Retirement Security Through the Fun-House Mirror

           We generally want the government to help those who need help.  And we expect those who can help themselves to do so.  Yet, our public policy system seems to get this exactly backwards.  The American government helps the people who most need help least while it helps the people who least need help the most.

            That’s the conclusion of a new Center for American Progress report written by Christian Weller of the Center for American Progress and Teresa Ghilarducci of The New School.  According to Weller and Ghilarducci, the American system is extremely inefficient in the way it incentivizes retirement savings, if it incentivizes them at all.

            That, in large part, is because we use the fun-house mirror world of the Internal Revenue Code to encourage people to save for retirement instead of directly subsidizing retirement security through government spending.

            To make this simple, imagine two taxpayers, Alice and Betty.  Alice is richer than Betty and pays tax at an effective rate of 25%.  Betty only has to pay tax at an effective rate of 15%.

            Let’s say that last year, Alice had gross income of $100,000 while Betty had income of only $50,000.  With no deductions Alice owes $25,000 in taxes while Betty owes only $7,500.  That seems fair under a tax system where the better off have to pay tax at a higher rate.

            But now lets suppose that the government allows both Alice and Betty to deduct or exclude from taxable income $2,000 for money they each deposited into retirement savings accounts.  That gives Alice $98,000 in taxable income while it gives Betty $48,000 in taxable income.  At their respective rates Alice owes $24,500 while Betty owes $7,200.  The deduction or exclusion reduces Alice’s tax bill by (and is therefore worth) $500.  Though Betty deposited the same amount of money in a retirement account, her tax bill is only $300 lower. Alice’s cost of savings with the deduction or exclusion is only $1,500 while Betty’s is $1,700.

            The first thing to notice here is that the national government made Alice and Betty collectively $800 better off than they would have been without the deduction or exclusion.  And it also reduced the amount of money available to the government to spend on other things by $800 because now Alice and Betty will be paying the government $800 less than they would have paid.

            Second, the amount of the benefit depends on the tax rate applied.  $500 is 25% the $2,000 Alice deducted and $300 is 15% of the $2,000 that Betty deducted.  The $200 difference between the value of the deduction to Alice and the value of the deduction to Betty is 10% of the $2,000 they both deducted, which is the difference between the tax rate that applies to Alice and the tax rate that applies to Betty.           

            The last thing to notice is that Alice has a bigger incentive to save than Betty, even though it is likely that, because of her higher income, Alice needs less incentive to save than does Betty. In fact, because Alice has more income than Betty, she was probably going to be able to save regardless of whether the government gave her an incentive to do so.  Betty’s income doesn’t leave her much room to save for retirement, and so if we want her to save for retirement, she’s probably going to need a bigger incentive.

            Weller and Ghilarducci also point out that Alice and Betty aren’t likely to have the same opportunities to save.  Alice probably works for a company that makes a tax favored 401(k) retirement plan available as a payroll deduction while Betty, if she’s going to save, will have to set up a private IRA. The maximum amount Betty can save in her IRA in any year is $5,500.  But Alice, with access to a 401(k) plan, can contribute up to $18,000 toward her retirement in any year.

            Because Alice’s company has specialists who can design the company’s retirement plan so that Alice can make a few meaningful choices in how her contributions are invested and have an automatic payroll deposit of a specified amount deducted from her paycheck and deposited in her account, the plan is gentle on her mind.  It takes her a few minutes to set it up and then she can forget about it. There are few if any fees.

            Poor Betty has to do it all on her own.  She has to figure out how to set up her own IRA.  She has to decide whether to use a bank or a brokerage.  She has to choose from an almost endless menu of investment choices.  And some of the investment vehicles will benefit her commissioned investment advisor more than they will benefit her.  Her investment advisor isn’t yet required to disclose that conflict of interests.  And she has to rely on self-discipline to see that some of her earnings are deposited in her retirement account.  Weller and Ghilarducci say that people like Betty are likely to forgo setting up retirement plans because it’s just too hard.

            Meanwhile, the government forgoes (and so it spends) over $100 billion in tax revenues every year that it could otherwise have collected on account of the special tax treatment of retirement savings accounts.  States forgo (and, therefore spend) about $20 billion.

             The lion’s share of this goes to the top 20% of all earners, three quarters of which goes to the top 10% of all earners.  Only 18% of the benefits of tax favored retirement accounts goes to the bottom 40% of all earners.

            No wonder we have a retirement crisis on our hands.

            Imagine the uproar that would occur if, instead of trying to incentivize retirement savings through the tax code, we simply asked the Treasury to write checks to people like Alice and Betty, correcting for the fact that Betty needs more help than Alice.

            Is there anybody who thinks Congress would adopt that kind of system?

            Probably the same people who want to cut Social Security.