The Saver’s Credit: Issues and Options

J. Mark Iwry, Peter R. Orszag, and William G. Gale

I. Introduction

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.