PRESENT LAW AND BACKGROUND

RELATING TO TAX INCENTIVES FOR SAVINGS

Scheduled for a Public Hearing

Before the

HOUSE COMMITTEE ON WAYS AND MEANS

on February 12, 1998

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

February 11, 1998

JCX-11-98

CONTENTS

INTRODUCTION

I. PRESENT LAW

II. BACKGROUND RELATING TO TAX INCENTIVES FOR SAVINGS

A. Role of Saving in the National Economy

B. Adequacy of Personal Saving

C. Tax Incentives for Saving

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INTRODUCTION

The House Committee on Ways and Means has scheduled a public hearing on February 12, 1998, on reducing

the tax burden. This hearing will focus on the tax treatment of capital gains and savings, including interest and

dividend income.

This document,(1) prepared by the staff of the Joint Committee on Taxation, provides a description of

present-law tax treatment of savings and background information on savings in the United States. A separate

staff document,(2) which was issued previously, provides a description of present law and background on the

taxation of capital gains.

Part I of this document is a description of present law relating to the taxation of savings. Part II provides

background information on savings in the United States.

I. PRESENT LAW

In general

Dividend and interest income is taxable under present law. However, present law also contains a number of

provisions which permit individuals to save on a tax-favored basis. These include provisions relating to

individual retirement arrangements, tax-qualified retirement plans and similar employer-sponsored

arrangements, tax-sheltered annuities, annuity contracts, life insurance, and medical savings accounts.

Individual retirement arrangements ("IRAs")

Deductible IRAs

Under present law, an individual may make deductible contributions to an individual retirement arrangement

("IRA") up to the lesser of $2,000 or the individual's compensation if the individual is not an active

participant in an employer-sponsored retirement plan. In the case of a married couple, deductible IRA

contributions of up to $2,000 can be made for each spouse (including, for example, a homemaker who does

not work outside the home) if the combined compensation of both spouses is at least equal to the contributed

amount.

If the individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan,

the $2,000 deduction limit is phased out for taxpayers with adjusted gross income ("AGI") over certain levels

for the taxable year.

The phase-out limits for a single individual who is an active participant in an employer-sponsored retirement

plan are as follows: for 1998, $30,000 to $40,000; for 1999, 2000, 2001 and 2002, the limits increase by

$1,000 each year, so that the limits by 2002 are $34,000 to $44,000; for 2003, $40,000 to $50,000; for 2004,

$45,000 to $55,000; and for 2005 and thereafter, $50,000 to $60,000.

The phase-out limits for a married individual filing a joint return who is an active participant in an employersponsored plan are as follows: for 1998, $50,000 to $60,000; for 1999, 2000, 2001 and 2002, the limits

increase by $1,000 each year, so that the limits by 2002 are $54,000 to $64,000; for 2003, $60,000 to $70,000;

for 2004, $65,000 to $75,000; for 2005, $70,000 to $80,000; for 2006, $75,000 to $85,000; and for 2007 and

thereafter, $80,000 to $90,000.

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In the case of a married taxpayer filing a separate return, the deduction is phased out between $0 and $10,000

of AGI.(3)

The maximum deductible IRA contribution for an individual who is not an active participant, but whose

spouse is, is phased out for taxpayers with AGI between $150,000 and $160,000.

Amounts held in a deductible or nondeductible IRA are includible in income when withdrawn (except to the

extent the withdrawal is a return of nondeductible contributions). Includible amounts withdrawn prior to

attainment of age 59� are subject to an additional 10-percent early withdrawal tax, unless the withdrawal is

due to death or disability, is made in the form of certain periodic payments, is used to pay medical expenses in

excess of 7.5 percent of AGI, is used to purchase health insurance of an unemployed individual, is used for

education expenses, or is used for first-time homebuyer expenses of up to $10,000.

Roth IRAs

For years beginning in 1998, individuals with AGI below certain levels may make nondeductible

contributions to a Roth IRA. The maximum annual contribution that may be made to a Roth IRA is the lesser

of $2,000 or the individual's compensation for the year. The contribution limit is reduced to the extent an

individual makes contributions to any other IRA in the same taxable year. As under the rules relating to IRAs

generally, a contribution of up to $2,000 for each spouse may be made to a Roth IRA provided the combined

compensation of the spouses is at least equal to the contributed amount. The maximum annual contribution

that can be made to a Roth IRA is phased out for single individuals with AGI between $95,000 and $110,000

and for joint filers with AGI between $150,000 and $160,000.(4)

Taxpayers with modified AGI of $100,000 or less may convert an IRA into an Roth IRA. The amount

converted is includible in income as if a withdrawal had been made, except that if the conversion occurs in

1998, the income inclusion is spread over 4 years.

Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not includible in income, nor

subject to the additional 10-percent tax on early withdrawals. A qualified distribution is a distribution that (1)

is made after the 5-taxable year period beginning with the first taxable year in which the individual made a

contributions to a Roth IRA, and (2) which is made on attainment of age 59�, on account of death or

disability, or is made for first-time homebuyer expenses of up to $10,000.

Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent

attributable to earnings, and subject to the 10-percent early withdrawal tax (unless an exception applies). The

same exceptions to the early withdrawal tax that apply to IRAs apply to Roth IRAs.

Nondeductible IRAs

To the extent an individual cannot or does not make deductible contributions to an IRA or contributions to a

Roth IRA, the individual may make nondeductible contributions to an IRA. Distributions from a

nondeductible IRA are includible in income and subject to the 10-percent early withdrawal tax to the extent

attributable to earnings.

Legislative history

The individual retirement savings provisions were originally enacted in the Employee Retirement Income

Security Act of 1974 ("ERISA"). Individuals who were active participants in an employer-sponsored

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retirement plan were not permitted to make contributions to an IRA. The limit on the deduction for IRA

contributions was generally the lesser of (1) 15 percent of the individual's compensation for the year, or (2)

$1,500.

The Economic Recovery Tax Act of 1981 ("ERTA") increased the deduction limit for contributions to IRAs

and removed the restriction on IRA contributions by active participants in employer-sponsored retirement

plans. Beginning in 1982, the deduction for IRA contributions was generally the lesser of (1) 100 percent of

the individual's compensation, or (2) $2,000. An individual was entitled to make a deductible contribution to

an IRA even if the individual was an active participant in an employer-sponsored retirement plan.

The Tax Reform Act of 1986 ("1986 Act") added the restrictions on deductible IRA contributions for an

individual (or the individual's spouse) who is an active participant in employer-sponsored retirement plan. For

years 1987 through 1997, if a single taxpayer or either spouse (in the case of a married couple) was an active

participant in an employer-sponsored retirement plan, the maximum IRA deduction was phased out between

$25,000 and $35,000 of AGI. For married taxpayers, the maximum deduction was phased out between

$40,000 and $50,000 of AGI. In the case of a married taxpayer filing a separate return, the deduction was

phased out between $0 and $10,000 of AGI. In addition, the 1986 Act added the present-law rules permitting

individuals to make nondeductible contributions to an IRA.

The Small Business Job Protection Act of 1996 ("1996 Act") modified the rule relating to the maximum

deductible IRA contribution by permitting deductible IRA contributions of up to $2,000 to be made for each

spouse (including a spouse who does not work outside the home) if the combined compensation of both

spouses is at least equal to the contributed amount.

The Taxpayer Relief Act of 1997 ("1997 Act") (1) increased the AGI phase-out limits for deductible IRAs, (2)

modified the AGI phase-out limits for an individual who is not an active participant in an employer-sponsored

retirement plan but whose spouse is, (3) provided an exception from the early withdrawal tax for withdrawals

for first-time home purchase (up to $10,000), and (4) created a new nondeductible IRA called the Roth IRA.

Employer-sponsored qualified retirement plans

In general

A plan of deferred compensation that meets the qualification standards of the Internal Revenue Code (a

qualified plan) is accorded special tax treatment under present law. Employees do not include qualified plan

benefits in gross income until the benefits are distributed, even though the plan is funded and the benefits are

nonforfeitable. The employer is entitled to a current deduction (within limits) for contributions to a qualified

plan even though the contributions are not currently included in an employee's income. Contributions to a

qualified plan are held in a tax-exempt trust.

Employees, as well as employers, may make contributions to a qualified plan. Employees may, subject to

certain restrictions, make both pre-tax and after-tax contributions to a qualified plan. Pre-tax employee

contributions (e.g., contributions to a qualified cash or deferred arrangement (sec. 401(k) plan)) are treated the

same as employer contributions for tax purposes.

The tax treatment of contributions under qualified plans is essentially the same as that of deductible IRAs.

However, the limits on contributions to qualified plans are much higher than the IRA contribution limits, so

that qualified plans provide for a greater accumulation of funds on a tax-favored basis. The policy rationale

for permitting greater accumulation under qualified plans than IRAs is that the tax benefits for qualified plans

encourage employers to provide benefits for a broad group of their employees. This reduces the need for

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public assistance and reduces pressure on the social security system.

The qualification standards and related rules governing qualified plans are designed to ensure that qualified

plans benefit an employer's rank-and-file employees as well as highly compensated employees. They also

define the rights of plan participants and beneficiaries and provide some limits on the tax benefits for

qualified plans.(5) Certain of the rules relating to qualified plans are designed to ensure that the amounts

contributed to qualified plans are used for retirement purposes. Thus, for example, an early withdrawal tax

applies to premature distributions from such plans, and the ability to obtain distributions prior to termination

of employment from certain types of qualified plans is restricted.

Types of qualified plans

Qualified plans are broadly classified into two categories, defined benefit pension plans and defined

contribution plans, based on the nature of the benefits provided.

Under a defined benefit pension plan, benefit levels are specified under a plan formula. For example, a

defined benefit pension plan might provide an annual retirement benefit of 2 percent of final average

compensation multiplied by total years of service completed by an employee. Benefits under a defined benefit

pension plan are funded by the general assets of the trust established under the plan; individual accounts are

not maintained for employees participating in the plan. Benefits under a defined benefit pension plan are

guaranteed (within limits) by the Pension Benefit Guaranty Corporation ("PBGC"), a Federal corporation

within the Department of Labor.

Benefits under defined contribution plans are based solely on the contributions (and earnings thereon)

allocated to separate accounts maintained for each plan participant. Profit-sharing plans and qualified cash or

deferred arrangements (called 401(k) plans after the section of the Code regulating such plans) are examples

of defined contribution plans.

Limits on contributions and benefits

Under present law, limits apply to contributions and benefits under qualified plans. In the case of a defined

benefit pension plan, present law limits the annual benefits payable under the plan to the lesser of (1) 100

percent of the participant's average compensation for his or her high 3 years, or (2) $130,000 (for 1998).(6)

Under a defined contribution plan, the qualification rules limit the annual additions to the plan with respect to

each plan participant to the lesser of (1) 25 percent of compensation or (2) $30,000. Annual additions are the

sum of employer contributions, employee contributions, and forfeitures with respect to an individual under all

defined contribution plans of the same employer. The dollar limits are increased for cost-of-living adjustments

in $5,000 increments.

An overall limit applies if an individual is a participant in both a defined contribution plan and a defined

benefit plan of the same employer. The Small Business Job Protection Act of 1996 repealed this overall limit

for years beginning after December 31, 1999.

Taxation of distributions

Under present law, a distribution of benefits from a qualified plan generally is includible in gross income in

the year it is paid or distributed, except to the extent the amount distributed represents the employee's

investment in the contract (i.e., basis). Special rules apply to lump-sum distributions, distributions rolled over

to an IRA, and distributions of employer securities.

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Early distributions from qualified plans generally are subject to the same additional 10-percent early

withdrawal tax that applies to early distributions from IRAs. However, certain additional exceptions to the tax

apply. For example, the early withdrawal tax does not apply to distributions made to an employee after

separation from service after attainment of age 55.

Qualified cash or deferred arrangements

As mentioned above, a qualified cash or deferred arrangement is a type of qualified plan. Thus, such

arrangements are subject to the rules generally applicable to qualified plans. In addition, special rules apply to

such arrangements.

A profit-sharing or stock bonus plan, a pre-ERISA money purchase pension plan, or a rural cooperative plan

may include a qualified cash or deferred arrangement (sec. 401(k)). Under such an arrangement, an employee

may elect to have the employer make payments as contributions to a qualified plan on behalf of the employee,

or to the employee directly in cash. Contributions made at the election of the employee are called elective

deferrals. The maximum annual amount of elective deferrals that can be made by an individual is $10,000 for

1998. This dollar limit is indexed for inflation in $500 increments. An employee's elective deferrals must be

fully vested. A special nondiscrimination test applies to elective deferrals under cash or deferred

arrangements. Employer matching contributions and after-tax employee contributions under qualified defined

contribution plans are also subject to a special nondiscrimination test.

SIMPLE retirement plans

Under present law, certain small businesses can establish a simplified retirement plan called the savings

incentive match plan for employees ("SIMPLE") retirement plan. SIMPLE plans can be adopted by

employers who employ 100 or fewer employees who received at least $5,000 in compensation during the

preceding year and who do not maintain another employer-sponsored retirement plan. A SIMPLE plan can be

either an IRA for each employee or part of a qualified cash or deferred arrangement ("401(k) plan"). If

established in IRA form, a SIMPLE plan is not subject to the nondiscrimination rules generally applicable to

qualified plans (including the top-heavy rules) and simplified reporting requirements apply. Within limits,

contributions to a SIMPLE plan are not taxable until withdrawn.

A SIMPLE plan can also be adopted as part of a 401(k) plan. In that case, the plan does not have to satisfy the

special nondiscrimination tests applicable to 401(k) plans and is not subject to the top-heavy rules. The other

qualified plan rules continue to apply.

A SIMPLE retirement plan allows employees to make elective contributions which cannot exceed $6,000 per

year. The $6,000 dollar limit is indexed for inflation in $500 increments. The employer is required to satisfy

one of two contribution formulas. Under the matching contribution formula, the employer generally is

required to match employee elective contributions on a dollar-for-dollar basis up to 3 percent of the

employee's compensation. Under a special rule applicable to a SIMPLE IRA, the employer can elect a lower

percentage matching contribution for all employees (but not less than 1 percent of each employee's

compensation). In addition, a lower percentage cannot be elected for more than 2 out of any 5 years.

Alternatively, for any year, an employer is permitted to elect, in lieu of making matching contributions, to

make a 2 percent of compensation nonelective contribution on behalf of each eligible employee with at least

$5,000 in compensation for such year, whether or not the employee makes an elective contribution.

In order for the employer to lower the matching percentage, (in the case of a SIMPLE IRA), or to make a

nonelective contribution for any year, the employer has to notify employees of the applicable match within a

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reasonable time before the 60-day election period for the year. The 60-day election period is the period within

which each eligible employee can elect to participate in the SIMPLE plan and modify any previous elections

regarding the amount of contributions. The 60-day period is the 60-day period before the beginning of any

year or the 60-day period before an employee first becomes eligible to participate.

No contributions other than employee elective contributions, required employer matching contributions or

employer nonelective contributions can be made to a SIMPLE plan. All contributions to an employee's

SIMPLE account must be fully vested.

Contributions to a SIMPLE plan generally are deductible by the employer and excludable from the

employee's income. Early withdrawals from a SIMPLE plan generally are subject to the 10-percent early

withdrawal tax. However, in the case of a SIMPLE IRA, withdrawals of contributions during the 2-year

period beginning on the date the employee first participated in the SIMPLE IRA are subject to a 25-percent

early withdrawal tax.

Simplified employee pensions ("SEPs")

Under present law, certain employers (other than tax-exempt and governmental employers) can establish a

simplified employee pension (SEP) for the benefit of their employees. A SEP is an IRA which may receive

contributions from the employer in an amount that is greater than the normal IRA deduction limits. The

employee is always 100-percent vested in employer contributions. SEPs are generally subject to the same

rules that apply to IRAs. In addition, certain other rules apply. An employee satisfies the participation

requirements if the employee (1) has attained age 21, (2) has performed services for the employer during at

least 3 of the immediately preceding 5 years, and (3) received at least $400 (for 1997) in compensation from

the employer for the year. An employee can participate even though he or she is also a participant in one or

more other qualified retirement plans sponsored by the employer. However, SEP contributions are added to

the employer's contribution to the other plans on the participant's behalf in applying the limits on

contributions and benefits (sec. 415).

Effective for taxable years beginning after December 31, 1996, employers can no longer establish a salary

reduction SEP ("SARSEP") under which the employees can elect to have contributions made to the plan or to

receive the contributions in cash (sec. 408(k)(6)). However, employers may continue to make contributions,

under rules in effect prior to January 1, 1997, to SARSEPs that were established before 1997. In addition,

employees hired after December 31, 1996, may participate in SARSEPs established by their employers prior

to January 1, 1997.

Tax-sheltered annuities

Tax-sheltered annuities are another form of employer-based retirement plan that provide the same tax benefits

as qualified plans and IRAs. Employers may contribute to such annuities on behalf of their employees, and

employees may contribute on a pre-tax basis through salary reduction. Tax-sheltered annuities are subject to

rules similar to some of the rules applicable to qualified plans. Tax-sheltered annuity plans may be maintained

only by certain types of organizations, in particular, tax-exempt charitable organizations and educational

institutions.

Annuity contracts

Present law provides that income credited to a deferred annuity contract is not currently includible in the gross

income of the owner of the contract nor is the income taxed to the insurance company issuing the contract. No

deduction is provided for, and no dollar limits are imposed on, amounts used to purchase annuity contracts. In

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general, amounts received by the owner of an annuity contract before the annuity starting date (including

loans under or secured by the contract) are includible in gross income as ordinary income to the extent that the

cash value of the contract exceeds the owner's investment in the contract. In addition, a portion of each

distribution received after the annuity starting date is treated as ordinary income based on the ratio of the

investment in the contract to the total distributions expected to be received.

A 10-percent additional income tax is imposed on certain early withdrawals under an annuity contract. This

additional tax does not apply to any distribution made after the owner of the contract attains age 59-1/2,

receives annuity payments under the contract, or satisfies certain other requirements.

Life insurance

Under present law, the investment income ("inside buildup") earned on premiums credited under a life

insurance policy generally is not subject to current taxation to the owner of the policy or to the insurance

company issuing the contract. This favorable tax treatment is available only if a life insurance contract meets

certain requirements designed to limit the investment character of the contract. The contract must satisfy the

statutory definition of life insurance by meeting either of two statutory tests: the "cash value accumulation"

test, or the "guideline premium/cash value corridor" test.

No deduction is provided for, and no dollar limits are imposed on, amounts used by an individual to purchase

life insurance contracts.

Death benefits paid under a life insurance contract are excluded from income, so that neither the policyholder

nor the policyholder's beneficiary is ever taxed on the inside buildup if the proceeds of the policy are paid to

the policyholder's beneficiary by reason of the death of the insured.

Distributions from a life insurance contract (other than a modified endowment contract) that are made prior to

the death of the insured generally are includible in income only to the extent that the amounts distributed

exceed the taxpayer's basis in the contract; such distributions generally are treated first as a tax-free recovery

of basis, and then as income. In the case of a modified endowment contract, however, distributions are treated

as income first, loans are treated as distributions (i.e., income rather than basis recovery first), and an

additional 10-percent tax is imposed on the income portion of distributions made before age 59-1/2 and in

certain other circumstances.

Medical savings accounts

Under present law, eligible individuals covered under a high deductible health plan may have a medical

savings account ("MSA"). In general, eligible individuals are individuals employed by a small employer and

self-employed individuals. Within limits, contributions made by an individual to an MSA are deductible, and

contributions made by the individual's employer are excludable from gross income. Earnings on amounts held

in an MSA are not currently includible in income. Amounts withdrawn for medical expenses are not taxable.

Amounts withdrawn for nonmedical purposes are includible in income and subject to an additional 15-percent

tax unless the distribution is made after death, disability, or age 65.

While MSAs are not available to all individuals, when used for nonmedical purposes, MSAs provide the same

tax benefits as IRAs and qualified plans. When used for medical purposes, they provide greater tax benefits,

because withdrawals are tax free.

II. BACKGROUND RELATING TO TAX INCENTIVES FOR SAVING

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A. Role of Saving in the National Economy

Investment and economic growth

When an economy's rate of investment increases, the economy's stock of capital increases. A larger capital

stock permits greater production of goods and services. Because a larger capital stock means more productive

workers, investment also leads to higher wages and salaries. Thus, increases in investment lead to future

increases in a nation's standard of living.

It is important to distinguish gross investment from net investment. Gross investment includes investment in

new capital as well as investment that is undertaken to replace depreciated or worn out capital. Net

investment(7) measures increases to the capital stock.

In the short run, increases in gross investment will increase the capital stock. As the capital stock increases,

worker productivity increases and the economy will experience a higher rate of growth. In the long run, any

given rate of investment will just be sufficient to replace the existing, though larger, capital stock as it

depreciates. Thus, in the long run, an increase in the level of investment increases a nation's standard of

living, but may not increase a country's long- run rate of growth.

It is possible that a higher investment level can lead to a higher growth rate even in the long run. Even if there

is no growth in net investment, investment to replace depreciated capital may still enhance economic growth

to the extent that the replacement capital embodies improved (and more efficient) equipment and

technologies. The higher the gross investment rate, the more new capital is purchased each year, and thus the

rate at which new technologies get adopted may be higher.

Sources of investment funds

Investment involves a trade-off between consumption today and consumption tomorrow. Investment can

either be financed by national saving, or by foreign borrowing (saving by foreigners). A basic accounting

identity of the national income and product accounts states that:(8)

Investment = Private Saving + Government Saving + Net Foreign Borrowing

Many analysts in the past ignored the foreign sector, primarily because at the time it was small relative to the

U.S. economy. These analysts interpreted this basic relationship as saying that national investment must equal

national saving, where national saving is the sum of private saving and public saving.

However, national investment need not equal national saving if foreigners can invest in the United States. The

experience of the 1980s, when investment in the United States greatly exceeded national savings,

demonstrates how important this source of funds can be. When demand for investment funds in the United

States outstrips the supply of national savings, interest rates rise in response. Increases in interest rates attract

foreign capital to the United States, and the excess of investment over national saving is financed by

foreigners' saving.

Foreign investment in the United States also is related to the value of the dollar and the trade deficit. To take

advantage of high interest rates in the United States, foreign investors first must convert their currencies to

dollars. This increases demand for the dollar, thereby increasing the dollar's exchange rate relative to the

foreign currency. A stronger dollar makes imported goods relatively cheaper and our exports relatively more

expensive. As a consequence, net exports fall and the trade deficit increases. A further accounting identity

states that:(9)

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Net Foreign Borrowing = (Imports-Exports)

When net foreign borrowing increases, the trade deficit (the difference between imports and exports of goods

and services) also increases. Thus, many people have blamed the trade deficits of the 1980s on the low

national savings rate during that period.(10)

Is the United States' saving rate too low?

Consequences of a low saving rate

The consequences of a low saving rate depend on the mobility of international capital. If capital is not mobile,

then, as discussed above, investment is equal to national savings. When the saving rate is low, so is the

investment rate. Historically, there has been a strong relationship between a country's rate of investment and

its rate of saving.(11) Although this relationship has become weaker over time,(12) it is still true that countries

with high saving rates also generally have high investment rates.

If capital is mobile (that is, if foreigners can invest in the United States at low cost and without a lot of added

risk), then investment will not decline as much when the saving rate falls. Instead, investment will be financed

by foreigners, either by direct foreign investment in the United States or by foreign lending to American

investors. When domestic saving rates are low, foreign financing of domestic investment results in a higher

rate of investment than would be possible if investment were financed by domestic saving. Foreign

investment in the United States does increase the productivity of American workers. However, the profits

generated by foreign investment flow abroad, since the United States has to pay interest on the funds it

borrows. Furthermore, eventually the debt will have to be repaid, so the net wealth that is left to future

generations of Americans is smaller than it would be if the investment were financed by domestic saving.

Trends in national saving

National saving is generally divided into private saving and public saving. Private saving is comprised of

household or personal saving and business saving. Households save by not spending all of their disposable

income (i.e., after-tax income). Businesses save by retaining some of their earnings. Public saving reflects the

extent to which the Federal, State, and local governments run combined budget surpluses or deficits. Table 1

presents data on the components of net national saving in the United States. In interpreting these data, it is

important to note that "personal saving" generally includes saving via an employer's pension plan contribution

made on behalf of the employee. For example, in 1994, of the $189.4 billion of personal saving, $80 billion,

or 42 percent, was attributable to employer pension contributions. The 1994 experience is somewhat

anomalous, as over the past two decades, employer pension contributions accounted for between one fifth and

one third of total personal saving.

Table 2 presents net saving by component as a percentage of gross domestic product ("GDP"). As the table

demonstrates, the personal saving rate, the net business saving rate,(13) the total net private saving rate, and

the public saving rate were all lower during the 1980s than in the 1960s or 1970s. As a result, the net national

saving rate was lower in the 1980s than in the 1960s or 1970s. The personal saving rate has continued to

decline in the 1990s. As a result, the total net private saving rate and the net national saving rate are also

lower in the 1990s than in the three previous decades. However, declines in dissaving by the public sector

recently have contributed to an increase in the net national saving rate. The net business saving rate also has

been higher over the past three years than over the prior 15 years. Figure 1 displays the arithmetic relationship

of the total net private saving rate, the public saving rate, and the net national saving rate.

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Some analysts suggest that because households save out of their disposable income (i.e., after-tax income), it

is more appropriate to examine personal saving relative to disposable income than to examine personal saving

relative to GDP. Table 3 presents personal saving as a percentage of disposable income. Generally, the same

trends observed in Table 2 are evident in Table 3. The personal saving rate of 3.8 percent of disposable

personal income in 1997 is the lowest computed by the Commerce Department since 1939. Some analysts

attribute recent low personal savings rates to strong stock market performance. Growth in asset values in the

stock market increases the wealth of many households and may lead households to conclude their need for

saving to meet future goals is reduced.

Prior to 1980, domestic saving generally financed domestic investment as well as providing funds for

Americans to be net investors abroad (negative net foreign investment). During the 1980s, net savings fell

short of domestic investment as a share of GDP. Domestic investment declined from its 1984 peak and net

foreign investment provided for the difference in domestic savings and investment. Thus, although the decline

in saving was coincident with a decline in investment, this decline was not as severe as it might have been had

there not been foreign investment.

Comparison of saving rates in the United States and other countries

The United States' national saving rate is low when compared to that of other nations. Table 2 showed that the

United State's net national saving averaged approximately 5 percent of GDP in the 1980s. The net national

saving rate of Canada during the 1980s averaged 7.3 percent of GDP. For Japan, the comparable rate was 17.9

percent; Germany, 9.2 percent; Italy, 8.3 percent; France, 6.7 percent; the United Kingdom, 4.5 percent; and

Australia, 3.4 percent.(14) Table 4 presents a comparison for household or personal saving. As Table 4

indicates, the household saving rate of the United States during the 1980s was below the household saving

rates of Canada, Germany, and Japan.(15)

Generally, saving rates of all nations have declined from the rates of the late 1960s. In percentage terms, the

decline in the national saving rate of the United States between the late 1960s and 1989 is greater than the

decline in the saving rates of Japan and Germany, but comparable to the decline of the saving rates of France

and Italy.

Although many people have pointed to the low saving rate in the United States as a cause of declining

productivity, others argue that the United States has long been a relatively low-saving nation, and yet has

enjoyed substantial economic growth. They note that many of the nations with higher saving rates were

nations which needed to rebuild after the destruction of war on their own territory.

Furthermore, some argue that the low saving rate in the United States may be a product of demographics, and

that the saving rate will increase as the baby boomers enter their forties and fifties, typically the years during

which people do much of their retirement saving. However, others note that in the past, demographic changes

have not been very successful at predicting saving rates.

In general, the decline in private saving rates is not well understood. It is likely that demographic changes,

capital market liberalization, increased insurance availability, increased asset values, and increased social

security benefits have all contributed to the decline. However, these factors have not proved significant

enough to account for the total decline in the saving rate. Similarly, there is no convincing explanation for

why saving rates have declined in other nations as well.

B. Adequacy of Personal Saving(16)

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Because social security coverage of workers has increased over time,(17) and because the labor force

participation of women has also been increasing, current workers are more likely to be covered by social

security than current retirees. Similarly, pension coverage of current workers is also substantially larger than

that of current retirees.(18) Although coverage by pensions and social security is expected to be higher for

current workers than it is for current retirees, the saving rate of current workers may be lower than the rate at

which current retirees saved during their working lives. This would imply that although one source of

retirement income, retirement benefits, is expected to be higher for current workers, another source, income

from savings, may be lower.

The measure of personal saving used in the National Income and Product Accounts attributes all corporate

pension contributions and earnings to the household sector. Thus, the increased pension coverage is already

included in the measure of household saving. Table 2, above, shows that personal saving has been declining

over the past 15 years. Private saving, which includes the saving of business, and which may provide a better

measure of total households saving since businesses are ultimately owned by households, exhibits the same

downward trend. Thus, the saving of the current generation of workers for their retirement seems to be low

relative to the past.

In a recent study, the Congressional Budget Office ("CBO") reported that while the saving rate of current

workers appears low relative to the past, this may not imply that the level of savings is inadequate for

retirement. That CBO study concludes that the so-called "baby boom" generation appears to be accumulating

assets at a rate equivalent to that of their parents who are currently retired. The CBO concludes that the

continued increase in real wages, the fact that baby boomers are more highly educated than their parents, and

the increased participation of women in the labor force portend "increases in household incomes of baby

boomers in retirement."(19) Some have criticized the conclusion of this study as too optimistic. Critiques note

that finding that baby boomers have accumulated approximately the same amount of assets as had their

parents at a similar age does not bode well for retirement income. Having the same amount of assets would

imply only the potential for the same amount of income as experienced by current retirees, and as incomes

grow this would imply future retirees would be less well off compared to the rest of society than are current

retirees. Critics also note that current retirees benefited from increases in social security benefits and

unexpected capital gains on housing that the baby boomers may not reasonably expect to experience.(20)

Finally, it is possible that the need for retirement income is increasing over time. Increases in life expectancies

and trends toward earlier retirement increase the number of years in retirement and therefore, increase the

need for saving. Furthermore, the normal retirement age for social security was changed in 1983. In 1995, the

normal retirement for social security (the age at which retirees receive full benefits) is 65. By 2010, normal

retirement will be 67 years. If the increase in the normal retirement age means that individuals will be

working more years, then current saving need not adjust. However, if the historical trend toward earlier

retirement continues, then the increase in normal retirement age for receipt of full social security benefits

means that individuals should increase their retirement saving.

C. Tax Incentives for Saving

Present law contains various tax incentives for savings. Tax incentives are provided to encourage taxpayers to

save for certain purposes and to encourage taxpayers to save in certain forms. Saving for the purpose of

education and retirement is subsidized through the tax treatment of certain Treasury bonds and of certain

retirement plans. Incentives are also provided for people to save in the form of investments in housing, life

insurance, and municipal bonds.

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Tax-favored treatment of assets does not always increase the rate of return on saving. If the supply of a

tax-favored asset is limited relative to the demand for that asset, much of the benefit of the tax treatment will

be realized by the initial owners of the asset, rather than by the subsequent holders of the asset. For instance,

holders of municipal bonds may not receive a higher after-tax rate of return than holders of taxable bonds

because, even though the earnings are tax exempt, municipal bonds offer lower rates of return. The issuers of

municipal bonds receive a tax benefit because they can pay lower interest rates than the rates paid on other

securities.

The tax benefits of IRAs and pension funds, however, are not limited to particular assets. Because investors in

IRAs and pension funds can invest in a wide range of assets, and because the amount of funds permitted to be

invested through these tax-favored vehicles is limited (the demand is small relative to the supply of assets),

investors in IRAs and pension funds do receive a higher rate of return than that available through other

investments, and thus do benefit from the tax-favored treatment.

Enactment of additional saving incentives would be expected to alter taxpayers' choices among various

taxable and tax-preferred assets. Because the income earned on assets held in IRAs effectively is exempt from

tax, the taxpayer maximizes the benefit of the tax preference by directing the investment of IRA contributions

in assets which are not otherwise tax preferred. The benefits of tax preferences for assets that are tax preferred

to one degree or another are maximized when such assets are held outside an IRA.

Some argue that tax incentives for saving are appropriate because the income tax system taxes the return to

income that is saved, thereby lowering the return to saving. This lower return on saving affects both the

national saving rate, as well as the assets that taxpayers accumulate for particular purposes. There is some

disagreement about whether the goal of tax incentives for saving should be to encourage saving for particular

purposes or to increase national saving. A tax incentive might induce more personal saving, or personal

saving for a specific goal, and reduce national saving. As discussed above, national saving is the sum of

private saving and public saving. Personal saving could increase, but if the tax incentive reduces Federal

receipts, public saving may decrease. The net effect could be a decline in national saving even as personal

saving increases. However, these purposes are not mutually exclusive; if sufficiently effective, incentives to

save for particular purposes will increase national saving. Oppositely, general saving incentives will not

necessarily fulfill more specific goals. Whether new tax incentives for saving should be aimed at increasing

national saving in general, or increasing retirement saving, depends on the perceived adequacy of each type of

saving.

[TABLE 1 NOT AVAILABLE IN ON-LINE VERSION]

[TABLE 2 NOT AVAILABLE IN ON-LINE VERSION]

Table 3.--U. S. Personal Saving as a Percentage of Disposable Personal Income,

Selected Years, 1929-1997

Year

Personal saving

as a percentage

of disposable

personal income

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1929 3.2

1939 2.6

1944 25.1

1949 3.9

1954 6.3

1959 7.0

1964 7.7

1969 7.0

1974 9.3

1975 9.0

1976 7.6

1977 6.6

1978 7.1

1979 7.4

1980 8.2

1981 9.1

1982 8.8

1983 6.6

1984 8.4

1985 6.9

1986 6.2

1987 5.0

1988 5.2

1989 4.8

1990 5.0

1991 5.7

1992 5.9

1993 4.5

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1994 3.8

1995 4.7

1996 4.3

1997 3.8

Source: Department of Commerce, Bureau of Economic Analysis.

[TABLE 4 NOT AVAILABLE IN ON-LINE VERSION]

[FIGURE 1 NOT AVAILABLE IN ON-LINE VERSION]

1. This document may be cited as follows: Present Law and Background Relating to Tax Incentives for

Savings, (JCX-11-98), February 11, 1998.

2. Joint Committee on Taxation, Present Law and Background Relating to Taxation of Capital Gains

(JCX-4-98), February 6, 1998.

3. A couple is not considered married for purposes of the IRA deduction rules if the individuals file separate

returns and live apart from one another at all times during the taxable year; each spouse is treated as a single

individual in such a case.

4. It was intended that the phase-out range for married taxpayers filing separately be $0 to $10,000. A

technical correction is necessary so that the statute reflects this intent. See Title VI (sec. 605) of H.R. 2676,

the Tax Technical Corrections Act of 1997, as passed by the House on November 5, 1997.

5. Qualified plans are subject to regulation under Federal labor laws (Title I of Employee Retirement Income

Security Act of 1974 (ERISA)) as well as under the Internal Revenue Code. The ERISA rules generally relate

to rights of plan participants and the obligations of plan fiduciaries.

6. Annual benefits may in some cases exceed this dollar limitation under grandfather and transition rules

contained in the Tax Equity and Fiscal Responsibility Act of 1982 and other legislation.

7. Net investment is equal to gross investment less depreciation.

8. The national income and product accounts measure the flow of goods and services (product) and income in

the economy. Two common measures of the size of the economy are the gross domestic product ("GDP") and

the gross national product ("GNP"). GDP measures the total value of the output of the American economy.

GNP measures the total annual value of goods and services produced by Americans, their gross income. GDP

is greater than GNP by the payment of factor income to the rest of the world (such as profits to foreign owners

of U.S. based businesses), but is less than GNP by the amount of factor income received from the rest of the

world by Americans (such as wages paid to Americans who work abroad). Examining the income measure,

GNP, is useful in understanding the trade-off between consumption today and consumption tomorrow. GNP

may be measured in several ways. One way is to measure GNP by expenditure on final product in the

economy. By this measure,

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(1) GNP = C + I + G + (X-M).

Equation (1) is an accounting identity which states that gross national product equals the sum of consumption

expenditures (C), investment expenditures on plant, equipment, inventory, and residential construction (I),

governmental purchases of goods and services (G), and net exports (exports less imports of goods and

services or X-M).

An alternative is to measure GNP by the manner in which income created in the economy is disposed of. By

this measure,

(2) GNP = C + S + T.

Equation (2) is another accounting identity which states that gross national product equals the sum of

consumption expenditures, saving by consumers and businesses (S), and net tax payments to the government

(T) (net tax payments are total tax receipts less domestic transfer, interest, and subsidy payments made by all

levels of government).

Because both measures of GNP are simple accounting identities, the right hand side of equation (1) must

equal the right hand side of equation (2). From this observation can be derived an additional national income

accounting identity,

(3) I = S + (T-G) + (M-X)

This is the basis for the statement that national investment equals private saving (S), plus public saving (T-G),

and net imports (M-X).

9. This ignores the relatively small amount of unilateral transfers to foreigners. For a more detailed discussion

of foreign trade and domestic saving and investment, see Joint Committee on Taxation, Background and

Issues Relating to the Taxation of Foreign Investment in the United States (JCS-1-90), January 23, 1990.

10. For instance, see Hatsopoulos, Krugman, and Summers, "U.S. Competitiveness: Beyond the Trade

Deficit," Science, 15 July 1988, vol. 241, pp. 299-307.

11. See, for instance, Martin Feldstein and Charles Horioka, "Domestic Saving and International Capital

Flows," Economic Journal, vol. 90 (June 1980) pp. 314-29.

12. See Phillippe Bacchetta and Martin Feldstein, "National Saving and International Investment", in Douglas

Bernheim ad John Shoven (eds.), National Saving and Economic Performance (Chicago: The University of

Chicago Press), 1991.

13. Tables 1 and 2 present net saving, which equals gross saving less capital consumption (depreciation).

14. Organization for Economic Co-Operation and Development, National Accounts, 1960-1989, vol. 1, 1991.

15. The data on international saving rates in the text and in Table 4 are not directly comparable to the data in

Tables 2 and 3 because such data are not always compiled consistently across nations. For example, in

computing household saving rates, the OECD subtracts household interest expense from income to determine

U.S. household disposable income. The Bureau of Economic Analysis does not make a similar adjustment in

defining household disposable income. Also, while the source of the international comparisons draws on data

from the OECD, which attempts to provide data on an internationally comparable basis, the data are not fully

comparable. For example, in computing household saving rates, the definition of the household sector is not

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identical across all countries. In particular, except in Japan, France, and Italy, private nonprofit institutions are

included in the household sector. See, Andrew Dean, Martine Durand, John Fallon, and Peter Hoeller, "Saving

Trends and Behaviour in OECD Countries," OECD, Economics and Statistics Department Working Paper,

No. 67, June 1989.

16. For a more complete discussion of adequacy of personal saving, see Joint Committee on Taxation,

Analysis of Tax Proposals Relating to Savings and Investment (Capital Gains, IRAs, and Estate and Gift Tax)

(JCS-5-97), March 18, 1997.

17. For a discussion of the legislative history of social security coverage, see Committee on Ways and Means,

Overview of Entitlement Programs (WMCP 102-9), May 7, 1991, pp. 105-106.

18. EBRI Databook on Employer Benefits, 1990, p. 75.

19. Congressional Budget Office, "Baby Boomers in Retirement: An Early Perspective," September 1993, p.

xiv. Also see, Joyce Manchester, "Baby Boomers in Retirement: An Early Perspective," in Dallas Salisbury

and Nora Super Jones (eds.), Retirement in the 21st Century: Ready or Not? (Washington: Employee Benefits

Research Institute), 1994.

20. B. Douglas Bernheim, "Adequacy of Savings for Retirement and the Role of Economic Literacy," in

Dallas Salisbury and Nora Super Jones (eds.), Retirement in the 21st Century: Ready or Not? (Washington:

Employee Benefits Research Institute), 1994.

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