And Andrew Biggs, the conservative economist at the American Enterprise Institute, and I are usually contrarians.
Our disagreements go back decades: including the privatization of Social Security, the adequacy of retirement income, and compensation for state and local government employees. Just a few weeks ago, I thought he was really wrong when he argued that workers weren't paying for their Social Security benefits.
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But sometimes we see things the same way. We both concluded that: 1) subsidies to private sector pension plans do little to increase private saving; and 2) the revenues generated by eliminating these “tax expenditures” could be better used to address the Social Security financing gap.
Tax expenses arise, under the personal income tax, because employees can defer taxes on compensation they receive in the form of retirement savings. This tax treatment significantly reduces lifetime taxes for participating employees, compared to saving through a regular investment account. It also cost the government $185 billion in 2020, equivalent to about 0.9% of GDP.
Who gets the tax expense? Studies show that 59% of current tax expenditures for retirement savings flow to the top fifth of the income distribution. This pattern is not surprising, because higher-income taxpayers are more likely to have access to employer-sponsored retirement plans, more likely to participate in employer plans, and to contribute more when they participate.
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The latest changes will increase the share going to the top quintile. The expanded “catch-up” contributions only benefit those limited by the current limits – approximately 16% of participants. Increasing the age to 75 to take required minimum distributions allows participants to benefit from an additional 4½ years of tax-free growth. In general, only the rich will be able to benefit from this provision.
What do tax expenditures buy us? Because tax expenditures go overwhelmingly to the highest-income families, who face almost no risk of poverty in old age, it is important to ask whether these expenditures achieve some broader social goals, such as increasing national saving.
The theory does not provide a strong basis for assuming that federal tax preferences increase aggregate saving. Yes, tax preferences make retirement saving more attractive and huge sums of money have been accumulated in retirement plans. But economists' life cycle model suggests that people may simply shift their savings from regular taxable investment accounts to tax-favored retirement accounts.
In fact, evidence supports the predictions of the life cycle model. The final 2014 study, using Danish tax data, looked at responses to cuts in support for pension contributions for those in the top tax bracket. The results show that pension contributions fell for some. But this decline has been almost entirely offset by an increase in other types of saving. In other words, the tax subsidy primarily induced individuals to shift their savings from taxable to tax-advantaged retirement accounts, not to increase overall household savings.
Because tax spending on retirement plans is a bad deal for taxpayers, it makes sense to reduce these tax breaks and reallocate the proceeds. Over the next 75 years, Social Security faces an actuarial deficit of 1.3% of GDP, so applying the revenue generated by eliminating tax spending would solve 70% of the problem. The gains will be higher than this estimate for two reasons: 1) the government will continue to collect income taxes on previous tax-favored contributions; and 2) payroll tax revenues will also be higher because they are also affected by tax preferences.
In short, let's move government resources from pension plans where the incentive does almost nothing to secure retirement to a program that indisputably does: Social Security.
