the number of years a household spends in retirement relative to working years. 2
The issue of how to motivate time consistent saving for retirement planning by households has entered front and center into the public policy arena. To induce households to save more, governments the world over have resorted to tax incentivized schemes. 3
Do these incentives increase household savings or do they simply result in portfolio rebalancing? 4
Tax incentivized schemes work by increasing the rate of return to a particular asset class, thus changing the price of future consumption relative to current consumption. This induces both an income effect and a substitution effect. Making future consumption cheaper induces households to save more. However, tax free compounding increases the after tax rate of return on assets; this will, in general, lead to portfolio rebalancing and may induce an household to save less. 5
The net effect on savings is ambiguous and will, in general, depend on the elasticity of intertemporal substitution. 6
We illustrate this in the context of a deterministic two period (partial equilibrium) model where agents have preferences of the form u ( c , γ ) = c 1 − γ − 1 1 − γ In the first period agents work, consume and save. In the second period (retirement) they consume their savings. . 7
Households solve the following problem: max u ( c 0 , γ ) + β u ( c 1 , γ ) s.t. c 0 + s ≤ Y c 1 ≤ s (1 + r ) The solution is: β 1/ γ s = (1 + r ) 1 − 1/ γ + β 1/ γ Y . ∂ s ∂ r < 0, = 0 or > 0 if γ < 0, = 0 or > 0 8
A Snapshot of Taxation in India 39 million individuals filed tax returns in the year 2014-15 This is less than 1% of India's total population. Of the 39 million who filed a tax return, 6.4 million filed a ‘zero return’. 92% of the households considered in this paper fall in the zero percent tax paying bracket, 7.6% fall in the 5% tax bracket, while less than 1% fall in the 20% and 30% tax brackets. Hence any quantitative effects of the policy changes addressed in the paper are likely to be insignificant. Something the authors acknowledge in section 6. 9
A Macro Perspective 10
The paper begins by documenting the changes to capital taxation over the last 15 years and examining the effects of these changes on savings in financial assets (stock expressed as a fraction of GDP). Figure 1 Household financial assets as percent to GDP 20 15 Per cent to GDP 10 5 Household financial assets as % GDP (Base series 2004 − 05) Household fianncial assets as % GDP (Base series 2011 − 12) 0 2001 2003 2005 2007 2009 2011 2013 2015 11
Based on this figure the authors conclude: “There appears to be no correlation between tax breaks and financial savings. Despite a continuous regime of tax breaks on one product or another, savings have risen in some years, stayed stable in others, and have actually fallen in one. The share of financial savings in total savings is lower in 2016 relative to 2001” 12
While this may be true, it is misleading to base this conclusion on the evidence presented in Figure 1 as it confounds two effects: inflows to financial assets and a revaluation of existing assets. 13
The stock of financial assets increases due to inflows. All assets must be held both before and after the announcement of the tax break. This will lead to a revaluation of existing assets. In addition, the value of the existing stock of assets (especially equity) fluctuates over time with changes in economic conditions. 14
To partly mitigate this, I present just the annual flows into financial assets as a fraction of GDP both with and without equity flows as equity flows are more volatile than flows into other asset classes. 15
Sum of all the Flows as % of GDP 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Plot Courtesy of Dr. Saurabh Bandyopadhyay (NCAER) 16
Sum of all the Flows (Without Equity) as % of GDP 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Plot Courtesy of Dr. Saurabh Bandyopadhyay (NCAER) 17
From these plots it is clear that inflows as a share of GDP have increased over time. In contrast to the paper’s conclusion, I view this as consistent with an increase in inflows (as a fraction of GDP) to financial instruments over the period of the study. Needless to say, (but said anyway), this does not imply causality. 18
A Micro Perspective 19
The authors next estimate the effect of being in a taxable income bracket on the probability of having investments in specific financial products. They do this by examining portfolio formation using the CMIE Consumer Pyramids Household Survey data for 2016-17 and running the following Probit regression: Y * = t i β 1 + X i β 2 + ε i The results are presented in Tables 5 and 6. 20
While Table 5 shows that the results are statistically significant the economically interesting results are in Table 6. Table 6 Marginal effects: Investments in instrument Instrument Marginal effect Fixed deposit 0.065 ∗∗∗ Insurance 0.280 ∗∗∗ Pensions 0.202 ∗∗∗ Small savings 0.073 ∗∗∗ The 0.065 implies that in moving from a non-taxpaying bracket to a taxpaying bracket, the probability of investing in Fixed Deposit increases by 6.5%. 21
There exist the potential for confounders in the empirical analysis. Some potential confounders in this paper include income, wealth (financial and non-financial assets), and financial literacy. For example, wealthy people both pay taxes and invest more. This mechanically induces a correlation between paying taxes and investing. The authors are aware of this and in an effort to mitigate this, exploit the differential tax status in income-matched households. 22
They categorize salaried households based on salary. They change X from being an indicator variable to one representing category values and re-run the Probit regressions. The results are reported Table 8. In Tables 5 and 6 where the comparison is between households in the non-taxpaying bracket with households in the taxpaying group, and the results are statistically significant. While in Table 8 where the comparison is between salaried taxpaying and non-taxpaying households in different salary brackets, the statistical significance largely vanishes (except for households in the 350-400 K and 400-450 K bracket). 23
Given this mixed evidence it would be premature to conclude that there exists a “tax-incentive” effect of investments in financial products, as the authors declare in their conclusion on Page 17. 24
Other Issues Regressive tax subsidies? How does the government balance its budget? Credibility of government policy? 25
Concluding Comments The paper documents the response of Indian households to tax incentivized financial instruments. It ventures into a relatively new and topical area of public policy research. The paper is a work in progress. I look forward to a more nuanced parsing of its implications for tax policy. 26
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