Tuesday, February 12, 2008

Tuesday Column: Savings incentives don't boost savings!

Australia's newest prime minister has been good at keeping his promises. Here's one he should ditch.

Two months after the election at a time when he no longer needed to pledge to do anything silly, Kevin Rudd promised as part of his five-point attack on inflation “attractive incentives” to help foster a culture of saving.

Those of us who know about incentives buried our heads in embarrassment.

The money-grabbers who run Australia's banks and superannuation funds and also Australia's high income earners lapped it up.

The idea has form...

Back at the start of the 1990's the Coalition put it forward in Fightback! Anyone who put up to $1,000 into a bank account would have their tax on its earnings cut by 30 cents in the dollar.

John Howard took a variant of the idea into the 1996 election but then dropped it on taking office, as had his predecessor Paul Keating a few years earlier. (That didn't stop Mark Latham resurrecting it in 2003, promising “nest-egg accounts” to create a “new culture of savings”.

Keating had listened to Dr Vince Fitzgerald, Australia's foremost expert on saving whose landmark 1993 report examined financial incentives and concluded that “an increased return on saving is an incentive to save more, but also an incentive to save less.”

That's right. A financial incentive can encourage saving, but it can also send it backwards.

Here's what can happen. On one hand the tax break increases the return for every dollar saved in that particular vehicle and so makes saving through that vehicle more attractive. It encourages people to shovel more of the money that they were going to save anyway into it. Economists call this the price effect.

On the other hand, the increased return for saving reduces the need to save as much. If I know that I need so many thousand dollars for when I retire or in order to buy a house and if the tax break helps me get there sooner, I'll be able to wind back my savings rate sooner. The tax break will reduce the need to save as much. Economists call this the income effect.

Fitzgerald found that neither theory nor evidence could provide much guidance as to which effect would predominate.

Since then, the growth of compulsory and tax-advantaged superannuation has given us a very good idea of which effect is the most important. The more money we have been forced or cajoled to put into superannuation the more we have taken away from other forms of saving. Our total savings rate has plummeted as the amount we have been forced to pump into super and the payoff for doing it has been hiked. Why save even more, when we can see that the nest egg we've got is building up nicely?

High returns from the share market have been doing much the same sort of thing. They haven't so much encouraged us to pump more money in as to spend more freely, knowing that we've become richer.

All of this would be an idle curiosity - a few wasted billions on incentives here, a few wasted billions there - were it not for the fact that tax incentives for saving eat into national savings.

National savings are what actually matters when it comes to an economy's health . They are the sum of private and public savings. Tax incentives probably achieve little one way or the other when it comes to private savings – they might help, they might hurt - but they rip the heart out of public saving.

Just last month the Treasury reported that our existing and recently expanded tax concessions for superannuation were on track to climb from costing $27 billion to $32 billion in three years.

The tax-advantaged First Home Saver Accounts already announced by Kevin Rudd will over time add billions more.

And, as with super, the tax breaks on the First Home Saver Accounts will directed to the well-off. That's how savings incentives work.

Anyone putting up to $5,000 into one of Rudd's new accounts will get a government contribution that will cut the effective tax rate on its earnings to 15 per cent.

But low-income earners can't put that money in. As a letter-writer to a Sydney newspaper put it, it's like offering a low-income family a 50 per cent discount on a Rolls Royce: “How on earth can a family struggling to make ends meet save $5,000 a year?”

The well-off do incredibly well out of the superannuation tax concessions, not only because they are the only people who have the spare cash to pump into extra contributions, but also because the 15 per cent concessional tax rate is a concession to them but not to a low earner already paying only 15 per cent tax.

The Opposition says it is worried that Mr Rudd will axe some of the super tax concessions. He should. It would boost national savings while making the tax system fairer.

It is unfortunate that as an “evidence-based” politician he is at the same time flirting with the idea of new tax incentives for saving.

Nowhere in yesterday's 56-page Reserve Bank Quarterly Statement did it bemoan the lack of an extra incentive to save. It bemoaned our neglect of infrastructure, it bemoaned capacity constraints, it bemoaned the latest round of tax cuts. It didn't mention incentives to save because it knows that we are broadly impervious to such incentives.

With good reason. Most of us are saving about what we should right now given our income and the demands on it and what we will need in the future.

The super industry likes to say that we are going to need a lot. It told a Senate Committee that we would need between 60 and 65 per cent of our pre-retirement gross income on retirement.

But we know that's not true. Most of us never get that much money to spend on ourselves while we are working.

While working our income goes into our mortgage, our children and the very large expenses involved in actually going to work.

These are genuinely more important priorities for us than putting money away for a future in which our needs are going to be lower.

“Attractive incentives” won't change that. But they will divert the government's attention away from the really important things it should be doing.