Tax breaks for saving

I come from a family of penny pinchers. My parents had to support themselves at young ages, and their thriftiness put them and their children through college. Though I’m a big spender compared to my parents (it would horrify them to know I’m on a first-name basis with our local Thai food delivery guy), I’m still careful to put away money for retirement.

Despite my personal predilections, I think it’s time we reexamined our knee-jerk support for tax breaks for saving. Admittedly, it’s much harder than in my parents’ day to save your way into the middle class. For instance, a new Center for Economic and Policy Research report points out that the number of hours a minimum-wage worker has to work to pay for college has more than tripled over the past three decades. Nevertheless, it’s quite difficult to design tax incentives that actually help ordinary people save—as opposed to simply lowering taxes for high-income households.

Our tax code contains a mess of contradictory provisions that both encourage and discourage saving. These range from 529 plans for college saving to the mortgage interest deduction, which subsidizes borrowing. Among the costliest of the savings incentives are those designed to promote saving in 401(k)s, IRAs and other retirement plans. According to Treasury estimates, the present value of tax breaks for 401(k) plans alone was $83 billion in 2010 (see Table 17 here), not counting payroll tax losses.

Problematically, two-thirds of these (and other) tax breaks go to taxpayers in the top income quintile (households with roughly more than $103,000 in income in 2011). Aside from the fact that upper-income households need less help saving for retirement than low- and middle-income households, these tax breaks do little to increase saving since most high-income households already save and simply steer funds to tax-favored accounts (see footnote 27 here for an overview).1

These upper-income tax subsidies are ripe for trimming. Erskine Bowles and Alan Simpson, co-chairs of the president’s fiscal commission, suggested capping tax-preferred contributions to the lower of $20,000 or 20 percent of income, as well as again taxing capital gains and dividends at the same rates as ordinary income. (The two proposals are related because the value of tax deferrals for retirement saving depends on the taxes that would otherwise be paid on investment earnings.)2

Though there’s not much else to like in the Bowles-Simpson plan, 401(k) tax breaks are a good place to look for budget savings. Even better would be reducing the contribution limit to $10,000 or less, as few people can afford a $10,000 contribution, let alone $50,000 (the maximum combined employer and employee contribution). Research by two Treasury Department analysts found that reducing the total contribution limit to $10,000 would have little effect on taxpayers making less than $75,000, but that roughly 80 percent of taxpayers with incomes greater than $150,000 (and 45 percent of taxpayers with incomes between $75,000 and $150,000) would see a tax increase. Affected taxpayers in the highest income group would lose a tax break averaging $3,166, even though the $10,000 cap would reduce their 401(k) contributions by only a third, on average.

As Drexel law professor Norman Stein points out in a working paper presented at a recent University of Virginia Tax Study Group panel, supporters of the status quo offer three less-than-compelling arguments in defense of maintaining 401(k) tax breaks: that their cost is exaggerated; that encouraging employers to offer 401(k)s on behalf of highly-compensated employees indirectly helps lower-income workers even if they reap little of the tax benefit; and that these tax incentives actually cost nothing if you believe that consumption, rather than income, should be taxed.

Stein is right to dismiss these arguments. Without going into the gory details, estimates of the long-term cost of 401(k) tax deferrals depend on many assumptions, not least of which is whether the George W. Bush-era tax cuts to dividends and capital gains realizations will be allowed to expire. Nevertheless, the Treasury Department estimates are undoubtedly less biased than the low-ball estimate put forward by the American Society of Pension Professionals and Actuaries.

As for the second argument, it’s inefficient to offer enormous tax breaks to high-income taxpayers in the hope that some benefit will trickle down to low- and middle-income savers. The majority of tax filers would be better off if the federal government simply deposited $785 into an account on their behalf, which would cost the same amount. Better yet, the money should be used to offset the cost of Guaranteed Retirement Accounts, which would provide retirement security for all long-career workers without increasing the budget deficit.

Last but not least, it’s absurd to assume away the cost of the tax break by claiming that our tax system has become a de facto hybrid between an income and consumption tax system, and that under a consumption tax, saving wouldn’t be taxed in the first place. This is circular logic. In any case, the 401(k) tax break doesn’t really reward saving as much as it does investment income.

Moving from an income to a consumption tax would entrench a rentier class by facilitating the accumulation and concentration of wealth. Nor is there any reason to encourage aggregate saving for its own sake, as opposed to saving by particular households for particular purposes. Higher savings would impede near-term recovery because economic growth in the United States is constrained by a lack of consumer demand rather than a dearth of investment funds. From a macroeconomic perspective (among other reasons), we’d be better off expanding Social Security—largely a pay-as-you-go system—rather than attempting to increase savings through 401(k)s.


1. As a wonky aside, the Tax Policy Center recently released a paper arguing that the conventional measure of government size may be understated because 401(k) tax breaks and other tax expenditures are counted as reduced government revenue rather than increased government spending. However, to the extent that supposed “tax incentives” often serve little purpose besides reducing taxes, the conventional accounting may be more accurate for many tax breaks. In any case, this is a good reminder of the arbitrariness of setting limits on government spending as proposed by House Budget Committee Chairman Paul Ryan and others, which would lead to more government initiatives being inefficiently channeled through the tax system.

2. Tax deferrals are similar to interest-free government loans. Their value depends on the taxpayer’s marginal tax rate (which determines the size of the initial “loan”) as well as how much would otherwise be owed in taxes on investment earnings accrued from the “loan.”


  • Anonymous

    4.3% of tax filers in “Tax Year 2012″ earned 28.4% of all income, according to the Joint Committee on Taxation. (See http://www.jct.gov/publications.html?func=startdown&id=4400)  21.0% was the effective federal tax rate on income over $141,900 in 2007, and 16.6% on the income of the top 400 households, earning more than $345 million. My point —  raising the effective tax rate on about 5% of the households who take in about 30% of all income, say to the 1950 to 1963 effective tax rate of 55% would do more for pension security than any thing else. Since 1979 the CBO reports the top 1% increased their income share from 8% to 17%, a 9% shift that all came out of the income shares of the lower-earning 80% of households’ (mostly) wage income. According to this american progress.org report on effective federal tax rates, incomes over $75,000 (in 2007) were taxed at the same effective tax rate as all incomes above $75,000. I’m of the rare opinion that the distribution of income and wealth is unjust, and the effective tax rates are unjust, and not to mention this is to be condoning or partially complicit in the injustice. Not to criticize this excellent article. 

  • Jane D’Arista

    Excellent points and analysis.  Agree – a new look at subsidies for saving long past due.