Saving and the Rate of Interest: A Clarifying Note

Abstract

Is the compensated interest elasticity of saving necessarily positive? In a classic paper in this Journal, MartinJ. Bailey (1957) argues that it is. This result has been controversial, as is indicated by James Buchanan's subsequent comment (1959) and Martin Feldstein's (1978) recent rejection of Bailey's point. Feldstein (1978, p. S30) states that although a compensated price increase unambiguously reduces the demand for a good (or increases its supply), this is not sufficient to establish that savings are increased by a rise in the net rate of This is incorrect. Feldstein has not and cannot show that Bailey's argument is wrong. What Feldstein can show is that he prefers a definition of income different from Bailey's and that the compensated interest elasticity of saving need not be positive using Feldstein's definition. As a corollary to his analysis of the compensated interest elasticity of saving, Feldstein rejects Harberger's (1964) measure of the welfare cost of an interest rate distortion (e.g., as a result of an income tax) because this measure makes the existence of such a welfare cost dependent on the compensated supply of saving being responsive to changes in the net rate of return. Specifically, Feldstein (1978, p. S36) states that Harberger's approach is incorrect. A capital income tax can impose a substantial annual or generational welfare cost even if the compensated effect on net saving is zero. Again Feldstein is incorrect for precisely the same reason that he was incorrect about the sign of the compensated interest elasticity of saving. If Harberger were using Feldstein's definition of income and hence saving, Har-