TFSAs and progressive savings policies
May 7, 2011

TFSAs and progressive savings policies

With Harper's majority secured, it is quite likely that the popular Tax Free Savings Accounts (TFSA's) will double the allowable contributions to $10k per year by 2014. There is a considerable benefit to policies that encourage higher savings rates but unfortunately the specific implementation of TFSA's leaves something to be desired.

Having a high level of household savings is a good sign of a healthy society and has many positive externalities. The negative consequences of economic recessions are minimized by the availability of savings, there can be a higher rate of investment particularly in small and local businesses, the country's government can owe their debt domestically and it promotes long term sustainability. Unfortunately, in the last 20 years, Canada's household savings rate has plummeted from 13% to 3% [1] while it now leads the OECD in terms of household indebtedness to assets [2]. In light of the significant public good and positive externalities that higher savings rate have that do not seem to be being met by the market, there is considerable cause for voluntary opt in macroeconomic government policies that encourage such higher savings rates.

We must be careful, however, to ensure that the policies we undertake are either neutral or progressive and do not create a regressive effect such that they asymmetrically benefit richer people over poorer people and exacerbate the wealth divide. While higher savings rates are desired, we must aim to implement them in such a way as to promote other values that society holds like some level of egalitarianism. Given the many positive economic externalities - let alone the moral impetuous - of more egalitarian societies a good economic policy thus optimizes their specific goals like higher savings rates alongside broader goals of economic progressivism.  Given the projected $6.6 billion dollar price tag of these accounts, a large deviation from this should not be acceptable because it absolutely does come at the expense of other programs.

Unfortunately, the implementation of Tax Free Savings Accounts is not progressive and indeed highly regressive. Immediately and quite generally, there is the issue that poorer people simply have less money or perhaps no money that they can save and this policy is therefore more or less helping the middle class and the rich. While this factor may be large, unlike the other factors I will mention it can't easily be dealt with by adjusting the policy - poor people won't be able to save much no matter what savings policy you implement - but it perhaps calls for adding in other progressive policies that assist the financial situation of the poor along side a program like TFSA's that benefit the middle and rich classes. For every dollar that is spent (or, more correctly, not received in tax revenue) from the savings program perhaps some proportional amount ought to be spent on those who cannot take advantage of the program due to their situation - this way we may hope to return the wealth balance at least to where it was before the implementation of new programs.

Moving to the specific implementation of the problem, because it results in a decline in taxable income it disproportionately benefits those in higher tax brackets than those in lower tax brackets. It advantages the higher tax bracket people more not just nominally but proportionally to income. The fact that we have progressive taxation is the largest and most significant counterbalance to the innately regressive nature of so many other aspects of society and despite it there remains a large - and widening - wealth gap. The effect of this policy is to make the tax system slightly less progressive. Incidentally, this exact same problem befalls the Tuition Tax Credit program in Canada that allows students to make significant tax deduction from their parents because of paying for tuition. Students with wealthier parents in high tax brackets (and parents willing to make this exchange) can thus receive a far larger nominal value from the tax credits than those in lower tax brackets.

What makes the TFSA's particularly unique is their ability to use the money put in these accounts to purchase a very wide range of different types of speculative investments including simply stocks and have the income made from those investments also be tax free. At $10,000 per year, someone who starts setting aside investment income with parental assistance at a young age could have a tax free portfolio worth - because of interest - many hundreds of thousands of dollars 20 years later that can be used to invest in the market without having to worry about capital gains or income from these investments being taxed. There has long been an attempt to reduce taxation on income and refocus the source of taxation on wages. This works well because most poorer people get a large portion of their wealth from wages while richer people get an increased share from non wage income such as investments. This ability to put a wide range of investment income under the tax free umbrella shifts the taxation balance from income to wages and accomplishes a goal long sought by vested interests through a policy with quite a separate purpose.

A large part of the problem with the shift from savings accounts to investment objects is that it undermines the actual savings that is going on and reduces the kinds of benefits and positive externalities discussed previously. As money flows from savings accounts to speculative investment, the stability and security against recessions is now removed. Savings are no longer safe from losses.

One of the advantages of the TFSA's are that they have a short term outlook, unlike many of the longer term savings plans that exist like RRSPs. One can immediately access the money but with a penalty: one has to wait until the next year to redeposit it. Incidentally, because many other investments have time frames that may require longer if one wants to avoid a loss reduces once again the benefit because if the money is transfered to an investment with, say, a three year time frame that money isn't available to curb the effects of a short term recession. I think the TFSA's still go too far with the length of time of the penalty. While I acknowledge that there is a need for a penalty in order to encourage genuine savings and not have the account simply be a temporary repository of money that isn't being saved much like a checking account, a three or six month delay would be sufficient while still encouraging small savings rate among people who may likely not be able to save continuously year round due to unforeseen circumstances.

Given the above, there is reason to consider some of the following possible changes. Firstly, there is no need to increase the limits. $20,000 per year for a couple that can be invested in almost anything is an enormous amount and while the initial program will make some difference in increasing the savings of lower income levels, the doubling is going to exclusively benefit people of higher income levels. Secondly, the types of investments that the TFSA's can be transfered to should be significantly limited to the types of investments which promote stable, long term growth and thus register as true savings opposed to speculative attempts to increase profits. Thirdly, the delay to put withdrawn money back in should be shortened.

The larger difficulty is the appropriate method to try and make it slightly less regressive. One thing that can be done is to use the decrease in government revenue from the $5,000 to $10,000 levels to instead give a small subsidization to increase interest rates on, say, the first $1000 dollars of income. One is thus paid a small premium from the government and receives greater than normal interest on that first bit of savings. This will increase the participation level among the poor because of the greater rates (while we don't have data yet in Canada, only 5% of low income people used a program similar to our TFSA's in Britain before accounting for unemployed partners of wealthier people).

Another possible option is to have a multiplicative scaling on the amount applicable for deductions. People who declared less income could deduct an amount proportionately larger than their income from the TFSA's and those with higher income would have to deduct less than the amount. Doing this in such a way as to balance the government revenue by redistributing the deductions makes it immediately more progressive while keeping it revenue neutral but one could also choose to leave the deductions for the rich fixed and only increase them for the poor,  financing this revenue loss again by not increasing the limits. The nominal value of the program would thus converge for differing income brackets. While it would be a substantially different program, one can even eliminate any business to do with taxation and simply provide interest subsidized accounts for the same revenue level with some minor frequent withdrawal penalty.

The general idea of attempting to put in place government policies that increase savings rates is a good one and should be done. I both use and support the general idea of a TFSA. However, its implementation is overly regressive and amounts to the kinds of decreases in taxation disproportionately for the wealthy and for income versus wages that fits an ideologically conservative agenda. With some modification it can and should be an excellent problem. 

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