0.22 Savings, taxation and the private sector  (Page 4/5)

Do people really behave this way? To a great extent, yes (worldwide). Consider if person (A) has saved 100K (stock of wealth of 100K) and has a junior college education, he will have a general expectation of his/her income over lifetime. If person (B) has saved 250K and has a MA in Computer Science, he/she would expect to have much higher lifetime earnings than person (A).

Now what is transitory income? This is nonrecurring or un expected income, such as lottery winnings, windfall gains, gains arising from increases in the value of your assets (such as housing assets), or for a nation or individual windfall from an increase in export earnings.

A major point about permanent income hypothesis. In its polar version,

b1 ≅ 0 ( little savings out of permanent income over time).

And b2 = 1( all transitory income is saved ).

Nowadays, we reject those values. Rather most economists believe that some savings does occur out of permanent income, and not all transitory income is saved.

That is to say: 0>b1>b2>1

Because permanent income does depend on the yield from accumulated assets (including Human Capital) it also partly depends on the interest rate . So in the permanent income hypothesis. Unlike the Keynesian hypothesis, there is a role for interest rates in influencing savings. One might view parameter b ₁ as in expression (5) below:

${\text{b}}_1={\text{c}}_1\left(\frac{w}{\mathrm{yp}}\right)+{\text{c}}_2\left(\text{N}\right)+{\text{c}}_3\left(\text{r*}\right)$

$\left(\frac{w}{\mathrm{yp}}\right)$ ----Wealth as a proportion of y _p , where Y _p = permanent income $\text{N}$ ---- Socioeconomic variables (life expectancy etc.) $\text{r*}$

N ---- Socioeconomic variables (life expectancy etc.)

r* ---- Real interest rate

Always, in these formulations the interest rate must be viewed as the real after tax rate of interest. Friedman, however originally did not think that the interest rate was a particularly important determinant of saving. However at a conference in Monterey, shortly before his death, shifted his view a bit on this point.

Empirical evidence on interest elasticity of savings

There are few reliable empirical estimates for emerging nations. Three important studies in the U.S. in the eighties concluded as follows:

In the Boskin formations a 10% increase in the net-of-tax interest rate would 4% increase in put-savings.

Larry Summers (Harvard) suggests a long-run interest elasticity of 2.0, indicating a strong response for savings to the real interest rate.

For emerging nations, there is little real systematic information but E _R * has tended to be higher in countries with positive after-tax real rate interest.

From this brief discussion, we might conclude that:

1. E _R * is definitely not zero
2. E _R is probably not higher than 0.32 in medium term, perhaps 0.5 in the longer term
3. Policymakers do have to be concerned about impact of taxes on savings on growth of aggregate savings
4. Interest rate controls usually reduce savings, especially in the face of inflation , because they reduce the return to savers.

When governments hold the nominal deposit rate of 12% and inflation is 20% the real interest rate is a negative 8%. Savers may be expected to respond to this incentive by saving less, but how much less? A precise answer is not likely, but the impact would not be trivial.