Fiscal Studies (1995) vol. 16, no., pp38 - 57

© Institute for Fiscal Studies, 1999

Taxation and Household Saving:Reflections on the OECD Report

MARK H. ROBSON1

I. INTRODUCTION

At the beginning of the 1990s, there was a wave of interest in the connectionsbetween taxation and saving, culminating in a series of reports and reviews in1994. So, for example,

! UK tax policy towards saving and investment has been reviewed in thecontext of the Industrial Finance Initiative;

! Finance Ministers had an extensive discussion at the IMF meeting in Madrid;! under the German presidency of the EU, work has continued on a possible

common basis for taxing savings, as initiated by Belgium last year;! the IFS Capital Taxes Group concluded its deliberations with Proposals for

the Taxation of Savings and Profits; and! in the August issue of Fiscal Studies, Boadway and Wildasin surveyed much

of the literature from the 1980s.

Then in November the OECD published an extensive survey on Taxation andHousehold Saving in each of its 24 Member countries in 1993, together with ananalysis of what lessons might be learned for good design of tax policy from the

1 Principal Administrator in the Fiscal Affairs Division of the Organisation for Economic Co-operation andDevelopment.Although the author was closely involved in drafting the report on Taxation and Household Saving, the viewsexpressed in this article are not necessarily those of the OECD or its Member governments. Helpful commentsfrom Michael Devereux, Bill McNie and Jeffrey Owens are gratefully acknowledged.

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literature and country experiences. This article summarises the report andconsiders what might be deduced from its conclusions.

II. THE OECD REPORT

Following publication of its last major comparative study at the end of 1991, ontaxation of company profits and cross-border flows between Member countries(OECD, 1991), the Working Party on Tax Analysis and Tax Statistics of theCommittee on Fiscal Affairs (which comprises economists and statisticiansresponsible for tax policy questions in each of the OECD countries) decided toexamine the taxation of saving, primarily those assets commonly held byhouseholds. The purpose of the study was to consider the available evidence toanswer the following questions:

(i) Does taxation actually affect the level of national saving?(ii) What principles should govern tax policy towards household saving?(iii) To what extent does taxation affect the composition of household

saving?(iv) What tax incentives are offered to encourage different types of saving?(v) What can we say about the effects of the tax incentives used?(vi) What alternative non-tax measures are used in OECD countries?(vii) What is the cost of tax incentives to various types of saving in terms of

tax revenue forgone?(viii) To what extent does the interaction between OECD countries’ tax

systems affect the global allocation of saving?(ix) How might the tax treatment of saving be changed in Member countries

in order to improve the national and global allocation of saving in a waythat benefits all countries?

After an initial round of data collection, it became clear that what countriesdid and why were much more difficult questions to deal with in a comparativeframework than might initially be supposed. In the corporate sphere, althoughthere are significant differences between domestic systems of company tax, it isrelatively straightforward to classify them, and well-understood rules have beendeveloped (based on the OECD Model Tax Convention on Income and Capital)to deal with cross-border flows. But domestic systems for taxing income ofindividuals are much more diverse (perhaps because individuals and theirincomes were for so long effectively immobile), even before taking account ofthe many special schemes that have been introduced in recent years, followingthe widespread removal of exchange controls and consequent internationalliberalisation of capital markets.

To make the report manageable, it was therefore necessary to concentrate ona small number of simple assets for which there was, in broad terms at least, a

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common institutional framework. In particular, it would have been impossible todeal on a comparative basis with the different tax and regulatory regimesapplying to various financial intermediaries, including insurance companies andopen- and closed-ended funds, without making arbitrary and unrealisticassumptions. This was regrettable, given the fact that most households holdingequities and bonds do so via such intermediaries rather than directly, but it ishoped to undertake further studies of the taxation of financial institutions.

The assets chosen for comparative analysis of effective tax rates were bankdeposits, government bonds, direct shareholdings, funded pensions and owner-occupied housing, concentrating on taxes at the level of the household (and so,for example, ignoring corporation tax paid on profits out of which dividends arepaid). Despite these severe restrictions on its scope, the report still runs to 308pages in English, plus a separate volume of Country Surveys comprising themore extensive descriptions of national taxes that were provided by Membercountry governments in response to the Working Party’s original questionnaire.

III. THE LEVEL OF NATIONAL SAVING

While the report concentrates on household saving, much of the concern that ledin the 1980s to calls for reform of saving taxation arose from perceived fallingrates of national saving, comprising four components — household, corporate,non- profit organisations and government. As little is known about the empiricaldeterminants of aggregate corporate saving, however defined (the biggestproblem being to explain companies’ net accumulation of financial assets), andthe non- profit sector is small, the link between household and national saving isperhaps the most important for tax policy, but not always clearly understood.

Assuming that pre-tax rates of return remain constant (as in a small, openeconomy), if the government cuts taxes on capital income, financed by higherborrowing, households could react in one of three ways. They might simply holdconsumption constant, reinvesting their additional after-tax capital income, sothat national saving would remain constant, the increase in household savingbeing exactly compensated by the fall in government revenue and hencegovernment saving. Or households might increase consumption, spending atleast a part of their additional after-tax income, so that national saving would fall(although household saving would rise as long as the extra income was not fullyspent); or conversely, attracted by the higher after-tax yield, they might chooseto consume less and save more of their labour income, so that both householdand national saving would rise.

A majority of empirical studies, including the most influential, find no effectof the rate of return on consumption — in other words, the first of these threescenarios. The effect of tax cuts on capital income would therefore be to transferassets from the government to the private sector, with an increase in thegovernment deficit matched by an increase in household saving. However, if

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such tax cuts are indeed financed by higher government borrowing, pre-tax ratesof return may increase, while households save more in anticipation of highertaxes in future to meet the higher cost of government borrowing (so-calledRicardian equivalence). If instead the tax cuts on capital income are offset byincreases in other taxes or by lower government expenditure, then the likelyresponse of households and its causation is even less evident without a specificmodel.

Having reviewed the extensive literature on the determinants of saving andwhether tax treatment affects the overall level, the report concludes that there isno clear evidence of significant tax effects. Whether tax incentives make adifference to overall levels of saving in a particular country at a given timedepends on many other factors, as diverse as wealth effects, expected inflation,and the availability of public and private pension schemes and consumer credit.This conclusion is echoed in a recent review article by Gylfason (1993), whosummarises the results of 24 empirical studies between 1967 and 1992, of whichhalf estimate the elasticity of the saving rate to the real interest rate at zero (oneof the best-known studies being Hall (1988)); he also quotes Blinder’s view that‘... there is zero evidence that tax incentives that enhance the rate of return onsaving actually boost the national saving rate. None. No evidence. Economistsnow accept that as a consensus view’. (Gylfason’s response is to propose amodel in which both saving and rate of return are endogenous.)

Even considering household saving in isolation, it is far from obvious that anincrease in the rate of return resulting from reduced taxes will lead to increasedsaving. It is not difficult to think of assets where the opposite effect woulddominate, i.e. individuals save less simply because they need to save less toachieve a given target sum. For example, the level of premiums payable on low-cost endowment policies to finance mortgage repayment evidently increases withthe tax rate on the return within the fund. In a wide class of neo-classical models,whether substitution effects outweigh income effects depends only on theelasticity of intertemporal substitution.

The absence of a clear link between rate of return and saving appears to beborne out by the comparison in the report between movements in the componentsof gross saving in OECD countries from 1960 to 1992 and changes in the taxtreatment of capital income over the same period. There is no obvious patternacross countries, as regards either national or household saving.

IV. THE COMPOSITION OF HOUSEHOLD SAVING

But when considering tax effects on the composition of household saving, theempirical evidence is striking by contrast, although the literature is relativelysmall, due primarily to the lack of data sets of good quality. There are two well-known ways in which taxes may affect portfolio composition. First, differencesin effective tax rates should lead to some portfolio specialisation or ‘clientele’

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effect. Households facing lower marginal tax rates should hold a greaterproportion of more heavily taxed assets than those facing higher tax rates, whichshould prefer a greater proportion of tax-exempt or tax-privileged assets. Second,taxes affect the trade-off between risk and return, although their impact ondemand for risky assets is theoretically ambiguous, as discussed in Feldstein(1976), who concluded from his study of 1962 Federal Reserve Board data forthe US that ‘the personal income tax has a very powerful effect on individuals’demands for portfolio assets, after adjusting for the effects of net worth, age, sex,and the ratio of human to non-human capital’ (p. 648). The early 1980s saw aseries of studies based on large micro-data sets, the most important being Dicks-Mireaux and King (1983) using 1977 data for Canada, King and Leape (1984)using 1978 data for the US, Hubbard (1985) using 1979 data from a differentsource for the US, and Agell and Edin (1990) using 1979 data for Sweden. Eachstudy used a wide variety of explanatory variables but all found qualitativelysimilar and significant effects of the tax rate.

It is evident from the data used by these four studies that in all countries mosthouseholds choose to hold only a small number of the available savings assets.The first stage in the model used by all of them is therefore for each householdto decide whether to hold a particular asset at all — a discrete choice which willdepend on information and transaction costs, and constraints on negativeholdings of many assets. The second stage is the continuous choice of how muchof an asset to hold, conditional on the decision to hold it at all. The studies allfind strong effects of taxes on the decision whether to hold an asset (the firststage); the influence of taxation on the decision as to how much to invest in aparticular asset (the second stage) is less clear-cut, as might be expected from thediscussion above, and does not lead to an unambiguous conclusion as to whethertax reductions increase total household saving. Not all the results are easy toexplain in terms of a simple theory of household behaviour, and since each dataset is very heterogeneous, analysis of subgroups might give a richer picture. It isalso clear that fundamental features of each country’s tax system (for example,interest deductibility and the availability of other means of sheltering taxableincome) and other institutional aspects are important. However, given thisheterogeneity, the fact that tax rate effects are so significant in the first-stagedecision is impressive.

One would therefore expect the principal effect of introducing new taxincentives for specific types of liquid saving to be a displacement from otherforms of saving, at least in the longer term and particularly if close substitutesare readily available. The dead-weight cost could be high unless such specialschemes are carefully targeted, which may be very difficult given the fungibilityof money and complications of trying to define ‘new’ saving in legislation. Forexample, if most of the money deposited in TESSAs represents transfers out ofexisting deposits the income on which was taxed, then their main consequencewill have been to transfer tax revenue from government to the household sector.

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And in general, even if an increase in short-run saving is achieved by a change inpolicy, this will not be carried over into the medium term to the extent thatplanned saving is simply brought forward to take advantage of the incentives. Sothe objective needs to be clear. If it is in fact simply to achieve a zero marginaltax rate for a large proportion of the population (excluding the wealthiest), thenit is unclear why there needs to be a minimum holding time or other conditionsattached — and indeed such restrictions were largely abolished for PEPs in1989. If the object is instead to increase total household saving, the scheme maynot be very effective. In the case of assets for which there are no closesubstitutes, the most obvious being housing, then tax incentives may insteadsimply be capitalised, with the most significant distributional effect being awindfall gain to existing owners.

Unfortunately it appears very difficult to collect reliable data for mostcountries which would enable such speculation to be tested. Many of the data arenot available from tax returns, either because a withholding tax at source is finaland income does not need to be reported, or because of a known widespreadproblem of under- reporting. Where the nature of the special schemes introducedis to exempt income from tax, then it would be difficult to justify a requirementto report it. Much of the machinery for collecting aggregate data no longer existsfollowing the removal of exchange controls.

However, there is some very recent North American evidence that taxconcessions may have a significant effect in stimulating overall householdsaving, in particular circumstances. Registered Retirement Savings Plans inCanada (studied by Venti and Wise, as yet unpublished) and section 401(k) plansin the US (see Kusko, Poterba and Wilcox (1994), the latest in a series of NBERpapers) both involve generous tax concessions to saving for retirement, but arealso associated with high-profile advertising and public information campaigns,and matching employer contributions. The effect on savers may have been duenot directly to the enhanced rate of return, but more to a ‘something for nothing’attitude, or an opportunity too good to miss, in a situation where there are noclose saving substitutes. In the US, this phenomenon is known as ‘IRA Hype’,and it may correspond to the very heavy selling of personal pension schemes inthe UK on the basis of the 2 per cent incentive rebate offered from 1988 to 1993.Two additional factors seem to be particularly relevant: first, an incentive forfinancial institutions to invest heavily in advertising to sell the product, which ismuch more likely in the case of long-term contractual savings vehicles, alsoassociated with generous upfront commissions for salesmen; and second, as areasonable inference from the advertising, not just that the government is givingaway money, but that by doing so it is implicitly endorsing the product as asound investment for households.

To summarise, micro-data studies show that, even if it is not clear that taxesaffect the overall level of household saving, they do have an important effect onthe decisions of households as to what assets to hold, and so induce a bias in

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favour of particular assets. Of course, this is not necessarily undesirable. Asubsidy may be justified in terms of economic efficiency wherever there ismarket failure. Perhaps in earlier times of much lower net wealth and incomesper head, individuals would have been reluctant to undertake long-term savings(which is really to say no more than that their discount rates were higher thanthose the government judged to be socially optimal, or that they faced moralhazard if they were confident that the government would not let them starve inold age). Although because of valuation problems it is notoriously difficult toestimate accurately the stock of wealth held in pensions and housing, where dataare available for OECD countries these assets now appear to dominate householdsaving, and a policy of subsidising long-term savings may no longer beappropriate.

V. TAX NEUTRALITY AND TAX REFORM

As an alternative approach to ad hoc tax concessions distorting household savingdecisions, a desire for neutrality in the taxation of saving has led manycommentators to argue for a pure Comprehensive Income Tax or ExpenditureTax treatment. Few countries come even close to these idealised forms, but thereare two other approaches that have been applied and that have many of theattractions of the ideals, while being easier to operate: Tax-Free SavingsAccounts and Flat- Rate Taxes on Investment Income.

The OECD report explains the tax regimes applying to the chosen five assetsin each country, as far as possible comparing them with these four forms asbench- marks. There turn out to be remarkable variations, both within and acrosscountries. There are three main occasions to consider: acquisition of the asset;the holding period; and disposal. The ‘normal’ tax regimes for each of theseassets vary greatly across OECD countries, although in some cases there areclear modes.

The tax treatment of pensions and to a lesser extent owner-occupied housinghas been historically more generous than that of other forms of householdsaving, perhaps because these are associated with provision for old age andhence independence from the state. While it seems clear that many countries areconcerned about the disparity of tax treatment of different forms of saving,politically it has proved very difficult to increase effective tax rates on suchlong-term investments. In the case of pensions, almost all countries permitdeduction from income tax of contributions to approved pension plans, most ofwhich are exempt from tax on their income. In addition to these exemptions,amounts withdrawn at pensionable age, whether as lump sums or as annuities,are often tax-free or taxed at special low rates of tax.

Tax treatment of housing is at first sight often as generous as that forpensions, although for different reasons. In several countries, interest is tax-

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deductible on borrowing for house purchase whereas it would not be for mostother assets, and seven countries allow some form of relief for capital cost.Where imputed income is taxed on the owner-occupier (in only eight countries),the value assessed is below market rental value, and most countries that taxcapital gains on disposal of assets exempt at least first homes. However, takinginto account often high transaction taxes (stamp duties) and local property taxesincreases the tax burden on housing significantly, bringing it more into line withother assets.

There appears to be no clear trend in the taxation of savings in recent years.Many countries have reduced tax rates, particularly withholding taxes on interestat source, or introduced flat-rate or tax-free schemes for particular kinds ofsaving. However, some countries have introduced or increased certainwithholding taxes (Austria, Germany, Italy) and many have removed orrestricted exemptions or tax deductions for interest expense. Denmark, Finland,Norway and Sweden have moved their tax systems towards flat-rate taxes oncapital income generally, to greater or lesser extents, although interestinglyDenmark decided in 1994 to move back in the direction of ComprehensiveIncome Tax as a result of lower levels of inflation and consideration ofhorizontal equity. Radical reforms have also been put into effect in Ireland andPortugal to reduce differences in the taxation of different types of saving.

There has also been interest in many countries in using withholding taxes tolimit avoidance and evasion of tax on capital income, which has motivatedchanges in Germany, Ireland and Italy. But it is apparent that pressures drivingchange in the taxation of savings differ in intensity across the OECD.

VI. EFFECTIVE MARGINAL TAX RATES

Using the well-known King–Fullerton methodology (King and Fullerton, 1984),it is in principle not difficult to calculate marginal effective tax rates for each ofthese assets in each country, using stylised assumptions. In the report, this hasbeen done for two hypothetical individuals: the ‘average production worker’(APW) whose situation is examined in an annual OECD study of TheTax/Benefit Position of Production Workers, and a ‘top-rate taxpayer’ supposedto be liable at the top marginal rates of each relevant tax (i.e. this case providesan upper bound). Although it had been hoped to derive results using averagemarginal tax rates on capital income, this proved to be impossible, largelybecause in almost all countries there are insufficient data on the value anddistribution of tax-free assets (i.e. accruing pension rights and tax-exemptsavings). The results calculated using tax and actual inflation rates as at January1993 are shown in Tables 1 and 2.

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The columns in the tables represent a marginal investment in the five types ofasset analysed, assuming the ‘normal’ tax regime applies rather than any specialschemes (such as TESSAs and PEPs in the UK). The case of government bondsis subdivided into those issued at a discount because they bear a lower coupon(20 per cent of the pre-tax nominal return is assumed to be a capital gain) andthose issued and redeemable at par; in the former case, an average holding periodof five years is considered, as well as that of a one-year investment. These threecases illustrate the effect of differential treatment of interest and capital gain,and of transaction taxes. The case of pensions is subdivided into deductible andnon- deductible premiums (since in many countries a ceiling applies) and then

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into cases where pension income is taxed at a lower rate, again often subject to aceiling, rather than the standard income tax schedule. Results for owner-occupied housing are shown without and with local property taxes, since inmany countries these serve as a rough proxy for failure to tax fully the value ofoccupation as imputed income.

In the majority of countries, the tax burden on bank deposits and ongovernment bonds issued at par does not differ greatly, but in a minority, specialprovisions result in a significantly lower tax burden on government bonds.Furthermore, in most (but not all) countries, bonds issued at a significantdiscount to par are taxed more lightly, because gains are taxed at lower rates thaninterest income. However, looking at the position of the APW, effective tax rateson bank deposits at rates of inflation actually experienced by countries, mostlymuch lower in 1993 than for the 1970s and 1980s, are in general still startlinglyhigh as compared with tax rates on labour income.

In the case of shares, tax rates at the personal level are generally much lowerthan the rates on interest income, obviously more so in countries that give no oronly little relief or credit for tax paid at the corporate level since without relieffor the resulting double taxation, overall tax rates would be unacceptably highunless tax rates at the personal level were low; evidently there is less dispersionof rates across countries. However, without a detailed examination of theintegration systems used, these numbers are more difficult to interpret than thosefor the other assets.

For pensions, negative tax rates can be achieved by an APW in 12 countries,although the dispersion of rates across and within countries (for the differentcases) is striking.

The case of housing is slightly different because it is the obvious asset forwhich most savers borrow to purchase. However, for comparability the figurespresented in the tables assume a marginal purchase financed entirely by equity;the case of 75 per cent debt (where appropriate, with interest paid eitherdeductible or not at the margin) has been considered separately. Without debt,tax rates are in most cases noticeably lower than for interest income — reflectingzero or low imputed income and capital gains exempt or taxed at lower effectiverates than income — but, with the exception of Germany, they are positive. Theeffect of introducing debt finance depends on whether treatment of interest paidis symmetrical with interest received on the opportunity cost asset (assumed tobe government bonds). If, at the margin, interest paid and interest receivable aredeductible/taxed at the same rate, then the effective tax rate on the investment isindependent of whether it is financed by debt or equity. If interest paid isdeductible at a higher rate than interest receivable — as is the case in countrieswhere capital income is taxed at a flat rate, lower than taxes on labour incomeagainst which mortgage interest is deductible — then evidently the effective taxrate falls, reflecting the fact that debt finance is attractive. Conversely, if interestpaid is not deductible (or deductible at a lower rate than interest receivable is

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taxed — the position for all taxpayers in the UK from April 1995), then theeffective tax rate for debt finance is higher than that for equity finance.

In the last 10 years, most countries have enacted major reforms in thetaxation of capital income. Many have reduced marginal income tax rates orintroduced flat- rate taxes. However, from the perspective of neutrality, normaleffective marginal rates on interest income often remain disconcertingly high ascompared with saving in the form of pension funds or owner-occupied housing.Effective tax rates on direct holdings of shares are also generally high ifcorporate as well as personal taxes are taken into account.

Governments concerned about such a wide dispersion of tax rates acrossassets and high marginal tax rates on more liquid forms of saving could havereacted in several different ways. These include indexation of capital income forinflation, the introduction of separate, lower schedules of marginal rates orfurther reductions in flat-rate taxes. Instead, many governments have adoptedvariations on one particular theme, namely introducing special tax thresholdsbelow which the effective tax rate is zero.

VII. SPECIAL INCENTIVE SCHEMES TO ENCOURAGE HOUSEHOLDSAVING

Since bank deposits, bonds and equities are generally taxed more heavily thanpensions and housing, and in the absence of indexation provisions the tax burdenon interest rises dramatically at even modest levels of inflation, many countrieshave introduced special schemes (that is to say, tax privileges for a limited classof assets or income, rather than capital income generally) in recent years in anattempt to encourage saving in forms that would otherwise be relatively heavilytaxed. These schemes are catalogued in the OECD report and Country Surveys.The motive may not be solely to encourage household saving; in severalcountries, the encouragement of wider share ownership has been given as areason for tax concessions to dividends and capital gains on equities.

1. Tax Relief for Interest

Many countries now tax interest on bank deposits or government bonds at flatrates below the progressive marginal income tax rates that apply to earnedincome. The most straightforward way to do so is to apply a withholding taxwhich is final, either for all taxpayers (Austria, Finland, Greece, Ireland, Italy,Japan, Turkey) or repayable to a taxpayer with a lower marginal tax rate(Belgium, France, Portugal).

Rather than follow this course, which is of greater benefit to investors withhigher marginal rates of income tax and therefore higher incomes, a smallnumber of countries have adopted limited exemption schemes while retainingprogressive income taxation for levels of income or capital above a threshold. In

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France, interest payable on a plan d’épargne populaire (PEP) is exempt fromtax. Interest on some other types of account is also exempt up to a ceiling, suchas the first savings deposit account (Livret A) and accounts for industrialdevelopment (‘CODEVI’). In the UK, Tax-Exempt Special Saving Accounts(TESSAs) were introduced in January 1991. Interest is free from tax providedthat the deposit remains in a designated account for five years. A simplerapproach, adopted by the Netherlands, is simply to exempt a fixed amount ofinterest income from all sources.

Some countries have for many years operated similar schemes where thedeposit is earmarked for a specific purpose, such as house purchase. However,since this form of subsidy benefits only taxpayers, non-tax incentives may beused to provide a flat-rate benefit, either universally (instead of tax relief) orexclusively to non- taxpayers (alongside tax relief).

2. Tax Relief for Investment in Shares

Several schemes exist allowing privileged treatment of investment in shares, toencourage issue of new equity to individuals and so widen share ownership. Thefirst kind of scheme gives tax relief on purchases of shares, up to the fullpurchase price including transaction costs, and operates in many countriesaccording to conditions on the shares concerned. Usually only newly issuedequity in approved, domestic resident companies qualifies.

In many countries that tax long-term capital gains, there are exemptions forshares, subject to various ceilings and conditions. In a small number of countries,although dividends generally are subject to income tax, special schemes allow aspecific tax exemption up to a ceiling. Very similar schemes have operated in theUK since 1986 (personal equity plans or PEPs) and in France since 1992 (plansd’épargne en actions or PEAs). In each case, subject to annual limits on theamount that can be invested (and in France, a minimum holding period, asapplied originally in the UK), the income and any capital gains from theinvestment are exempt from tax, with the dividend imputation credit beingrefunded by the government. In some other countries, such as the Netherlands,there is an exemption or lower tax rate limit which applies not to the amount ofthe investment but instead to the amount of annual dividends received.

3. Non-Tax Incentives

Non-tax incentives take many different forms, although most are associated withsaving for house purchase. Usually they are made available instead of tax relief,so that the benefit to all individuals, whether they are taxpayers or not, is at thesame marginal rate. Occasionally a non-tax incentive may operate alongside taxrelief, providing a subsidy to non-taxpayers only, usually at the lowest positiverate of tax.

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VIII. INTERNATIONAL ISSUES

Although the principal source of capital remains domestic savings, thisrelationship has weakened since the early 1980s, notably within the EuropeanCommunity. There are some particular reasons for this change (such as somelarge public sector deficits at that time, especially in the US), but more generally,many countries have removed capital controls and financial markets havebecome more globally integrated.

The most pressing issue is that at present much interest income may beescaping tax altogether, as a result of deposits being placed with banks overseas,which is exacerbating the budget deficits of several countries as well as raisingconcerns of horizontal equity as between different taxpayers (if it is held thatinvestment incomes reflect ability to pay taxes to any extent). Many OECDcountries have no withholding tax on bank interest, and most of those that dohave currently exempt non-resident individuals under domestic law or treatyarrangements, so attracting savings from abroad. There is a sharp contrastbetween the rather high effective domestic tax rates shown in the first columnsof Tables 1 and 2 for most countries and a de facto zero rate from cross-borderevasion. Moreover, there is a presumption that individuals with higherinvestment incomes may have greater motivation, greater access to advice andopportunities, and lower proportionate transaction costs than those with lowerincomes, so that the burden of tax on interest income which is currently beingcollected may be highly regressive.

Because of practical limitations on the operation of exchange of informationarrangements, much of this cross-border interest income may not be declared orreported to the tax authorities in the country of residence. This is certainlysuggested by recent Belgian and German experiences with withholding taxes oninterest, and has prompted calls from these governments for a generalwithholding tax at the EU or preferably OECD level (if not wider) on mostpayments of interest to individuals. Belgium and Germany had to respectivelyreduce and redesign withholding taxes on interest to try to stem the flight of cashdeposits to countries with no domestic withholding tax applied to non-residents.If a common withholding tax were introduced and, whether as a matter of law orpractice, were final, then the source basis of taxation would apply. Althoughthere are formidable technical difficulties, it is apparent that the possibility of co-ordination, combining the threat of withholding taxes with improved exchange ofinformation, should be reconsidered so that countries are able to choose andenforce positive rates of tax on capital income if they wish (in fact, this is aconstitutional requirement in Germany).

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IX. LESSONS TO BE LEARNED?

There is no clear evidence that the level of taxation, along with other factorsaffecting the rate of return, does affect the aggregate level of saving. Somestudies claim to find a positive relationship, but some a negative one; the mostinfluential have concluded that there is no discernible effect. At first, this mightseem surprising: certainly cuts in capital income taxes among many OECDMember governments in the 1980s were at least partly motivated by a concern toincrease the saving rate. However, such policies could be justified on alternativegrounds. In a number of countries (but most notably the UK and the US), it wasargued that resources were likely to be more efficiently used in the private sectorthan in the public sector. On this argument, even if the level of national savingdid not increase, reducing taxes so as to leave greater post-tax income in thehands of households would lead to better allocation of resources. Because ofconflicting objectives, there can be no uniform prescription for the taxation ofsaving, which will reflect political judgements on horizontal equity, taking intoaccount social security systems, benefits, public expenditure and the role of thestate generally.

The report stresses the importance of tax neutrality, deviations from whichshould be clearly justified by reference to some overriding policy objective.However, neutrality may be difficult to achieve for certain assets. For example,if Expenditure Tax treatment is followed, pension contributions are fullydeductible from taxed income, the return to the fund should also be free of tax,but payments made to the pensioners should be taxed as income. Assuming thatmarginal tax rates do not change over time (although they have fallensignificantly in most countries), a zero marginal effective tax rate results; but formany individuals, marginal tax rates do fall in retirement simply because theirincomes are lower and in most countries earned income tax schedules areprogressive. A negative tax rate will therefore result ex post for manyindividuals, leading to rent-seeking behaviour which is very difficult to police byanti-avoidance measures. This may also lead to problems with schemes allowingboth a deduction from current income for a capital sum invested and exemptionsfor subsequent returns (such as the former Business Expansion Scheme), andsuggests that there should be some levelling-up from the current position forcertain assets.

An alternative means of achieving a zero effective marginal tax rate is tocontinue to exempt the return to the asset but not to allow net saving as adeduction from taxable income — the ‘Tax-Free Accounts approach’. Thisapplies to most taxpayers’ bank deposits in Iceland and Luxemburg, but in othercountries, outside special schemes, deposit interest is taxed at positive rates. Ifspecial tax measures are introduced to encourage saving in particular assets, theymust be carefully targeted if their effect is not simply to increase governmentbudget deficits. A prior question should be why saving in those assets by

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particular groups is considered insufficient. For example, if it is because ofperceived risk, and the tax measures do not result in effective sharing of thatrisk, then the motivation for using those measures is unclear.

One way of reconciling conflicting objectives is to offer tax-free or low, flat-rate schemes up to a limit per person by type of asset, even though enforcementof the limit may be difficult. Several countries have introduced such schemes fordirect investment in equities, and some for saving in bank deposits or for a wideclass of, but not all, savings assets. But there seems to be no consensus on howand at what level the threshold under such schemes should be set. For example,when Germany reintroduced its withholding tax on interest in 1993, it wascoupled to a very high exemption for the first DM 6,000 (about US$ 3,700 inJanuary 1993) of capital income per person per year. Spain operates a similarexemption for just Ptas 25,000 (US$ 220) whereas the Netherlands is in themiddle of the range, with separate limits for interest and dividend income, of Gld1,000 (US$ 550) each. Comparison with the UK is rather difficult, since manycountries operate more restricted special schemes as well as the generalexemptions (France being the most complicated, offering a very wide range ofreliefs). However, an investor benefiting from the full £9,000 TESSA exemptionat 7 per cent interest and with, say, £60,000 in PEPs yielding 4 per cent individends and tax credits would enjoy exempt income from these sources of justover £3,000 (US$ 4,600).

Some commentators take the view that levelling-down of de facto tax rates,the limit of which would be exemption of all capital income from taxation, isdesirable whether it arises from a deliberate choice of neutral tax policy or fromcompetition between countries. Even if this view is accepted, it does not followthat there need be no concern about the migration of savings abroad to escapetax, because a misallocation of resources might still result. A government takingthe view that investment income of its residents should be taxed, but findingdifficulty in enforcement where deposits had migrated, might be better offreluctantly reducing the tax rate on both domestic and foreign-source investmentincome. This appears to have been one reason for the change in several countriesto flat-rate tax systems, although it is difficult to generalise because manyrelevant tax factors (such as the penalty regime for non-declaration andprobability of detection) differ widely between countries. But, interestingly, inDenmark and very recently in Japan, the issue of horizontal equity has againsurfaced, with debate as to whether capital incomes should be taxed atprogressive rates. The more pressing question in Belgium and Germany iswhether they can actually be taxed at all, and this depends on whether co-operation between countries can be improved so as to ensure that the residencebasis of taxing interest income in particular can be enforced.

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REFERENCES

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Boadway, R. and Wildasin, D. (1994), ‘Taxation and savings: a survey’, Fiscal Studies, vol. 15, no.3, pp. 19–63.

Dicks-Mireaux, L.-D. L. and King, M. A. (1983), ‘Portfolio composition and pension wealth: aneconometric study’, in Z. Bodie and J. B. Shoven (eds), Financial Aspects of the United StatesPension System, Chicago: University of Chicago Press.

Feldstein, M. S. (1976), ‘Personal taxation and portfolio composition: an econometric analysis’,Econometrica, vol. 44, pp. 631–50.

Gylfason, T. (1993), ‘Optimal saving, interest rates and endogenous growth’, ScandinavianJournal of Economics, vol. 95, pp. 517–34.

Hall, R. E. (1988), ‘Intertemporal substitution in consumption’, Journal of Political Economy, vol.96, pp. 339–57.

Hubbard, R. G. (1985), ‘Personal taxation, pension wealth and portfolio composition’, Review ofEconomics and Statistics, pp. 53–60.

IFS Capital Taxes Group (1994), Setting Savings Free: Proposals for the Taxation of Savings andProfits, London: Institute for Fiscal Studies.

King, M. A. and Fullerton, D. (1984), Taxation of Income from Capital: A Comparative Study ofthe United States, United Kingdom, Sweden and West Germany, Chicago: University ofChicago Press.

— and Leape, J. I. (1984), ‘Wealth and portfolio composition: theory and evidence’, NationalBureau of Economic Research, Working Paper no. 1468.

Kusko, A. L., Poterba, J. M. and Wilcox, D. W. (1994), ‘Employee decision with respect to 401(k)plans: evidence from individual-level data’, National Bureau of Economic Research, WorkingPaper no. 4635.

OECD (1991), Taxing Profits in a Global Economy: Domestic and International Issues, Paris:Organisation for Economic Co-operation and Development.

— (1994a), Taxation and Household Saving, Paris: Organisation for Economic Co-operation andDevelopment.

— (1994b), Taxation and Household Saving: Country Surveys, Paris: Organisation for EconomicCo- operation and Development.

— (1994c), The Tax/Benefit Position of Production Workers: Annual Report 1990–1993, Paris:Organisation for Economic Co-operation and Development.