For decades the U.S. private pension system has
provided preferential tax treatment to employer-provided
pensions, 401(k) plans, and individual retirement
accounts relative to other forms of saving. The
effectiveness of this system of subsidies is controversial.
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 outcomes
among those households most in danger of inadequately
preparing for retirement.
Many of the major concerns stem, at least in part,
from the traditional form of the tax subsidy to pensions.
Pension contributions and earnings on those contributions
are treated more favorably for tax purposes than other compensation: They are excludable (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 a taxpayer's marginal tax rate:
The subsidies are worth more to households that face
higher marginal tax rates, and less to households that
face lower marginal tax rates.2 The pension tax subsidies
therefore are problematic in two important
respects: They reflect a mismatch of subsidy and needand represent a poorly targeted strategy for promoting
national saving.
First, the tax subsidies are worth the least to
lower-income families, and thus provide minimal
incentives to the households that, on
average, most need to save more to provide for
their basic needs in retirement. The tax preferences
instead give the strongest incentives to
participate in pensions to higher-income
households that least need to save more to
achieve an adequate retirement living standard.
Second, higher-income households are disproportionately
likely to respond to pension tax
incentives by shifting assets from taxable to taxpreferred
accounts. To the extent that shifting
occurs, the net result is that the pensions serve
as a tax shelter, rather than as a vehicle to increase
saving, and the loss of government revenue
does not generate an increase in private
saving. The implication is that national saving
declines. In contrast, moderate- and lower-income
households, if they participate in pensions, are
most likely to use the accounts to raise net
saving. 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 designed to
help address those problems. The saver's credit in effect
provides a government-matching contribution for
voluntary individual contributions to 401(k) plans, individual
retirement accounts, and similar retirement
savings arrangements. Like traditional pension subsidies,
the saver's credit currently provides no benefit
for households that do not owe any federal income tax
after other credits. However, for households that do
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 thus the first and only major
federal legislation that is directly targeted to promoting
tax-qualified retirement saving for moderate- and
lower-income workers. Although this is an historic
accomplishment, it should not divert attention from
some key design problems in the version of the credit
that was enacted, not the least of which is the
scheduled expiration of the credit at the end of 2006.
Policymakers, including Representatives Rob Portman,
R-Ohio, and Benjamin Cardin, D-Md., are exploring
possible expansions of the saver's credit. Rep. 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"
by expanding the saver's credit. This article is intended
to inform those efforts.
Section II of this article provides background on the
evolution and design of the saver's credit. Section III
discusses the rationale behind the saver's credit and
the role of a saver's credit in the pension system as a
whole. Section IV examines empirical data and model
estimates of the revenue and distributional effects of
the saver's credit. Section V discusses measures that
would expand the scope and improve the efficacy of
the saver's credit.