The Interest Elasticity of Saving and the Functional Form of the Utility Function

This paper deals with the important issue of the elasticity of saving with respect to the interest rate. Michael Boskin, and more recently, Lawrence Summers, have argued that saving is much more interest-elastic than economists have generally believed, and as a consequence that the dynamic efficiency losses from capital income taxation are much higher than they were previously thought to be. In Summers' life-cycle simulation model an increase in the interest rate depresses the present value of future labour income and this leads to declines in the consumption of younger cohorts, more saving, and a higher capital stock. These results are established with a CES utility function. I argue that it is reasonable to introduce minimum consump- tion levels into the model, as in the stone-Geary utility function, and that when this is done, younger cohorts do not decrease their consumption by as much in response to an interest rate increase. I show that the interest elasticity of saving is significantly reduced and may even be negative.