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12.3 Income Taxes and Saving

Learning Objectives

After you have read this section, you should be able to answer the following questions:

  1. When income taxes are cut, what happens to private savings?
  2. When income taxes are cut, what happens to national savings?

Look back at Figure 12.2 "Macroeconomic Effects of Tax Policy". We explained that there are three channels through which income taxes affect the economy. In Section 12.2 "The Kennedy Tax Cut of 1964", we discussed the first of these in some depth: a cut in income taxes can stimulate consumption and increase aggregate spending. Figure 12.2 "Macroeconomic Effects of Tax Policy" reveals that taxes can also affect potential outputThe amount of real GDP the economy produces when the labor market is in equilibrium and capital goods are not lying idle., both through their influence on saving (and hence capital accumulation) and through their effect on labor supply. We turn next to the savings channel.

Tax Cuts and Private Saving

We have already conducted most of the analysis we need to examine the effects of tax cuts on saving. We know that a tax cut increases disposable income. Our theory of consumption smoothing tells us that households will respond by increasing consumption and savings. Specifically, we predict that a dollar’s worth of tax cuts will cause saving to increase by (1 − marginal propensity to consume).

It is tempting to conclude that tax cuts therefore will lead both to higher consumption, increasing output now, and to higher saving, increasing output in the future. Such an argument is not right because it looks only at saving by households. We also need to look at the effect of the tax cut on the government surplus or deficit.

Tax Cuts and National Saving

If the government is spending more than it receives in tax revenues, then it is running a deficit. Conversely, if it is spending less than it receives in tax revenues, it is running a surplus. National savings is the combined savings of the government and the private sector. If the government is running a deficit,

national savings = private savings − government deficit,

and if the government is running a surplus,

national savings = private savings + government surplus.

These are just two different ways of saying the same thing because, by definition, the government surplus equals minus the government deficit.

What happens if the government cuts taxes? If there are no associated changes in government spending, then tax cuts translate dollar for dollar into the government budget. One million dollars worth of tax cuts will increase the deficit (or decrease the surplus) by exactly $1 million. So even though a tax cut of a dollar increases private savings by $(1 − marginal propensity to consume), it costs the government $1. The net effect (to begin with) is to reduce national savings by an amount equal to the marginal propensity to consume.

If the tax cut succeeds in increasing income, there is additional savings resulting from the multiplier process. Still, we expect the overall effect is a decrease in national savings. For example, consider the Kennedy tax cut again. Taxes were cut by $10 billion. The resulting change in income was roughly $20 billion. With the marginal propensity to save equal to 0.07, the offsetting increase in private savings would have been about $1.4 billion. Evidently, the result was a large decrease in national savings.

Here we see one of the biggest problems with tax cuts. They are attractive in the short run because they stimulate aggregate demand and increase output. They are also attractive politically, for obvious reasons. Unfortunately, they have the adverse long-run consequence of reducing national savings. When national savings decreases, the economy does not build up its capital stock so quickly, so future living standards are lower than they would otherwise be.

Key Takeaways

  1. Since the marginal propensity to consume is less than 1, a tax cut will lead to a household to consume more and save more.
  2. National savings, the sum of public and private savings, will generally decrease when there is a tax cut.

Checking Your Understanding

  1. If the marginal propensity to consume from a tax cut is zero, what will happen to national savings when taxes are cut?
  2. If income taxes increase, what happens to the incentive of an entrepreneur to start a new business?