The personal saving rate in the United States is alarmingly low.  The average person saved about nine percent of his disposable (after-tax) personal income in the mid-1980’s, about five percent in the mid-90’s, but only about two percent so far this decade.  These very low rates of saving restrict investment, which, in turn, considerably retards the growth of productivity, wages, and employment and slows the growth of individual income and wealth.

Why is the saving rate so low?  In a word: taxes.  Income is taxed when it is earned.  If you use after-tax income to buy food, clothing, or a television, you can generally eat, stay warm, and enjoy the entertainment with no additional federal tax (except for a few federal excise taxes).  If you buy a bond or stock or invest in a small business with that same income, however, you pay income taxes on the stream of interest, dividends, profits, or capital gains received (which is a tax on the “enjoyment” that you “buy” when you save).  This added layer of tax is the basic income-tax bias against saving.  If your saving is in corporate stock, the business also has to pay the corporate tax before distributing dividends to you or reinvesting earnings to increase the value of the business.  Either way, corporate income is taxed twice.  If you leave your loved ones a modest bequest at death (beyond an exempt amount that is barely enough to keep a couple in an assisted-living facility for a decade), that amount is taxed again by the estate and gift tax (the “death tax”).

The cumulative marginal tax rates that result from these multiple layers of taxes on saving can be surprisingly high.  The marginal tax rate is the tax rate that would be imposed on the last or next unit of activity.  Marginal tax rates are key because they govern the choice between working longer or taking more leisure and between consuming more or saving more and expanding a business.  In a tax system with exemptions and several progressive, escalating tax rates, the marginal tax rate on the next dollar earned may be much higher than the average tax rate.  Also, if the same income is taxed more than once, marginal tax rates can compound and become prohibitively high, destroying incentives to produce and earn.

Before the 2001 Tax Act, there were five statutory federal marginal income-tax rates for individuals: 15 percent, 28 percent, 31 percent, 36 percent, and 39.6 percent.  There is also an “Alternative Minimum Tax” (AMT), with rates of 26 to 28 percent, which applies to a broader definition of personal taxable income.  The 2001 and 2003 Tax Acts have lowered the rate structure to 10 percent (a new lower bracket), 15 percent, 25 percent, 28 percent, 30 percent, and 35 percent.  The 2001 Tax Act will expire in 2011, however, and the rate structure will revert to the pre-2001 levels.

Applying these tax rates twice to saving, both on the income that is first saved and on the returns to the saving, is a form of double taxation.  This second layer of tax against saving can be offset by deferring the tax on all income that is saved and taxing the savings upon withdrawal, as done for limited amounts contributed to a standard IRA or pension plan.  It can also be offset by taxing the money before it is saved but not taxing the returns, as in a Roth IRA.  The two methods are equivalent if savers face the same tax rate over time.

Neutral tax treatment of saving provides an enormous benefit for savers.  For example, assume a 20-percent tax rate.  Putting $1,000 yearly of pre-tax income into a tax-deferred pension plan (or $800 after taxes into a Roth IRA) beginning at age 20, at a 7.2-percent real rate of return (the average real growth of the stock market with dividend reinvestment since 1926), would provide $280,000 in retirement assets—after federal taxes—at age 65, or $400,000 at age 70.  If the same $1,000 of pre-tax income is subject to ordinary tax treatment, only $800 in after-tax principal can be saved each year, and the interest and dividends would be taxed annually.  That account would provide only $178,000 for retirement spending at age 65, or $240,000 at age 70.  Savers would be 57 to 67 percent better off under a tax-neutral treatment of saving.

The 2001 Tax Act addressed this problem by expanding the amounts that people can contribute to their IRA’s and adding “catch-up” contributions for people over age 50.  The act also increased the amounts people can contribute each year to 401(k) and 403(b) plans, lifted the income limits for participating, allowed catch-up contributions, and created education IRA’s.  And the President’s 2005 budget proposes replacing most current law regarding retirement, education, and medical saving arrangements with three broad, simple saving programs.  Lifetime Savings Accounts (LSA’s) would let people put aside, after tax, up to $5,000 each year, and all earnings would be free from additional tax.  The money could be withdrawn for any purpose, at any age.  LSA’s would replace current education and medical saving plans.  Retirement Saving Accounts (RSA’s) would let people put aside for retirement up to $5,000 or their total wage income, whichever is less.  RSA’s would replace current IRA’s for future contributions.  Employer-Based Savings Accounts (ESA’s) would replace future contributions to 401(k), SIMPLE 401(k), Thrift, 403(b), and Governmental 457 plans, and SIMPLE IRA’s and SARSEP’s.

In addition to the basic income-tax bias against saving, people who save by purchasing stocks face another layer of tax bias: the corporate income tax.  The top corporate tax rate is 35 percent, and there is a corporate AMT.  Before the 2001 Tax Act, the combined corporate and top personal income-tax rates on corporate earnings paid out as dividends exceeded 60 percent.  The combined top tax rate on retained earnings resulting in a long-term capital gain, at a top capital-gains rate of 20 percent, reached 48 percent.  The 2001 Tax Act trimmed personal income-tax rates.  Even better, the 2003 Tax Act lowered the long-term capital-gains tax rate to 15 percent and did the same for dividends paid out of corporate income that had been subject to tax.  (Dividends of firms not subject to a corporate tax are treated as ordinary income.)  At the reduced 15-percent tax rate, the top combined tax rate on corporate income for either dividends or retained earnings is just under 45 percent.

The 2003 dividend and capital-gains tax-rate cut raised after-tax incentives to save and own stock and made it less costly for firms to raise money to invest.  It encourages firms to issue more stock and to take on less debt and significantly reduces double taxation.  Fully eliminating the additional layer of tax on corporate income would require taxing corporate income on either the corporation’s tax return or the shareholder’s tax return, instead of on both.

The federal unified gift and estate tax (the “death tax”) hits saving yet again.  Every cent saved to create an estate either has been taxed or will be taxed under some provision of the income tax.  Ordinary saving by the deceased was taxed repeatedly when he and any companies whose shares he may have owned paid individual and corporate income taxes.  Saving in a tax-deferred retirement plan will be subject to the heirs’ income taxes and was subject to the corporate income tax in the case of stock holdings.

Before 2001, the estate and gift tax rate topped out at 55 percent if a parent left money to a child, but it could reach almost 80 percent under the Generation Skipping Tax (GST) if the bequest went to a grandchild or other relative more than one generation removed from the deceased.  The GST rate is equivalent to imposing a 55-percent tax on the estate (as if it had gone to a child) and then imposing another 55 percent on the remaining 45 percent of the estate, as if it had gone from the child to the grandchild.

The death tax probably does not raise any net revenue for the government.  Prof. B. Douglas Bernheim of Stanford estimates that deliberate avoidance of the estate tax—by giving assets to children, most of whom are in lower income-tax brackets than their parents—costs more in reduced income-tax revenue on the earnings of the assets than the estate tax picks up.  Gary and Aldona Robbins of Fiscal Associates estimate that the reduced savings and capital formation lower the GDP and wages enough that the reduction in income and payroll taxes exceeds the take from the estate tax.  Even if they are both only half right, the tax loses money.  Repeal of the estate tax would pay for itself and would encourage wealth and job creation.

If a couple nearing retirement thought of working an extra year to add to an estate, the combined income, payroll, and estate tax rates could have exceeded 78 percent, or even 90 percent with the GST, under the old law.  That is quite an incentive to retire instead of continuing to work or to reinvest interest or dividends in an estate.  The 2001 Tax Act will reduce the top estate-tax rate to 45 percent by 2007, and it raises the exempt amounts for the estate and gift tax.  It will eliminate the estate tax in 2010, but the tax will reappear at the old rate in 2011 unless Congress votes to make the repeal permanent.

The income of all businesses (including noncorporate businesses) is overstated and overtaxed by forcing businesses to wait for years or decades to record the costs of their capital outlays.  The write-offs lose the time value of money and lose value to inflation.  For example, a dollar spent on a seven-year asset gets a write-off that is worth only 91 cents in present value if inflation is zero.  A dollar spent on a building (written off over 39 years) gets a deduction worth just 55 cents in present value.

The cost of the delay rises with inflation.  At five percent inflation, the seven-year asset’s write-off is worth only 81 cents, and the building’s write-off drops in value to 30 cents.  At modest rates of inflation, the overstatement of business income by depreciation can effectively double the apparent tax rate.  During periods of double-digit inflation in the 1970’s, some capital-intensive businesses with lots of long-lived assets, such as utilities, steel mills, and railroads, were taxed at more than 100 percent of their real earnings!  To reflect the timing and the cost of investment accurately, businesses’ capital outlays should be written off at once (expensed), not depreciated.  The 2002 Tax Act provided a “bonus depreciation” provision allowing all businesses to expense 30 percent of their equipment spending (depreciating the rest as usual).  The 2003 Act raised that “bonus depreciation” allowance to 50 percent.  Both provisions expire at the end of 2004.

Many tax deductions, exemptions, or credits are phased out as people’s incomes rise.  These phaseouts cause taxable income or tax liability to rise faster than the jump in actual earnings would otherwise bring about, and they act as a hidden increase in the tax rate on the added income.

For example, the phaseouts of personal exemptions and itemized deductions effectively raise the top income-tax rates by 2.5 to 5 percentage points for a couple, depending on the number of their dependents.  The 2001 Tax Act will gradually eliminate these phaseouts between 2006 and 2010, but they will reappear if the cuts are not made permanent.

Social Security recipients who have enough income to be subject to income taxation of benefits face very high marginal tax rates.  Effective marginal tax rates on an added dollar of interest and pension income can reach 42 or 52 percent for people supposedly in the 28-percent bracket.  These penalties punish people for having saved for retirement.  For added wage income subject to the payroll tax, the rates can reach 65 percent.  If the wages exceed the Social Security earnings test limit, the combined federal tax rates and loss of benefits can cost retirees over 100 percent of their incremental income.  This is a federal edict not to work, issued against the most experienced people in the workforce.

Various provisions of the Bush tax cuts have directly addressed each of the excess layers of taxation of saving and investment.  In fact, I would describe the changes as incremental tax reform.  However, these provisions were enacted on a temporary basis because of ridiculous congressional budget-process rules.  The expensing provisions die at the end of this year.  The marginal-tax-rate cuts and the estate-tax repeal will expire at the start of 2011.  The reduced tax rates on dividends and capital gains will expire at the start of 2009.

The President’s 2005 budget proposes making permanent the rate cuts, dividend and capital-gains relief, and the estate-tax repeal—all good moves.  It would allow the 50-percent “bonus depreciation” provision to lapse, which is a mistake.  These provisions should be extended or replaced with more sweeping pro-saving, pro-investment reforms.  Claims that these provisions favor the rich are false.  Those who gain the most from additional saving and investment in the U.S. economy are the workers who become more productive and better paid as a result.