About a month ago, in an orientation speech for my study abroad program in Copenhagen, a Danish government official explained to my fellow Americans and me how expensive it would be for us to live in Denmark. Thanks to an unfortunate exchange rate, it costs about 5.5 kroner to purchase $1 dollar. Here, a cheap cup of coffee costs about 22 kroner. Smirking, the speaker said, “Don’t blame us—blame your parents. Perhaps if they’d spent a little less and saved a bit more, the dollar wouldn’t be so cheap.”
Our parents’ generation isn’t the only one with a poor saving record, though: the personal savings rate in the United States for the second quarter of 2010 is around 6 percent, which is higher than in pre-crisis years, but still abysmally low. Between 2005 and 2008, the personal savings rate hovered between 1 percent and 2 percent of income earned. That means that on average, for every $100 earned, we now spend $94. In China and India, the savings rates are considerably higher, 38 percent and 35 percent respectively. Our low savings rate contributed substantially to the mortgage crisis, and will likely play a role in what experts expect to be the next big financial problem: underfunded pension plans. So, how can Americans start to save more and spend less?
Given how hot the current debate over extending the Bush tax cuts is, few are likely to be interested in a flat tax. However, reworking the tax code—specifically, introducing a modified flat tax—might help solve our savings issues. Typically, for a flat tax, the government sets a tax rate on income, say 20 percent, and everyone has to pay the same percentage of their income in taxes, no matter what their earnings. There is an initial deduction based on family size, so no one pays taxes on the first $30,000 to $40,000 of income. Beyond that, whether your income is $45,000 or $4,500,000, you pay 20 percent of your income, minus the initial deduction—with very few other deductions.
The current tax system is highly complex. With a flat tax, filing a tax return would take about 10 minutes. Systems like this have been successful in many countries, such as Lithuania, Latvia, Estonia, Russia, and a slew of other former Soviet bloc countries. The tax code is so simple that it’s nearly impossible to cheat. As a result, fewer people feel disgruntled about paying.
Where do the savings increases come in? Since flat tax systems usually involve either no tax or very little tax on capital gains, interest, and dividends, people will save more because the interest on their savings and the gains on their investments won’t be taxed when they take the gains.
As a caveat, people whose incomes come primarily from capital gains, like professional investors, could be taxed at the normal flat income rate. Or perhaps a capital gain could be redefined from investments not traded for one year to investments that are not traded for five years. This would reward investors (who allocate capital to help business grow), not traders (who profit from price movements in financial markets). If there’s no penalty for saving and investing, more people will be inclined to do so.
Given the current state of affairs in Congress, it is highly unlikely that we will see a flat tax any time soon. After all, part of the reason a flat tax system came about in so many former Soviet countries is because before the early 1990s, most of these countries did not exist so they had to write their tax systems from scratch.
While a flat tax may be too extreme for the United States, we need to confront the fact that we have a serious problem when it comes to personal saving. Cultural habits may be part of the problem, but the government needs to start considering more tax-based incentives to save, encourage saving rather than spending.
