DISCUSSION PAPER

Report No~ DRD186

THE DETERMINANTS OF SAVINGS IN DEVELOPING COUNTRIES:

THEORY, POLICY AND RESEARCH ISSUES

by

Arvind 'll irmani

August 1986

Development Research Department Economics and Research Staff

World Bank

The World Bank does not accept responsibility for the views expressed herein which are those of the author(s) and should not be attributed to the World Bank or to its affiliated organization's. The findings, interpretations, and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material~ and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitations of its boundaries, or national affiliation.

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August 1986 World Bank

THE DETERMINANTS OF SAVINGS IN DEVELOPING COUNTRIES:

THEORY, POLICY AND RESEARCH ISSUES*

by

Arvind Virmani

* My thanks to S. S. Bhalla and T. N. Srinivasan for comments on an earlier version of this paper.

The World Bank does not accept responsibility for the views expressed herein which are those of the author and should not be attributed to the World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitation of its boundaries, or national affiliation.

ABSTRACT

The paper reviews the savings behavior of households from the

perspective of developing countr.ies. Though the standard analytical framewcrk

used to explain savings in developed countries is still relevant to developing

countries, it must be applied with care. Two sets of issues must be given

particular attention. One is the role of market imperfections and extra

market institutions which have developed to ~upplement them. The other is the

role of activist government budgetary and tax policies, and other market

interventions.

1. INTRODUCTION

In a completely closed economy savings determine the amount of funcs

available for investment in the country. As investment in physical and human

capital and in research anti development is vital for growth, it is of great

policy interest to governments. In a completely (perfect) open economy,

savings have a direct effect on the capital account, but not on dome,:tic in­

vestment. A change in the capital account will lead to changes in the ex­

change rate and the balance of trade. This in turn could effect the entire

structure of the economy, and consequently domestic investment. In any real

economy which is neither completely closed nor completely open both the effect

on domestic investment and the ~~ffect on the current account will ~e observed,

and be of immediate policy concern.

The 1~orld Development Report for 1985 reports that the weighted

average of gross investment rates in low income developing countries was 26%

of their GDP and their gross domestic saving rate was 24%~ Thus foreign

capital inflows financed less than 10% of their investment. It financed an

even smaller proportion of investment in the middle income developing

countrieso As the climate for capital flows he1 deteriorated over the bast

few years it is possible that these proportions will be even smaller in the

near future. It is therefore imp1Jrtant to understand the determinants of

domestic saving.

Saving rates vary substantially among countries and over time. For

instance, in Japan the net saving rate was 15% compared to 4% for the U.S. in

1984. In India the saving rate averaged 13% in the sixties and 24% in the

ear.ly eighties (1980-82). India and China together, among the low income

countries, saved and invested 28% of their GDP in 1983, an increase from 22%

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in 1965. On the other hand, low income sub-Saharan African countries invested

only 16% in 1983 compared to 15% in 1965. These differences in cross country

saving behavior and in changes in rates over time are intriguing and beg ex­

planation. We must first identify in somewhat greater detail the problems and

issues in saving behavior which may contribute to an explanation of these

facts. It is useful to start on a more fundamental level with the motivations

of individuals and the constraints and policy effeLts impinging on saving

behavior.

This paper offers a brief review of the analytical ~asis of savings

behavior. As much of this work has been done the developed countries partic­

ular attention is paid to the factors which are of interest ~o developing

countries. Some of these are peripheral to developed country situations, or

have been neglected in the literature. In the process i~~ues of particular

relevance to developing countries are identified for future research.

Section 2 outlines the motivation for individual saving as seen in

the analytical literature. Section 3 discusses the role of market imperfec­

tions, market constraints and extra market institutions in saving behavior.

Section 4 deals with the influence of government policies on saving be­

havior. Section 5 reviews some of the other determinants, and section 6

concludes the paper.

2. MOTIVATIONS FOR SAVING

Why do people save? There are three basic reasons for savings. To

undertake future personal consumption, to make provisions for expenditure on

children, and to leave bequests to their heirs (and others). The amount and

pattern of savings does not depend only on the tastes and motivation of

savers. It is also affected by the constraints imposed by market opportuni-

- 3 -

ties and the government, and the incentives provided by the latter. Many

savings puzzles must be traced to the interaction between the tastes and

opportunities of savers and the constraints and incentives that they face.

2.1 CONSUMPTION SMOOTHING: CREDIT MARKETS AND FL\MILY STRUCTURE

Much of the analysis of savings behavior has focused on own consump-

tion of the nuclear family. One aspect of this is the desire of such a family

or household to smooth consumption over time. Leaving aside uncertainty and

unanticipated fluctaations for the moment, the anticipated pattern of consump-

tion will not match th~ pattern u~ income over the lifetime. Earnings are

likely to increase over time with education and experience. Similarly,

earnings will fall at the time of retirement for employees, and due to

weaker-ing health for the self employed. Over shorter t\me periods such as the

agricultural year, income from production and agricultural employment will

also bave a cyclical pattern.

Families will prefer to smooth out their consumption of many goods

(e.g. nondurables) to the extent possible. !/ Savings (and dis-saving) is a

way of reducing or eliminating the expected mismatch between the time pattern

of earnings and the desired pattern of consumption (Ando and Modigliani

(1963), Ghez and Becker (1975)). ~/ Though household age-income and age-

consumption profiles are fairly well known in developed countries, little is

known about them for developing countries. The extended family prevalent in

1. Expenditures on housing and other consumE~r durables often have a lumpy character which also affects the consumption pattern.

2. The extent to which income and consumption streams can be matched is of course critically dependent on the nature of credit markets. This issue is considered below.

- 4 -

many developing countries may make these profiles quite different. This type

of family structure also complicates the problem of defining the unit--nuclear

family including minors, two generation and three generation families--over

which household savings are defined.

2.2 UNCERTAINTY AND PRECAUTIONARY SAVINGS

In addition to the broadly known or anticipated changes in earnings

and consumption, there are several sources of uncertainty which can lead to

unanticipated changes in both. Household agricultural producers are subject

to uncertainty about the weather and crop epidemics which in turn cause income

uncertainty. Exporters of crops and minerals face uncertainty with respect to

cyclical fluctuations in the world price of these co~noditiesa J/ Other self

employed producers are s:milarly subject to both technological and market

uncertainty which will affect their production and income (Levhari and

Srinivasan (1969), Sandmo (1970) on uncertainty in returns to capital).

Employees similarly face uncertainty with respect to their jobs. For informal

sector employees the uncertainty might relate to having employment the next

day. For salaried employees the question is when they might become unemployed

and how long they will have to search for another job (Leland (1968), Hall

(1978), Sargent (1978) and Eden and Pakes (1981) on earnings uncertainty).

The more developed LDCs are also subject to the usual business cycles.

The most important source of uncertainty in consumption is uncer-

tainty about the individual's time of death. The shorter (longer) the life

span the less (more) consumption w~ll take place after retirement. The

3. On an aggregate level the corresponding issue is terms of trade effects (section 5).

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provision which must be made for it therefore depends on the degree of

uncertainty (Levhari and Mirrman (1977), Davies (1981)). The amount of

bequest that may be left to heirs is also affected by this uncertainty. 4/

These and other sources of uncertaint~ influence savings in a way very similar

to the usual income and substitution effects. The net effect of precautionary

demand on savings is therefore often ambiguous. 5/

2.3 CHILDREN: CONSUMPTION OR HUMAN CAPITAL

The timing and number of children also influences the time profile of

both earnings and consumption. The simplistic view has been that more

children result in greater consumption and reduced savings by households (see

Kelly (1976) and Bilsborrow (1979) for criticisms). Savings may however in-

crease in anticipation of a planned birth, ~nd the expenditures associated

with it. The expected reduction in the mother's input into production or her

withdrawal from the labor force will also contribute to this. To the extent

that children provide consumption benefits, parents will substitute away from

personal consumption of market goods. As the former involves spending more

time with children, goods which are more complimentary with leisure are likely

to be affected more. There may also be a shift away from financial to housing

assets with an associated increase in housing consumption (Freedman and Coombs

(1966), Espenshade (1975)).

As the children grow older, they are likely to themselves start con-

tributing labor input 1n household and agricultural activities. In an urban

4. See for example Davies (1981). The issues connected with bequests are considered below.

5. The availability of different types of insurance also plays a role, as is discussed below.

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or semi-rural setting parents may also start saving in anticipation of in-

creased expenditures on schooling and college. Female labor force participa-

tion may also increase. These and other actions related to children affect

the time profile of household consumption and income, and consequently their

saving behavior.

2 -..4 BEQUESTS

Whether households leave bequests or not, and if so what the reasons

for such bequests are is a critical issue in savings behavior. The issue is

not an abstract theoretical one, but has a profound bearing on the effect of a

host of government policies. Any policy which shifts the burden of taxation

(includ~ng inflation tax) between generations will have completely different

affects in the "pure" life cycle and "altruistic" models.

In the "pure" life cycle view households do not receive or give

bequests because they get no satisfaction from the latter. In this case each

household plans its savings and dis-savings to cancel out over the lifetime.

One implication of this is that asset holdings have a hump shaped pattern with

age, and the marginal propensity to consume changes with age (Tobin (1967),

Davies (1981), King and Dicks-Mireaux (1982) and Modigliani (1983)). Another

is that total household saving is merely the result of aggregating over all

households, of which the relatively young are saving and the relatively old

dis-saving. 61

A polar view of "altruistic" households was propounded by Barra

(1974). In this view households derive utility not only from their own life

6. Assuming perfect markets. Imperfect market issues are addressed below. A more detailed discussion of aggregation issues is also postponed.

- 7 -

time consumption, but also from the life time consumption of their children.

This effectively means that they derive utility from the consumption of all

their descendants. Kotlikoff and Summers (1981) found that a substantial

proportion of U.S. savings could be due to the provision of bequests. Other

evidence in favor of intergenerational gifts and transfers has been presented

by White (1978), Mirer (1979), Darby (1979), Bernheim (1982), Kurz (1981,

1982, 1984) and Soskin and Lau (1984). King (1983) concludes that the polar

altruistic model is unlikely to be true for more than a minority of households

(in developed countries) and that more realistic versions of the life cycle

model would apply to a majority of households.

Several reasons for bequests have been suggested in the context of

the basic life cycle model. The simplest is to assume that households derive

utility from bequests to their children (and possibly to others). In this

~ontext Blinder (1975) s~ggested that bequests may be a luxury good. In a

~imilar vein it might be thought that parents care about the opportunities

available to children but not their entire lifetime utility. Another approach

is that the possibility of bequests is used as an inducement to children to

spend time with their aged parents (Bernheim, Shleifer and Summers (1985)). A

third approach is connected to uncertain lifetimes, bequests merely being the

random residual wealth which remains at death. Whatever the reasons for

bequests they will influence the age profile of asset holdings (Atkinson

(1971)). They will also influence the composition of household portfolios

(King (1983)).

3. MARKET CONSTRAINTS AND IMPERFECTIONS

The essence of the approaches to savings considered above is a for­

ward looking attitude by households. The extent to which this attitude is

- 8 -

fruitful depends on the nature of the credit, insurance and annuity markets

that existo Thus for example consumption smoothing depends critically on the

ability of households to lend and borrow freely at a single interest rate.

Similarly how uncertainty influences savings depends on the type of insurance

and annuity markets that exist. The effect of government policies on savings

also depends on the nature of these marketso We therefore consider credit,

insurance and annuity markets in turn.

3.1 CREDIT MARKETS

Even in countrier with highly developed credit markets such as the

U.S. there is increasing evidence that the implications derived under perfect

markets are not universally valid. Among the evidence is the following: a)

Low and middle income households have low levels of liquid wealth (Diamond

(1977), Diamond and Hausman (1983)). b) The pattern of lifetime consumption

is closely related to the timing of lifetime resources (Kotlikoff, Spivak and

Summers (1982)). c) Retirement probability depends on the level of tangible

wealth (Hurd and Baskin (1984)). d) The life cycle model as tested is in-

valid for approximately 20% of U.S. and Canadian households (Hall and Mishkin

(1982) and King and Dick-Mireaux (1982) respectively). e) 50% of US

households are liquidity constrained, though consumption is only reduced on

average by 3% due to this constraint (Hayashi (1982)). Zl As this work has been carried out in the developed country context,

the problem has been seen largely in terms of the inabilicy to borrow against

7. A smaller percentage of young households is constrained by as much as 10%.

- 9 -

human capital. In most developing countries this is likely be the least im-

portant problem with the loan market. Consumer credit is seldom available for

the purchase of household consumer durables. Mortg~ge loan markets for

housing are often absent, and housing is financed entirely by own and extended

family funds. The absence of mortgage markets has been suggested as a pos-

sible cause of the high saving rate in Japan as it forces households to save

for these lumpy investments. B/ The pactern of household saving could also be

directed away from financial and physical assets into consumer durable goods

(including housing). 21

In many developing countries a perfect market cannot be assumed even

for borrowing against physical capital or the future returns from it. The

assumption of separability between production and consumption decisions may

therefore be invalid for agricultural and other small producers. In this case

consumption and production decisions will jointly affect savings and must be

incorporated in the analysis. One way of analyzing this problem is in terms

of differential lending and borrowi~g rates faced by households. lO/

Credit market imperfections also change the role played by col-

lateral- It can be shown that though collateral is basically irrelevant in a

perfect market, it has a critical role in an imperfect one. The amount of

loan depends on it (Virmani (1986)). It is likely that households with land

8. The existence of an extended family structure may be an important factor.

9. Housing would appear to be a collaterable asset, unless markets for resale of residential housing are thin or absent. The lack of mobility in traditional societies, and government policies, such as rent control aPd the legal treatment of defaulters, may be responsible.

10. See Hu (1980) for an analysis using this approach for a somewhat different problem.

- 10 -

and other collaterable ~ssets will be less constrained in their inter temporal

consumption smoothing. Households may therefore save in collaterable assets

like land and jewelry. Inter linkage of markets which allow sharing of infor-

mation and reduce monitoring costs can also reduce the effect of credit market

imperfections (Braverman and Srinivasan (1981)). Similarly the extended

family may make tacit loans to its members, which will have similar effects.

The extended family and other social institutions substitute for formal credit

markets and will jointly influence saving behavior.

It has long been thought that one feature of underdeveloped capital

markets is segmentation (Shaw (1973)). Many developing countries have there-

fore set up a host of financial institutions like cooperative credit, agricul-

tural and small industry banks and term lending institutions. Following Shaw

(1973) and Mckinnon's (1973) analysis of the role of financial intermediation

in development this was seen as an essential element of economic

development. 111

The simplest way to view this problem from the current perspective is

in terms of separate credit market islands imperfectly linked to each other.

Development of modern banks and other financial institutions and introduction

of deposit insurance can facilitate the flow of funds between them. Improve-

ments in transport and communications can have similar effects. Integration

will lead to a higher interest rate in some islands and a lower rate in

others. The net effect of credit market development on total savings is

therefore ambiguous, and needs to be empirically investigated. The allocation

11. McKinnon's analysis also depends on the lumpy nature of investment in irrigation, but reaches the opposite conclusion from that reached (above) for housing.

- 11 -

efficiency of investment will simultaneously improve. To the extent this hap-

pens there will be a fall in the average spread between returns to savings and

to investment. This will have a positive impact on saving.

The conventional view on the effects of interest ceilings, following

Mckinnon, is that they retard financial development. Another view is that

interest ceilings have negative consequences on allocation efficiency and

distribution independent of whether markets are developed or not (Virmani

(1982, 1984, 198Sa)). Deposit interest ceilings will harm those who have no

opportunities for direct investment, and reduce their savings. Those who have

to save for lumpy investment may however increase their saving, particularly

in the context of the extended family. On the other hand, loan interest

ceilings will create rationing and distortion where none existed and increase

it where it was already present (Virmani op. cit.). Allocation efficiency

will therefore worsen. They are likely to reduce savings and have adverse

effects on distribution and allocation.

Even in the most highly developed capital markets, it is difficult if

not impossible to obtain loans against future labor income. Money lenders

will make such loans at interest rates which include a hefty risk

premium. lZ/ Arbitrary bans on money lenders are likely to worsen rather than

alleviate any existing distortion. On the other hand certain policies such as

loan interest subsidies through subsidized rediscounting can have positive

12. A high contracted rate is quite different from fraudulent change of contract terms. The latter must of course be dealt with severely by the socio-legal system.

- 12 -

effects if properly focused on distorted segments of the market. 131 A care­

ful consideration of these issues may help in disentangling the effect of a

slew of contrary credit market policies on saving behavior.

3.2 INSURANCE AND EQUITY MARKETS

The influence of uncertainty on household decisions depends critical­

ly on whether insurance markets exist. A well functioning insurance market

effectively eliminates all interpersonal uncertainty leaving only system-wide

uncertainty. In some cases such as health insurance the latter may be unim­

portant. A perfect insurance market would convert unknown health care expen­

ses into an ordinary monthly ex~enditure such as on food. The degree of un­

certainty therefore depends on how good these markets are. Social arrange­

ments such as individual labor contributions to produce food for the tribal

granary constitute partial health insurance. Government provision of health

services combine insurance with subsidies. Their effect depends on how good

the private provision of health insurance is.

Income uncertainty arises from uncertainty in returns to labor

earnings, and the uncertainty in returns to capital. The former can be miti­

gated by unemployment insurance and the latter by efficient capital/equity

markets. Even in developed countries unemployment insurance is either pro­

vided by the government or is a side effect of implicit contracts between

employees and large firms (Baily (1974), Aziardes (1975)). Though there are

not many developing countries with unemployment insurance, government laws on

dismissal of employees may force large companies to implicitly provide this

insurance. Agricultural landowners may also implicitly provide partial in-

13. See op. cit~ and Virmani (1986).

- 13 -

surance to'their regular labor, and to tenants through share cropping (See

Stiglitz (1974)). Public provision of crop insurance can also be an important

element in the reduction of uncertainty faced by households in weather de-

pendent agriculture.

Under some conditions earn1ngs uncertainty reduces both current con-

sumption and leisure (Leland (1968), Sandmo (1970), Miiler (1974,1976),

Skinner (1983a, b))~ This implies a positive effect of uncertainty on

savings. In this case a breakdo~m in traditional arrangements for risk

sharing or a removal of policies forcing such action will increase the saving

of labor. Earning risk related to acquisition of human capital similarly

leads to reduced training and increased labor supply (Barsky, Makiw and Zeldes

(1984))o Households would tend to substitute physical for human capital re-

sulting in higher measured saving. Policy packages such as wage taxation com-

bined with unemployment compensation implicitly provide human capital insur-

ance and would reverse this effect (Varian (1980), Eaton and Rosen (1980)).

Perfect equity markets eliminate diversifiable risk through pooling, leaving

only the economic risks to which the entire system is subject. Corporate en-

terprises constitute a much smaller fra~tion of total production in developing

countries relative to developed countries. Even where equity markets exist

they are very thin and controlled by particular household groups. l~/ For

these controlling groups the corporation is effectively like a household

enterprise. Large conglomerates will in this situation constitute "internal

capital markets" which effectively eliminate nonsystematic risk (Virmani

14. This applies even to a relatively developed developing country equity market such as Korea (Virmani, 1985c).

- 14 -

(1985c)). For noncontro1ling shareholders however equity shares are a

relatively illiquid long-term investment which permits some diversification of

risk.

Whether households decide on personal or on private savings is

closely linked to the "corporate veil" issue (Feldstein (1973)). Controlling

shareholders are likely to make personal and corporate saving decisions in

terms of their personal consumption plans. It is clearly a veil for them, and

a study of their savings must take account of accrued capital gains. It is

likely not to be a veil for other shareholders who will take little account of

retained earnings and consequent capital gains on household wealth. To the

extent that this is so policies such as investment credits, development rebate

and tax holidays, which provide incentives for corporate investment will in-

crease total saving.

A system of capital taxation with full loss offset is effectively

like a government partnership in productive enterprises. In this case govern­

ment by sharing risk can reduce individual risk and ~ncrease investment. 15/

This would tend to increase direct savings. As few countries have full loss

offset provisions the effect is more uncertain. Other government policies

which promote or ·retard the development of equity and futures markets also

have long term effects. For instance, restrictions on equity trading by pen-

sian funds and other financial institutions can retard the development of

equity markets by keeping markets thin.

15. Stiglitz (1973, 1976), and Gordon (1985) show that this happens even with a complete equity market. It seems even more probable in the developing country situation.

- 15 -

For the majority of households uncertainty in returns to capital is

untouched by the equity market. The institution of the extended family may be

a partial substitute for absent capital and insurance markets. By investing

in children the family can diversify its portfolio and provide old age secur-

ity thus compensating for missing annuity markets. Investment in children's

education can also be used as an asset diversification device which reduces

capital risk. In this case savings which only take account of physical cap-

ital could be negatively affected if the improvement in allocation efficiency

is not sufficient to raise total capital.

To the extent that family members have different sources of labor and

capital income family risk pooling will take place. Specific family policies

such as migration of one or more members out of a risky agricultural environ­

ment may also be adopted for this purpose. 161 Increased physical and

occupational mobility will therefore reduce household risk and influence

household saving.

In a nuclear family life insurance for the primary earner reduces

earnings uncertainty (from date of death uncertainty). Life insurance could

also be used to make bequests to grown children. More importantly, if bor-

rowing against life insurance 1s possible it can be almost equivalent to an

annuity market. Annuity markets basically act as an 1nsurance against time of

death uncertainty. If these markets were perfect time of death uncertainty

could be effectively eliminated in a manner similar to perfect health insur-

ance. In the life cycle view there would then be no bequests, while in the

16. Care has to be exercised in empirically separating this motive from a search for higher return to human capital.

- 16 -

altruistic view there would be no annuities purchased (only life insurance).

Moral hazard problems are notorious in this market however (See Pauly (1974),

Rothschild and Stiglitz (1976)). Th~ extent to which life insurance is avail-

able will influence the level of saving and the ~ssets in which it is accumu-

lated.

Annuity markets are seldom observed even in d~veloped countries.

Households cannot therefore plan to run down their assets by the time of death

even if they wanted to do so. Bequests are therefore viewed by pure life

cycle individuals as a consequence of life time uncertainty. 171 Indexed pen­

sions and social security act as substitutes for absent annuity markets. 181

The issue of children as old age security is directly linked to im-

perfections in life insurance and annuity markets. Kotlikoff, Shaven and

Spivak (1983) have shown that an extended family can provide imperfect insur-

ance. This will result in higher household wealth than if markets were per-

feet. Parents may therefore have more children to insure that an extended

family survives into their old age. The number of children in turn influences

the level and pattern of saving.

4. GOVERNMENT POLICY INCENTIVES AND CONSTRAINTS

Government policy influences household behavior and national savings

at severnl levels. Individual taxes, transfer schemes, government expenditure

and subsidies will affect some group of households. Before getting into the

17. See Davies (1981), Kotlikoff and Spivak (1981). Eckstein, Eichenbaum and Paled (1983) have studied the steady state behavior of an economy with no annuity markets.

18. Government policies along these lines are considered below.

- 17 -

detailed consideration of each of these, it is useful to look at the aggregate

picture.

Short term macroeconomic analysis of economic performance and govern-

ment budgets commonly focuses on the issues of deficit financing and borrowing

by public enterprises. IMF and other recommendations for short-term adjust-

ment usually involve measures to limit government and public enterprise bor-

rowing and money creation. Alternatively the recommendation is to increase

tax effort and ·limit inflationary finance because of the likelihood of nominal

expenditures rising faster than nominal revenues. The effect on the real net

debt of the government, which determines its dis-saving, is usually ignored.

With the advent of structural adjustment lending there has been increasing

concern with the long-term effect of these policies on growth. The influence

of these policies on savings is the critical link between their short run and

long run effects. The pattern of government expenditures and the pattern of

taxes can all affect savings. Consider first the pattern of financing.

4.1 PATTERN OF FINANCING

Government expenditure ~ust be financed by taxes (and nontax

revenues), by base money creation (inflation tax) or government debt. 19/

Taxes will have effects on savings which we consider subsequently. Money

creation is usually seen as the residual in discussions of macro policye From

the saving perspective the inflation tax 1s another way of raising resources

which will have its own set of distortions. It is changes in the government's

19. Transfers and subsidies are commonly included in government expenditure data. The former are however subtracted from taxes to get net taxes in most economic analysis. One could do the same for subsidies, though it is much more difficult to extract this data from government accounts.

- 18 -

net debt which constitute public (dis)saving. As most developing countries

invest in productive assets, this must be subtracted from formal debt before

getting a true picture of net government indebtedness (Eisner and Piper

(1984)).

In analyzing whether the pattern of financing influences household

behavior, taxes are assumed to be nondistorting lump-sum taxes for simplic­

ity. For any given level and pattern of government expenditures, the issue is

what extent changes in government saving are offset by changes in private

saving. Given the government budget constraint this change must be due either

to a reduction in taxes or in money creation. The Ricardian Equivalence pro­

position is that a change from taxes to debt will have no effect on total

saving. The Barro argument depends on the previously mentioned altruistic be­

quest motive linking generations. An increase in government debt entails

future tax liabilities on heirs to pay interest and/or principal. The dis­

counted value of these future liabilities exactly balances the current reduc­

tion. There is no crowding out. The increase in government supply of bonds

is exactly balanced by increased demand from the public to leave as bequest to

heirs who will have to pay the extra taxes.

There are a number of direct arguments against this reasoning, but

three are most relevant for developing countries (Tobin and Buiter (1980)).

Firstly, the chain is broken if parents expect children to be so much better

off than them that they would &ctually like to leave negative bequests. The

second is if households are liquidity constrained. The third is that if

households expect debt to be financed by future money creation instead of

future taxes, the effect could be quite different (see below). In the life

- 19 -

cycle view of households the argument does not apply at all. 20/ In this

view, the extent to which tax liability is shifted to future generations,

households will perceive an increase in their net wealth (discounted after tax

income). They will therefore increase their consumption and national saving

will fall. To the extent that any increase in private saving falls short of

the increase in government borrowing (dis-saving), private borrowing will be

crowded out.

In investigating this crowding out issue in developing countries it

has to be remembered that government bond markets are seldom present. Finan-

cial institutions are often forced to hold government debt by fiat or by the

nature of it being the only acceptable reserve asset. Part of the effect of

this forced lending is an implicit tax on the financial institutions. If how-

ever their net lending to the private sector falls by an amount equal to the

increased holding, and private bonds increase to fill the gap, the effect may

not be very different. 21/

In considering the change in pattern of financing from taxes to money

creation open market operations are likely to have different effects from

government borrow~ng from the central bank. The former involves changes in

government bonds as an intermediate step, and therefore requires some of the

above analysis (Tobin and Suiter (1980)). In the latter case the effects de-

pend on whether there are any unemployed resources and the relative distorting

20. Strictly it does apply to a person's own future tax liability.

21. The degree to which government and private bonds are substitutes i~ an issue here. See Frankel (1985) for an empirical study.

- 20 -

effects of ordinary taxes versus the inflation tax. It also depends in

general on whether inflation is anticipated or not.

In practice inflationary finance or the inflation tax can influence

household savings through several channels. In the hypothetical case of a

fully anticipated and frictionlessly adjusted price level (with relative

prices unaffected) inflation will provide an incentive to shift out of money

and into physical assets. From the growth perspective, in the long run steady

state it is a tax on the holding of wealth in the form of money. As Tobin has

emphasized, even if total savings fall there will be shift away from money

holding to saving in physical assets.

In the medium-term inflation will influence the real interest rate

and the distribution of income and wealth. For instance unanticipated infla­

tion will tend to redistribute income between younger people who are likely to

be net savers and older people who are net dis-savers. Differences in mar­

ginal savings propensities between these groups will change total

saving. 221 Though household savings may fall investment and capital stock

may be higher if the value of government debt falls.

Inflation will operate through a number of other channels, some of

which have a positive and others a negative effect on savings. Among these

are the problems of disentangling individual price changes from general infla­

tion, a redistribution of income between young and old, a change in the real

interest rate, a change in real income uncertainty and precautionary saving,

and portfolio shifts (Deaton (1977), Juster and Wachtel (1972 a,b), Von

Furstenberg (1980a, 1981)).

22. The issue of intergenerational transfers is considered further below.

- 21 -

4.2 PATTERN OF TAXES AND TRANSFERS

The government budget constraint dictates that a change in one tax

must be offset by some other change. As the effect of debt and money creation

have already been considered these will be assumed fixed. Either some other

tax, a transfer or government expenditure must change. We can look at these

in turn.

Consider first a change in the pattern of taxes so that the income of

households remains unchanged. In this case the standard argument is that a

shift from capital to labor taxation will increase savings because of substi-

tution effects. As Atkinson and Sandmo (1980) have shown the effect of a

shift from labor to capital taxation is much more complicated. This is be-

cause taxes on returns to capital (labor) have cross-effects on labor

(capital) supply. The effect also depends on whether the economy is on the

golden rule path. 23/ In developing countries collection problems and costs

often limit the flexibility of the government in shifting from one tax to

another. 24 / The effect of the existing pattern of taxes on saving particu-

larly the mix of capital, labor and commodity taxes still merits investi-

gat ion.

The taxation of interest, dividends and other earnings from capital

changes the after tax returns to capital. Baskin (1978) found a significant

effect of the after-tax interest rate on saving. Such an analysis has not

23, When saving is less than required by the golden rule, the total effect of after tax interest rates rather than the substitution effect is relevant (op. cit.).

24. See Virmani (198Sb). Auerbach, Kotlikoff and Summers (1973) have simulated the effect of a number of such tax substitutions.

- 22 -

been done for any developing country. This issue is however closely linked to

the question of interest elasticity of saving. Gylfason (1980) and Howry and

Hymans' (1978) for the DCs contradict Baskin's results. Fry (1978) and

Giovanini (1985) similarly produce contradictory results for the developing

countries. Some of the difficulties which have prevented a clear answer are

as follows. Temporary changes can have an opposite effect from a permanent

one. Defining the tax on corporate capital requires a careful consideration

of financing decisions as the two interact (King (1977), King and Fullerton

(1985)). The use of one interest rate to represent the rate of return to all

savers is also problematic particularly in developing countries with credit

market imperfections. The treatment of inflation requires consideration of

the effect on the value of outstanding debt as well as the real rate (nominal

minus inflation). Summers (1981a) has also emphasized that the human wealth

effect of interest changes can be quite substantial and is often neglected.

Both interest and labor taxes influence human capital formation

(Heckman (1976), Kotlikoff and Summers (1979) and Baskin (1975)). Capital 1n­

come taxation will therefore also provide an incentive to shift from saving in

physical capital to human capital. Though total saving may fall only

slightly, savings as measured in the national income accounts could be nega­

tively affected. In the case of labor taxation, the effect depends on whether

households have to incur out of pocket expenses, and whether the income tax is

nonlinear. The pattern of taxes therefore influences the pattern of saving in

human versus physical capital. Systematic differen~es across countries in the

pattern of taxes and major tax reform episodes may form part of the explana­

tion for the observed saving rates.

- 23 -

Tax changes can also lead to changes in asset prices. Thus for

example a land tax will reduce the price of land and an investment incentive

will reduce equity prices (Feldstein (1977), Summers (198lb), Auerbach and

Kotlikoff (1983)). If this results in intergenerational redistribution

savings will be affected. For instance, as older individuals are likely to

have more assets than younger ones, the life cycle model suggests that savings

will rise. In the ~!truistic model there would be no effect on saving (Calvo,

Kotlikoff and Rodriguez (1979)).

The usual public social security system found in the US and Latin

America is the "pay as you go" one,, As labor taxes on worker~; finance social

security payments to the retired, this is an example of an int:ergenerational

tax-transfer poli~. Such income transfers from the relatively young to the

old will have a negative effect on saving if the marginal propensity to save

of the former is greater than that of the latter. The effect of a social

security system on savings is therefore an important issue in many developing

countries.

Balooning food and fertilizer subsidies have become of concern in

countries as diverse as Bangladesh and Korea. Though these are touted as

transfer payments to the poor the effective transfer to this segment of the

population is often questicnable. Similarly public sector inefficiency and

below cost pricing often represent hidden transfers to the rich and middle

classes. The issue of user charges for irrigation, health and education is a

reflection of the concern that the subsidy may be much larger than can be

justified by the difference between social and private returns. In combin­

ation with the taxes that finance them these subsidies represent intra­

generational transfers.

- 24 -

In some countries provident fund schemes, certain government pension

schemes and some types of life insurance make a lump sum payment to the in­

dividual. They are therefore essentially contractual saving schemes. These

often involve an implicit tax as the implicit rate of return is below the

market rate of interest, and therefore also involve intragenerational

transfer.

If the marginal propensity to consume (MPC) of the rich and poor is

different, tax-transfer policies (intragenerational redistribution) can have

affects similar to that of intergenerational ones. Blinder (1975) found that

redistribution would have a mildly positive effect on saving. More recent

empirical work suggests that the MPC declines with wealth implying the op­

posite conclusion (Menchik ~nd David (1983), Diamond and Hausman (1983)).

The influence of government fisc4l policy is critically dependent on

whether insurance markets exist. Merton (1983) suggested that fiscal policy

as a veil for insurance. For instance unfunded social security in combination

with a consumption tax would pool both human and physical capital risk.

Similarly indexed pensions and social security can substitute for absent an­

nuity markets. Thus a government pension will have ambiguous effects on

saving if households are altruistic, but is likely to be positive for life

cycle households as precautionary demand declines (Sheshinski and Weiss

(1981), and Hubbard (1983) respectively). Similarly in an involuntary bequest

- 25 -

life cycle economy fully funded social security will reduce savings (Abel

{1983, 1985)}. 25 1

If markets exist some of these government policies will merely dis-

place private markets. They could even have negative effects if government

policy is itself a source of uncertainty (Weiss (1976), Stiglitz (1982), Eaton

(1981), Skinne~ (1983)). Z6/ The empirical results depend on the nature of

n1arkets. The evidence on the effect of unfunded social security on private

saving is contradictory (Feldstein (1974) and Lesnoy and Leamer (1981)). 27/

This is also partly the result of econometric problems as suggested by

Williamson and Jones (1983).

4.3 PUBLIC CONSUMPTION AND PATTERN OF EXPENDITURES

Though transfer and subsidy policies are conventionally analyzed as

negative taxes, for some purposes it is useful to view them as expenditures.

In this context one can take the financing pattern including the structure of

taxes (excluding transfers and subsidies) with its associated welfare costs as

given. We can then consider the effect of shifting resources from one type of

government expenditures to another.

To determine the influence of public expenditures on investment it is

necessary to distinguish between different types of expenditures. There are

broadly four different categories of government expenditures, though any in-

25. See also Diamond and Mirrlees (1978) on how the means test actually contributes to making the implicit insurance more efficient.

26. The earlier idea of Friedman was focussed primarily on money growth uncertainty and business cycles.

27. See also Barra (1978), Darby (1929), Kurz (1981), Diamond and Hausman (1983).

- 26 -

dividual expenditure item may often have elements of more than one. The big-

gest and the most difficult category to empirically disentangle in developing

countries is transfers and subsidies. This is because subsidies are assoc-

iated with each of the other three categories of expenditures. Any investment

is likely to be associated with a stream of (future) subsidies. The three

types of expenditures are (Samuelson) public goods, goods and services in-

volving externalities or appropriation problems, and pure substitutes for pri-

vate goods.

General administration expenditure (particularly police), defense and

certain urban and rural amenities may be thought of as public goods. If there

is deliberate over manning and other political and social expenses this part

of expenditure should strictly be separated and included in subsidies. The

extent to which public consumption crowds out private consumption is an issue

of direct crowding out (Tobin and Buiter). This element has usually been ig-

nored even in developed country studies in savings (see however Kormendi

(1983)).

The second type of goods and services are popularly associated with

the term infrastructure. They include things like market and institutional

development, agricultural and other R & D, public health, water supply, popu-

lation control, canals, dams, roads, water and sewer, post telephones and

telegraph, and electricity. 281 These are goods which are generally seen as

complementary to private production, because increasing returns to scale or

private sale would produce an inefficient amount. Again, however, any subsidy

28. In small developing countries electricity production is also included because the efficient size is beyond the capability of private entrepreneurs.

- 27 -

amount greater than the difference between social and private returns is a

transfer element which should be separated out. We expect that such cornple-

mentary investment and expenditures will increase returns to private invest-

ment. In an economy with producer-consumer households or a closed one they

will have a positive influence on saving (Von Furstenberg (1980b), Blejer and

Khan (1984)).

Government current expenditures on education and health, have an in-

come and a substitution effect. The income effect is like the tax-transfer

policy discussed earlier and the important question is whether transfers are

to the poor or middle classes. Expenditures on primary and rural secondary

education are more likely to provide subsidies to the poor. In contrast

higher education usually subsidies the urban middle classes. In addition the

former are more likely to be complementary to and the latter substitutes for

private investment in physical capital. 29/ Though the net effect on

(physical) saving is ambiguous, saving in the form of human capital will

definitely increase. This will tend to raise labor productivity as long as

the return to education is greater than the return to physical capital.

Investment in goods which are or can be produced by private indivi-

dual (substitutes) should have no effect on private saving if financed by lump

sum taxes. Real world taxes to finance such investment will tend to reduce

total savings, and possibly even the rate of saving. Even more important is

the fact that the rate of return to such investment is often less than the

private. Thus there is a stream of future subsides associated with it. As

29. Education may also have some element of externality which is very hard to define and measure.

- 28 -

with the previously mentioned subsidies, these involve a pure transfer to

workers and buyers of these goods. In most cases the nominal subsidy is an

underestimate because the true subsidy should include a rate of return equal

to the private one. In the context of many developing countries, these im-

plicit subsides are likely to go to the relatively well educated and richer

people. Such reverse redistribution will therefore invert the effect of any

explicit welfare policies.

5. AGGREGATION ISSUES AND OTHER DETERMINANTS

In the pure life cycle view household net wealth is the discounted

stream of labor earnings. Households consume their entire net wealth over the

life time, so that saving and dis-saving cancel out. As Summers (1981) has

shown total saving arise only if the relative young are saving more than the

relatively old are dis-savings. In a static economy total net savings would

be zero. In this view aggregate saving arises because of growth in produc-

tivity and population. Higher economic growth has a positive influence on

saving in the long run. In the short run however an increase in the growth

rate results in an increase in lifetime wealth. Households will want to bor-

row against future income and savings would fall (Summers (1985)). The kind

of loan market problems mentioned earlier may reduce or eliminate this effect.

An exogenous increase in population growth, due to fertility increase

or reduced infant mortality, will have similar long-run effects if labor is

fully employed and markets are efficient. 301 Birth control programs directly

influence population growth. Expenditures on health also influence other

30. See however Arthur and McNicol (1977, 1978), Lee (1980), Mason (1977, 1980, 1981, 1984), Modigliani and Sterling (1983).

- 29 -

factors which lie behind the change in population growth. Each can have a

different effects on savings in the medium term. Life expectancy will have an

unambiguously positive effect on saving only in the long run. A decline in

infant mortality will reduce the wasted ttinvestment" in children and could

lead to an increase in investment in children's human capital. Public health

measures which reduce or eliminate debilitating diseases and epidemics will

raise life time productivity. Other demographic changes will also influence

household and national saving.

With imperfect markets the effects are less clear. In the short run

the effects are similar to those discussed in an earlier section. An increase

in life expectancy will however have an unambiguously positive short-term

effect. This is because households have to make provisions for a longer re­

tirement period. 31 / With fertility decisions endogenous this simple analysis

has to be modified along the lines indicated earlier (Schultz (1974, 1985)).

Many developing countries control the foreign investment of savings

by their nationals. Illegal capital flows through the grey market financed by

under invoicing of exports and over invoicing of imports. In many countries

of Latin America (e.g. Argentina) and Africa this market is ·virtually an open

one. In countries like Egypt, Pakistan and the Philippines where there is a

large flow of remittancest a proportion of these also flow through the grey

market. Exchange rate policies have an effect on these flows and consequently

on measured national savings. Some of these effects may be temporary, in an­

ticipation of a devaluation. Such flow have also been influenced in the past

by the perception of political risk in countries such as Chile, Argentina,

31. See however Arthur (1981), Hammer (1980) on mortality rates.

- 30 -

Ghana, Pakistan and the Philippines. Long-term effects of these policies are

difficult to disentangle but may be quite important in some countries.

In recent years the old debate on the extent to which foreign aid

substitutes for domestic saving has been revived. Associated with this is the

issue of whether governments slacken their saving effort, and waste resources

on public consumption. Recent work has shown the necessity to distinguish

long term project related aid commitments from emergency short-term human-

itarian aid. As the latter is closely connected to severe falls in income,

the propensity to consume out of it is relatively high. When allowance is

made for this the propensity to save out of long term aid flows is found to be

quite high. This issue could be clarified by the individual country analysis.

Terms of trade changes are an external source of changes in national

income. The policy response to these changes has an important influence on

national savings. The effect of changes in terms of trade depends on whether

private individuals or the government is more directly affected. In the case

of natural resources owned by the government public dis-saving would be lower

in countries which take better account of long cycles in trade prices~ In

this case governments should increase savings during positive trends and

reduce them during negative ones. The effect of terms of trade changes on

private saving will depend on the degree of permanence of the change. 32 / It

will also be influenced by the government's behavior in taxing away positive

changes in income.

32. Changes in weather which effect agricultural production will have to be similarly analyzed. In this case too, government procurement and tax­subsidy policies must be accounted for.

- 31 -

6. CONCLUSION

In studying saving behavior from a policy perspective, a number of

interesting and important issues will have to be resolved. First, some light

needs to be shed on the differences in saving behavior acrdss countries and

within countries over time. This will enable insights into the economic cir­

cumstances, particularly public policies, that result in greater savings in

some countries over certain periods. The second is to examine certain con­

troversies and unresolved policy issues which have so far been considered ex­

clusively in the developed country context. Among these are liquidity con­

straints, public social security programs, corporate veil and the effect of

corporate incentives on saving, the role of bequests and the Ricardian equi­

valence proposition.

Third, existing work on saving has not given due attention to certain

aspects specific to developing countries. Among these are the absence of, or

imperfections in relevant markets, extended family structures, terms of trade

changes, demographic effects and widespread use of infl~tionary finance.

Similarly there are a wide range of policy interventions carried out by de­

veloping countries which are re'· ,:.vant to saving behavior, but whose effect has

not been thoroughly evaluated. These range from interest controls, develop­

ment of financial and insurance markets to large public expenditure programs

in infrastructure, education and health.

- 32 -

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Some Recent DRD Discussion Papers

171. Retention of Basic Skills Among Dropouts from Egyptian Primary Schools by Michael J. Hartley and Eric V. Swanson, May 1986.

172. Abstracts of DRD Discussion Papers April 1985 - April 1986.

173. The Chilean Labor Market: From the Structural Reforms of the 1970s to the Crisis of the 1980s by Luis A. Riveros, April 1986.

174. Comparative Advantage and Structural Transformation: A Review of Africa's Economic Development Experience by Uma Lele, March 1986.

175. Credit Markets and Credtt Policy in Developing Countries: Myths and Reality by Arvind Virmani, August 1985.

176. Tax Reform in Developing Countries: Isstles, Policies and Information Gaps by Arvind Virroani, June 1985.

177. China's Economic Reforms in a Comparative Perspective by Bela Balassa, April 1986.

178. Economic Prospects and Policies in Mexico by Bela Balassa, May 1986.

179. Calibration of Macroeconomic Models with Incomplete Data: A Systems Approach by Michael J. Hartley, April 1985.

180. Structural and Stabilization Aspects of Fiscal and Financial Policy in the Dependent Economy, by Willem Buiter, September 1986.

181. Domestic Credit and Output Determination in a "New Classical" Model of a Small Open Economy with Perfect Capital Mobility, by Peter Montiel, September 1986.

182. Stability, Budget Deficits, and the Monetary Dynamics of Hyperinflation, by Miguel A. Kig~el, September 1986.

183. Public Debt Guarantees and Private Capital Flight, by Jonathan Eaton, September 1986.

184. Saving Behavior in an Economy Without Fixed Interest, by Nadeem Ul Haque and Abbas Mirakhor, September 1986.

185. International Differences in Industrial Robot Use: Trends, Puzzles, and Possible Implications for Developing Countries, by Kenneth Flamm, July 1986.

186. The Determinants of Savings in Developing Countries: Theory, Policy and Research Issues, by Arvind Virmani, August 1986.