Debit or Credit?

As an economist and beloved shopper, I shudder in disbelief at how many credit-card owners still purchase items with their debit card. Assuming that you have a debit card and a credit card that is not maxed out, I present the following economic argument for why you should choose to use your credit card over your debit card.

The classic rebuttal I get to this argument is, "People are not responsible; they simply charge things without keeping track until their bill comes in." But how sound an argument is this? When you use your debit card, you still need to maintain a positive balance in your checking account so you don't overdraw and incur any fees. It only takes a little more effort to keep track of credit card purchases if you get into a routine of noting expenditures. For example, you could do the following: Upon making a purchase, set aside the purchased amount into a separate interest-bearing checking or savings account (which is easy and quick to do thanks to online banking), or track purchases in a spreadsheet or program (also easy to do with programs such as Microsoft Excel or Microsoft Money).

Another common response I hear is, "Some people keep a high balance on their credit card." When you use a debit card, the money is automatically withdrawn from your account. So the existing balance on your credit card is irrelevant when deciding whether to purchase the next item with either debit or credit since using your debit card would imply you have the cash on hand to buy it.

Even under the assumption that there is some cost to tracking expenses, there are still three significant reasons why you should use your credit card over your debit card.

1. The time cost of money
2. Typically credit cards offer better rewards programs
3. Build credit

Everyone knows that a dollar today is not worth the same as a dollar tomorrow. If you can forgo spending a dollar until a later time, then that dollar can earn interest until you actually spend it. In economics and finance, we analyze problems such as this using the concepts of present value (PV) and future value (FV). That is, the future value (FV) of a dollar today (PV) is

FV = PV x (1 + r),

where r is the interest rate over the time period in question. Since your debit card requires you to pay for the good today while the credit card allows you to pay for the good in the future at the same nominal price, economically you are better off letting the payment value collect interest until the balance is due and then paying off the balance.

Although debit cards are beginning to offer more competitive rewards programs, credit card companies typically still offer more diverse and appealing options such as cash back, miles, and points programs.

Last, the use of debit cards does not contribute to your credit rating. The responsible use of a credit card is a significant way that you as a consumer can build credit and improve your credit rating.

Discussion Questions

1. Why are some consumers unable to qualify for a credit card? Is their inability to qualify a good signal of their financial well-being?

2. How do rewards programs affect the bottom line of a credit card company? How can they afford to offer such incentives?

3. What kind of rewards would induce you to pay for something immediately rather than in the future by using your debit card over your credit card?

4. One argument for the use of debit cards is the option to receive cash back with your purchase if your bank's ATM is not near by. How does this affect your choice to use you a debit or credit card?

Should the Government Tax Consumption or Income?

Robert Frank devoted his most recent New York Times column to the idea of shifting taxes from income to consumption. It’s not a new idea, and it’s one that many economists of various political stripes agree on.

Right now, the amount of tax you pay is based on your income. The more you earn, the more you pay in taxes on each additional dollar earned—the “marginal income tax rate.” One important argument against the income tax is that it penalizes savings. Consider an unmarried taxpayer—let’s call her Sally—who is in the 25% tax bracket. (For an individual, that means earning between about $30,000 and $70,000 per year.)

Now suppose that Sally gets a $10,000 raise. She faces a marginal tax rate of 25%, so that $10,000 raise is really a $7,500 raise at most. If she saves that money at 6% interest, the additional income will also be taxed at 25%, bringing it down to about 4.5% per year—barely more than inflation. It would take her eight years to earn enough interest to get her bank account back to the initial “raise” of $10,000.

Now consider a different tax system: one in which Sally’s consumption is taxed rather than her income. That is, suppose she would owe exactly $0 in taxes on any money she saves. This means she could put away the entire $10,000 raise and let it accrue interest at the full rate of 6% per year. After eight years, she would have nearly $16,000 in the bank. Such a system would clearly encourage Americans to save more money.

The fact that a consumption tax would encourage savings by not taxing saved money has earned it the nickname of the “unlimited savings allowance.”

Discussion Questions

1. If one were choosing between a pure income tax and a pure consumption tax, the former would be more likely to encourage consumption, while the latter would be more likely to encourage savings. Which of these—consumption or savings—would be more beneficial to the economy as a whole? Why?

2. Frank suggests a highly progressive consumption tax (i.e., the marginal tax rate would rise as consumption increased). He even does a thought experiment with a 100% marginal tax rate on consumption beyond a certain level. A famous tax proposal by economists Bob Hall and Alvin Rabushka would levy a “flat tax” on consumption. How would you compare these two proposals? What are the pros and cons of each?

3. Frank is famous for his belief that because people care about “keeping up with the Joneses,” consumption actually has a negative externality associated with it. If that is true, is a consumption tax in reality a kind of Pigovian tax?

4. Two of the guiding normative principles by which many people judge tax systems are the ability to pay principle (briefly, that the rich should pay more in taxes) and the benefits received principle (briefly, that if taxes are used to fund a public good, those who benefit the most from the good should pay the taxes). Does Frank’s proposal follow these principles? Why or why not?

Saving America

The U.S. trade deficit increased 2.4% between March and April 2006, which should be no surprise to our blog readers (archived entry: trade deficit and the negative saving rate). Some people point to China's fixed exchange rate or to the high oil prices for America's trade woes, but many macroeconomists contend that it is the lack of national saving that drives the trade deficit in the long run.

There are two markets that we have to consider when we examine the impact of saving on the trade deficit. First, consider the market for loanable funds, which determines the long-run real interest rate. Second, consider the relationship between the real interest rate and net exports. For simplicity, we're going to deal with absolute amounts (dollars) rather than relative amounts (percentages).

The market for loanable funds is where savers and lenders interact. Like any market, there's a supply and a demand. The demand for loanable funds consists of U.S. firms that want to borrow. The supply of loanable funds consists of U.S. firms, households, foreigners, and governments that want to lend. The price of loanable funds is the real interest rate, which is considered the "cost of borrowing" to borrowers and the "rate of return" to savers. The equilibrium real interest rate is where supply intersects demand, r*.

So what happens when the federal government increases its budget deficit and households decide to spend a larger share of their disposable income? An increase in the government budget deficit reduces public saving, and the increase in consumption reduces private saving. Put those two effects together, and we have a net decline in the supply of saving, which causes the equilibrium real interest rate to rise from r* to r2. (See Fig. 1.)A decrease in total saving in the United States pushes up the real interest rate. The real interest rate represents the rate of return for holding U.S. assets. If the real interest rate rises, then foreigners will want to buy more U.S. assets than they did before the rise. In order for foreigners to purchase U.S. assets, they must purchase U.S. dollars. Consequently, the demand for dollars increases, which increases the price of U.S. dollars. An appreciation of the U.S. currency, in real terms, will make U.S. exports less competitive and imports from foreign countries more attractive. An increase in the real interest rate causes a decrease in net exports and worsens the U.S. trade deficit. (See Fig. 2.)

Discussion Questions

1. According to our analysis, a fall in total saving actually increased the U.S. consumer's purchasing power of foreign goods and services (more U.S. imports) while it decreased the foreign consumer's purchasing power of U.S. goods and services (fewer U.S. exports). Is this an economic disaster or a sign that Americans are relatively wealthier than most people in the world?

2. A decrease in total saving increases the real interest rate, and a higher real interest rate increases foreign demand for U.S. assets, causing the price of the dollar--the real exchange rate--to rise. China purchases many U.S. assets in order to keep the value of its currency, the renminbi, relatively cheap compared to the dollar. In doing so, China intends to sustain American demand for Chinese-made goods. How does China's fixed nominal exchange rate policy affect the U.S. trade deficit in the long run?

3. If permanently higher oil prices reduce U.S. potential output, how does this affect national saving in the long run? How does this affect the trade deficit in the long run?

Saving Early

Countless surveys and reports show that a majority of Americans, regardless of age, are woefully financially illiterate. The U.S. personal savings rate has been steadily declining over the past decade, even turning negative in 2005. According to many pundits, the problem is that youngsters are not learning financial responsibility and the importance of saving for the future. These bad habits follow them as they get older.

To fight this trend, some schools are promoting financial literacy at a young age and even starting savings banks. At Sunrise Valley Elementary School in Fairfax, Va, students operate the Sunrise Valley Savings Bank, a school branch of a local bank. There is no minimum balance and student deposits earn 5% annual interest.

Elsewhere, educators and financial institutions have sprung into action, teaching kids about basic money management skills. Indirectly, students will be learning about the power of the time value of money. The TVM is a central topic in finance and revolves around the concept that a certain amount of money received today is worth more than the same amount received sometime in the future. A variety of factors including inflation and the choice to consume or save play a role in this.

The basic TVM equation solved for future value: FV = PV (1 + r)ⁿ, where PV is the present value of the amount, r is the interest rate, and n is how long the amount is invested. The story mentions how a ten-year-old student, Nate, is depositing a $5 bill. If Nate continues to earn 5% on his savings until he retires at age 65, that $5 deposit will be worth $73.18, doubling nearly four times. If Nate continues his practice of saving $2 a week until he retires, he would have $30,414 when he retires. This is a slightly more complicated calculation, because there is a periodic payment being made, but trust me it’s right!

1. Near the end of the article, 11-year-old student William says he wants to buy a new skateboard. What is his opportunity cost of saving for a new skateboard?

2. The Sunrise Valley Savings Bank pays its members 5% interest, but it is reasonable to assume students will get higher returns for their money in the future. How much will Nate’s $5 deposit be worth in 55 years if he earns 6% interest? 8%? 10%?

3. To see the importantce of teaching youths to save early, access this savings calculator. If a 10-year-old student saved $1 every day and deposited $365 at the end of each year from now until retirement (at age 65), how much would he/she have at retirement in 55 years? (Hint: Starting amount = $0; Years = 55; $365 additional contributions made annually; and a 10% rate of return compounded annually)

4. Use trial-and-error with the savings calculator to see what annual contributions another student would have to make if he/she didn’t start saving until the age of 55 (ten years from retirement) and wanted the same ending amount. (Hint: Change Years to 10 and try different values for additional contributions until you have about the same ending amount.)

Negative Saving Rate

In 2005, the U.S. personal saving rate fell to -0.5%--the lowest personal saving rate since the Great Depression! Some facts about the negative personal saving rate are presented in this Associated Press article. What does a negative personal saving rate mean and what does it imply for the U.S. trade deficit?

The personal saving rate is the percentage of real GDP saved by households within a given year. A negative personal saving rate implies that households consumed more than they earned by using their current stock of savings or borrowing money.

Saving becomes loans to U.S. businesses that use the funds for investment spending--the purchase of new capital.

So does a decrease in the personal saving rate mean that the investment rate, too, must shrink? Not necessarily. In a closed economy, the investment rate is equal to the national saving rate. However, in an open economy, this need not be true, because American firms can borrow funds from overseas. A negative personal saving rate means that not only are American firms borrowing from overseas to finance investment--American consumers are also borrowing from foreigners to finance consumption of foreign goods and services. In effect, one of the U.S.'s biggest imports is foreign saving.

This importing of foreign saving has an important implication for the U.S. trade deficit. Think about what happens when Chinese financial investors buy U.S. treasury bonds--in effect, lending money to the U.S. government. In order to do so, they must have U.S. denominated assets (dollars). In order to get those dollars, China must export more than it imports--that is, the Chinese must sell more of their goods and services to the United States than they buy from the United States. The leftover dollars can then be lent to the U.S. government or American firms.

The graph above shows that a decrease in the national saving rate causes the trade deficit as a share of real GDP to increase if the investment rate stays at (I/Y)*.

Discussion Questions

1. Why are foreign financial investors willing to lend to the United States?

2. If foreign financial investors refuse to continue lending funds to the United States, how would this affect the U.S. investment rate?

3. In the 1930's, the saving rate was negative because incomes were so low that people had to dip into prior savings in order to survive. But the United States is prosperous now. Why, then, do you think the U.S. saving rate is so low?