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For decades, the U.S. tax code has provided preferential tax treatment to employer-provided pensions, 401(k) plans, and Individual Retirement Accounts (IRAs) relative to other forms of saving. The effectiveness of this system of subsidies remains a subject of controversy. Despite the accumulation of vast amounts of wealth in pension accounts, concerns persist about the ability of the pension system to raise private and national saving, and, in particular, to improve saving among households most in danger of inadequately preparing for retirement.1
Many of the major concerns stem, at least in part, from the traditional form of the tax preference for pensions. Pension contributions and earnings on those contributions are treated more favorably for tax purposes than other compensation: they are excludible (or deductible) from income until distributed from the plan, which typically occurs years, if not decades, after the contribution is made. The value of this favorable tax treatment depends on the taxpayer's marginal tax rate: the subsidies are worth more to households with higher marginal tax rates, and less to households with lower marginal rates.2
The pension tax subsidies, therefore, are problematic in two important respects. First, they reflect a mismatch between subsidy and need. The tax preferences are worth the least to lower-income families, and thus provide minimal incentives to households that most need to provide for basic needs in retirement. Instead the tax preferences give the strongest incentives to higher-income households, which, research indicates, are the least likely to need additional saving to achieve an adequate living standard in retirement.3
Second, as a strategy for promoting national saving, the subsidies are poorly targeted. Higher-income households are disproportionately likely to respond to the incentives by shifting existing assets from taxable to tax-preferred accounts. To the extent that such shifting occurs, the net result is that the traditional pensions and subsidies for saving serve as a tax shelter, rather than as a vehicle to increase saving, and the loss of government revenue does not correspond to an increase in private saving. In contrast, moderate- and lower-income households, if they have pensions, are most likely to use them to raise net saving.4 Because moderate-income households are much less likely to have other assets to shift into tax-preferred accounts, any deposits they make to tax-preferred accounts are more likely to represent new saving rather than asset shifting.
The saver's credit, enacted in 2001, was expressly designed to address these problems. The saver's credit, in effect, provides a government matching contribution in the form of a nonrefundable tax credit for voluntary individual contributions to 401(k) plans, IRAs, and similar retirement savings arrangements. Like traditional pension subsidies, the saver's credit currently provides no benefit for households that owe no federal income tax. However, for households that owe income tax, the effective match rate in the saver's credit is higher for those with lower income, the opposite of the incentive structure created by traditional pension tax preferences.
The saver's credit is the first, and so far only, major federal legislation directly targeted toward promoting tax-qualified retirement saving for moderate- and lower-income workers.5 Although this is a historic accomplishment, the credit as enacted suffers from key design problems, not the least of which is the its scheduled expiration at the end of 2006. Policymakers, including Representatives Rob Portman (R-OH) and Benjamin Cardin (D-MD), are exploring possible expansions of the saver's credit. Representative Portman recently emphasized his desire to "get at what I think is the biggest potential for saving in this country, and that is those who are at modest and low income levels."6 This paper is intended to inform such efforts.
Section I provides background on the evolution and design of the saver's credit. Section II discusses the rationale behind the saver's credit and the role of such a credit in the pension system as a whole. Section III examines empirical data and models of the revenue and distributional effects of the saver's credit. Section IV discusses measures that would expand the scope and improve the efficacy of the saver's credit. Section V concludes.
Notes from this Section of the paper:
1. For a broader discussion of these issues, see William G. Gale and Peter R. Orszag, "Private Pensions: Issues and Options," in Agenda for the Nation, edited by Henry J. Aaron, James M. Lindsay, and Pietro S. Nivola (Washington, DC: Brookings Institution Press, 2003); Peter R. Orszag, "Progressivity and Saving: Fixing the Nation's Upside-Down Incentives for Saving," Testimony before the House Committee on Education and the Workforce, February 25, 2004; and J. Mark Iwry, Testimony before the House Committee on Education and the Workforce, Subcommittee on Employer-Employee Relations, June 4, 2003. These and related publications are available on the Retirement Security Project web site (http://www.retirementsecurityproject.org).
2. Technically, the lifetime subsidy from such accounts comes from two sources: the difference (if any) between the tax rate at the time of contribution and that at the time of withdrawal, and the tax-free accumulation of funds. See Leonard E. Burman, William G. Gale, and David Weiner, "The Taxation of Retirement Saving: Choosing between Front-Loaded and Back-Loaded Options," National Tax Journal 54, no. 3 (September 2001); and Eric M. Engen, John Karl Scholz, and William G. Gale, "Do Saving Incentives Work?" Brookings Papers on Economic Activity, no. 1 (1994), 85-151. In practice, however, these items are often correlated with the tax rate at the time of the contribution, and casual evidence suggests that the up-front deductibility of most of these plans (such as 401(k)s and traditional IRAs, which provide the tax advantage at the time of contribution rather than distribution) is an important determinant of whether people make contributions.
3. See, for example, Eric M. Engen, William G. Gale, and Cori E. Uccello, "The Adequacy of Household Saving," Brookings Papers on Economic Activity, no. 2 (1999): 65-165.
4. See, for example, Eric M. Engen and William G. Gale, "The Effects of 401(k) Plans on Household Wealth: Differences across Earnings Groups," Working Paper 8032 (Cambridge, MA: National Bureau of Economic Research, December 2000); and Daniel Benjamin, "Does 401(k) Eligibility Increase Saving? Evidence from Propensity Score Subclassification," Journal of Public Economics 87, no. 5-6 (2003): 1259-90.
5. Retirement saving for these workers is promoted—or designed to be promoted—indirectly by nondiscrimination and certain other provisions of the Internal Revenue Code of 1986 (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA). Those provisions, which are subject to extensive exceptions, are intended to impose some constraint on the degree to which tax-favored benefits accrue to a limited number of owners and executives rather than the large majority of workers. The IRC and ERISA also protect and regulate the accumulation and preservation of retirement benefits. For additional discussion of these issues by the Treasury Department, see Donald C. Lubick, Assistant Secretary (Tax Policy), U.S. Department of the Treasury, Testimony before the House Committee on Ways and Means, Subcommittee on Oversight, March 23, 1999.
6. Michael Wyand, "Savings Effort to Continue Based on RSA Plus Savers Credit, Not LSA, Portman Says," BNA, March 16, 2004.
Note: This report is available in its entirety in the Portable Document Format (PDF).
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