Tax Subsides for 401(k)’s Work, But Not for the Reasons You May Think

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Nov 30, 2012

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.

Breaking News: Supreme Court Upholds Individual Mandate

Filed Under (Health Care, U.S. Fiscal Policy) by Nolan Miller on Jun 28, 2012

Hot off the Internet, the Supreme Court has upheld the “Obamacare” individual mandate, which requires most people to buy health insurance or else pay a tax.  The ruling isn’t available yet, but I have to say that I’m really, really impressed by this decision because it shows that the Supreme Court was able to look beyond the politics of the situation and the poor argument by the administration in defense of the bill, and rule according to the law.

The argument against the mandate was that it violated the Commerce Clause of the Constitution in that it regulated economic “inactivity” rather than activity.  That is, it forced people to participate in the individual insurance market even if they didn’t want to.  The administration flubbed its defense on this point by failing to show how health insurance markets are different than most other markets, giving the Supreme Court a limiting principle that would prohibit the ruling from establishing that Congress can regulate anything it wants.

It sounds like the Supreme Court did not buy the argument that the indivual mandate was justified under the Commerce Clause.  But, in some sense this is all a red herring.  The individual mandate is a tax, plain and simple.  People who do not buy health insurance must pay a fine to the IRS.  A fine paid to the IRS is a tax.  The Democrats and the administration tried to hide the fact that this was a tax while rallying support for the bill for obvious reasons.  Nobody wanted to be seen as raising taxes, and President Obama had promised during the campaign that he would not raise taxes for middle income Americans.  But, just because the Democrats wanted to pretend that this wasn’t a tax, that doesn’t make it true.  It’s a tax. And, Congress has the right to impose taxes.

Despite the fact that the administration did not emphasize the tax aspect of PPACA’s indivual mandate in either its presetation of the bill to the public or in its defense before the Supreme Court, the Court was able to step beyond the narrative that was being fed to them and identify the key legal principle involved.

Whether you support the bill or not, I think that in a post Bush v. Gore / Citizens United world, when people are wondering whether the Supreme Court really is an impartial arbiter of the law, you have to see this as a great moment for the Court.  Hooray for them.

More after I have a chance to look at the ruling.

Should we raise the amount of income subject to Social Security taxes?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jul 18, 2011

 The political climate in Washington has finally shifted to one in which long-term deficit reduction has become a priority.  This is definitely a good thing, given that our long term fiscal path is unsustainable and that any changes we enact will have to be much more painful the longer we wait to enact them. 

While Social Security is only one piece of the federal budget, it is a topic that merits attention.  As part of the debate, one idea that seems to be gaining traction (at least among Democrats) is the idea of raising the amount of income subject to the 12.4% Social Security payroll tax.  Currently, this tax is applied to the first $106,800 of income.  Consistent with this, only income up to $106,800 is counted in the computation of Social Security benefits.  This cap is indexed over time so that it rises with average wage growth.

It has been pointed out by many scholars and analysts that the share of the overall payroll in the U.S. that is above this “taxable maximum” has grown over the decades, a consequence of rising income inequality.  As such, many are calling for this cap to be gradually raised so that it covers a fraction of total payroll that is consistent with decades past.  A common benchmark is to raise contributions by an additional increment – such as an additional 2% per year – until 90 percent of all earnings are covered.  Social Security Actuaries have estimated that, at this rate, it would take about four decades to reach the new, higher taxable maximum, which would be equivalent to about $215,000 today (so roughly a doubling of the income subject to the tax).

Many have argued for this in terms of “fairness.”  Basically, the argument goes, why should the rich not have to pay these taxes on the income above the cap?  The usual argument against raising the cap is that this is essentially 12.4% increase in marginal tax rates on mid/high level earners, and that this level of a tax hike would reduce labor supply incentives and lead to loss of efficiency and reduced economic growth.  In short, it is a classic example of “equity versus efficiency.”  Or so it seems …

In some very good testimony before the House Ways and Means Committee a few weeks ago, Dr. Mark Warshawsky presented some additional arguments against raising the cap.  [Full disclosure – Mark and I are former co-authors, and we also served on the Social Security Advisory Board together for two years.]  In his testimony, Mark raises four additional points that have are often missed, some of which call into question the argument that raising this tax is “fair.”  These four points are:

  1.  “It unfairly targets a specific segment of the population that has not seen particularly large gains in earnings.”  Mark gives a great explanation of this, showing that the vast majority of the increase in earnings for the top 20 percent of the income distribution is actually concentrated in the top 1 percent (in other words, there is growing income inequality even at the top).  Raising the cap from $106,800 to $215,000 would be slamming those who have experienced only moderate earnings growth.
  2. “It is an extra burden in addition to the new taxes imposed on this and other groups to finance Medicare and in the recent health care legislation to finance health insurance coverage for poor and middle-income households.“  The populist tendency is to want to “tax the rich.”  But Mark points out that we have been hitting this group pretty hard.  As he notes, “In 1991, the earnings cap for Medicare Health Insurance (HI) payroll taxes was increased, and in 1994, it was lifted entirely. So these workers already have seen a significant payroll tax increase of 2.9 percent of earnings. Moreover, under the new health care law, an additional HI payroll tax of 0.9 percent will be collected from workers with earnings over $200,000 for single filers and $250,000 for joint filers, effective for taxable years after December 31, 2012. These earnings thresholds are not indexed and hence many of the workers to be hit by this HI tax rate increase will be the same individuals to be hit by the proposed increase in the Social Security taxable maximum. In addition, there is a new tax of 3.8 percent on unearned income of individuals with modified adjusted gross income above $250,000 (in the case of a joint return) or $200,000 (in the case of a single filer return). On top, of course, a progressive income tax structure exists at the federal level and in most states and localities.”
  3. “It will cut private retirement savings.”  Mark calculates that those people affected by this would reduce their private savings by about 4 percent, this coming at a time when personal savings rates are already abysmally low (and even if you do not care about their savings rates directly, it is important to remember that savings is what drives investment, which in turn is what drives economic growth.)
  4. “It represents an unnecessary expansion of the Social Security program.”  This arises because these proposals would grant some additional benefits in return for the additional taxes (although the incremental benefits are a small fraction of the incremental taxes), meaning that we are expanding a fiscally unsustainable program for people who do not really need it (high earners).  You might object by stating that we should treat it as a pure tax and not provide any incremental benefits, but then that just magnifies the other downsides.


Let’s be clear – our fiscal situation is pretty dire, and we need to balance the budget.  As much as I would like this to be done primarily on the spending side, I recognize that we are going to need to raise some revenue.  But of all the possible ways of expanding the nation’s revenue that might providing some efficiency gains (e.g., carbon tax, eliminating numerous corporate tax deductions, limiting tax expenditures, etc.), raising the cap on Social Security should be pretty low on the list.


A Charitable Proposal

Filed Under (Uncategorized) by Jeffrey Brown on Mar 9, 2010

I just ran across an idea by one of my favorite policy economists, Gene Steuerle of the Urban Institute, in a piece he wrote entitled A New April 15: Make It a Day of Giving (Efficiently).  In a nutshell, he calls for treating charitable contributions in the same manner that we treat IRA contributions – by allowing tax deductibility to extend through the April 15 tax filing deadline.  This is one of those incredibly simple ideas that ought to be implemented tomorrow. 

As background, charitable contributions typically have to be made by December 31 to qualify for deductibility from that year’s taxes.  However, December 31 comes at a time of year in which a lot of people are focused on major holidays rather than taxes.  We allow people to make deductible 2009 IRA contributions as late as April 15, 2010, thus allowing people to make their IRA contribution decision simultaneously with figuring out their 2009 taxes.  This timing is much more salient and allows people to optimize more effectively.  Why not do the same for charitable contributions?  After all, we have done so after major disasters, including the 2005 Tsunami and the 2010 Haiti disaster.  Why not allow it for all contributions every year?

Clearly, this would be a better approach than favoring certain types of deductions over others by extending deductibility on a case-by-base basis, a point made by Howard Gleckman in January recent blog post.  The basic point he makes is that, yes, Haiti needs relief.  But so do hundreds of other incredibly good causes, be it starving children in Somalia or the American Red Cross response to a localized disaster.