Posted by Jeffrey Brown on Nov 30, 2012
Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy)
Earlier this week, the New York Times Economix Blog wrote a piece “Study Questions Tax Breaks’ Effect on Retirement Savings.” The article summarizes the findings of a fantastic research paper issued by the National Bureau of Economic Research (NBER). A quick summary of the paper written by the authors themselves can be found here. The short version is that the researchers used data from Denmark (where much better date is available) to provide evidence that tax subsidies have little effect on overall savings rates.
Their main finding is that “when individuals in the top income tax bracket received a larger tax subsidy for retirement savings, they started saving more in retirement accounts. But the same individuals reduced the amount they were saving outside retirement accounts by almost exactly the same amount, leaving total savings essentially unchanged. We estimate each that $1 of government expenditure on the subsidy raised total savings by 1 cent.”
The policy implications of their finding are extremely important given the current debate about fiscal policy in the U.S. After all, if tax subsidies for saving do not actually increase saving, then perhaps we should re-think the $100 billion per year that we forego in tax revenue by exempting retirement savings from the income tax base? Such a conclusion would be quite tempting to politicians who are desperately seeking ways of raising revenue without raising tax rates.
But I say “not so fast.” Although I do not disagree with the empirical findings of the study, I strongly disagree with the assertions being made by some that this finding justifies the elimination of the tax preference for 401(k) and other retirement vehicles.
The study itself is an outstanding intellectual contribution, and one that will likely (and deservedly) end up being published in a leading scholarly journal. I can personally vouch for the high intelligence and research integrity of the two U.S. authors. Raj Chetty was named a MacArthur “Genius” earlier this year, and is widely expected to be awarded the prestigious John Bates Clark medal sometime in the next 6-8 years. John Friedman of Harvard is also an emerging research star in the economics profession.
So, the researchers are top notch, the study is extremely well done, and the conclusion is that tax subsidies do not generate net much net savings. So, why not simply eliminate the tax preference for 401(k) plans in the U.S. and raise a trillion dollars of revenue over the next decade?
Because of the important role of plan sponsors, that is why.
For better or for worse, the employer plays a central role in the U.S. retirement system. Although there are several reasons that employers offer retirement plans and other employee benefits (e.g., to differentially attract certain types of workers, to help manage retirement dates, to motivate workers, etc.), there is little question that the large tax subsidy looms very large in their decision to use retirement plans – as opposed to other types of benefits – to achieve these outcomes.
To qualify for favorable tax treatment, employer provided retirement plans, including the 401(k), must meet a long list of “plan qualification requirements.” These requirements are what provide Congress and regulators the ability to influence the design of retirement plans.
An important example is the set of “non-discrimination rules” designed to ensure broad-based participation in an employer’s plan. These rules provide incentives for plan sponsors to find innovative ways of encouraging saving by their employees. Indeed, it is not much of a stretch to suggest that these rules are the reason we have seen the widespread adoption over the years of employer matching contributions, automatic enrollment, automatic escalation of contributions, and numerous other innovations in the retirement plan space that have been shown to increase saving.
The authors themselves note that “automatic enrollment or default policies that nudge individuals to save more could have larger impacts on national saving at lower fiscal cost.” I agree that behavioral nudges have had an enormous impact. But in an employer based retirement plan system, the only way to get employers to offer those nudges is to provide them with a compelling financial reason to do so. In essence, tax subsidies are the nudge for employers to provide the nudge for employees.
Of course, this does not necessarily mean that the existing system should be treated as sacrosanct. It may be that employers would continue to offer 401(k)’s – along with their numerous savings nudges – if the financial incentive were provided in a less expensive way (e.g., by capping deductibility). That is a debate we ought to have (hopefully informed by evidence of the same high quality as the NBER study). My point is simply that any policy discussion should recognize the very important role that employers play as trusted sponsors of the plan, and be careful not to throw out the baby with the bathwater.
Indeed, given that only about half of US workers have opportunities to save through their current employer, we should be looking for ways to encourage more employers to sponsor plans. If we go after the tax incentives for retirement saving, we must be careful not to inadvertently destroy the plan sponsor infrastructure that is the foundation of retirement security for millions of Americans.
Relevant Disclosures: I am a Research Associate of the NBER (through which the study above was released) and Associate Director of the NBER Retirement Research Center (through which the authors have received some funding for their study). I am also a trustee for TIAA CREF, a provider of retirement plans to the not-for-profit sector. I have also received compensation as a consultant or speaker for a wide range of other financial services institutions. The opinions expressed in this blog (and any errors) are my own.