Tax Policy’s Impediment to Economic Betterment

If saving is the first step to economic success, current tax policy is the gate at the bottom of the stairs. As a recent Congressional Budget Office report shows, most of the tax incentives associated with retirement savings under our current system are out of reach for lower income families, while the households with the highest incomes receive huge financial benefits that fortify their existing financial security. Tax policy has the potential to open the path to economic mobility by encouraging saving and ownership among those who have the farthest to climb. Instead, our system largely rewards those who would save anyway, without advancing the socially beneficial behaviors professed to be the purpose of our enormously costly tax expenditures.

The federal government spends almost 1 percent of GDP a year, $140 billion, providing tax havens for retirement savings. What do we get for such an extravagant sum? Some of us, primarily the wealthy, keep more of our money. What we don’t get, the evidence shows, is a higher saving rate. Raj Chetty and his team at Harvard and the University of Copenhagen, for instance, have shown that tax incentives for saving induce asset shifting, not asset creation. Yet even if the evidence showed that existing tax incentives raised retirement saving rates for certain individuals, it would never show an increase in savings for the nearly half of Americans who cannot benefit from nonrefundable tax credits. And it is this population of low- and middle-income earners that have the greatest need for more savings.

The 2010 Survey of Consumer Finance (SCF) showed that only one-third of families in the lowest income quintile save in any capacity, compared with three-fourths of families in the highest. The lesson from the CBO report is not that the rich are benefiting most from tax expenditures, which should come as no surprise in light of the income-based saving variances in the SCF findings, but that the expenditures’ asserted goals of promoting socially beneficial saving behavior through the tax code are foundering. In the case of retirement savings, the goal is to provide incentives for non-savers to save, not to lavish financial rewards on those who would save anyway. Low-income earners face a real sacrifice in saving for retirement: one dollar saved is one dollar not spent on pursuing a better quality of life. Higher-income earners, on the other hand, can deduct retirement savings contributions from gross income, meaning that one dollar saved doesn’t equal one dollar not spent on current consumption; it’s just one dollar more for consumption after age 65 and one dollar less given to the government in the current year. Retirement savings tax policy is not income-blind; the federal government’s persistent reliance on nonrefundable credits to deliver saving incentives awards significantly greater benefits to certain families on the basis of income alone, without improving social outcomes.

While the government spends trillions on tax expenditures, economic mobility remains stagnant, and household debt is increasing, while the personal saving rate declines. The capacity of the tax code to address all of these problems may seem like a pipe dream, but because taxation has been the primary policy method to induce savings for decades and remains the most politically viable option, it’s the best we have. The only major federal legislation to promote retirement savings targeted directly at low- and middle-income earners is the Saver’s Credit, which has been available since 2001. But it fails in large part to encourage saving. Because it is a nonrefundable credit, even at its maximum benefit level, it can only reduce tax liability to zero for taxpayers who very often already make use of other tax deductions to reduce or eliminate their tax liability. The Saver’s Credit has been found to have only a minimal effect on low-income earners’ decisions to save at tax time, and very little compared to the effects of matched-incentives arrangements, such as our proposed Financial Security Credit. Reform of the tax code is sorely needed for many reasons, not least of which must be to correct these outrageous inefficiencies in the delivering of retirement savings tax incentives.

The CBO does well to call attention not only to the enormous cost of these tax expenditures, which is well known but needs restating, but also to the gross inequities in the showering of benefits to the highest-income families. From subsidizing superfluous retirement savings, as we’ve addressed before, to awarding conspicuous consumption in home buying, tax expenditures, as they are currently designed, are wasteful and inefficient. Some of us make out great in the current system; a few rise to the top. But the rest press against a rigid system that rewards inefficiency — and obstructs upward mobility.