A Proposal to Restructure Retirement Saving Incentives in a Weak Economy with Long-Term Deficits

William G. Gale


This paper discusses a proposal that would reform public policies toward retirement saving by replacing the current deduction for contributions to retirement saving accounts with a flat-rate refundable credit that would be deposited directly into the saver’s account. The proposal would (a) address long-standing concerns in the retirement saving system by improving incentives for most households to participate and by raising national saving, (b) offset pressures created by the current weak economy for households to reduce their retirement saving, (c) help solve the long-term fiscal problem facing the country by raising $450 billion over the next decade in a manner that is consistent with the principles of broad-based tax reform and distributes the fiscal burden in a progressive manner.

I. Introduction

Concerns with the adequacy and security of the retirement system in the United States are well-known and long-standing. Many households do not save for retirement, and those that do contribute too little, invest poorly, or withdraw funds early. These patterns leave households vulnerable to insufficient savings during old age.

A weak economy has exacerbated these issues. Unemployment in general (and long-term unemployment in particular) is exceedingly high relative to historical norms. Real wages have stagnated, housing prices have fallen far below previous peaks, and the stock market has grown more volatile. Each of these factors threatens to reduce the vitality of the retirement system-for example, by driving workers to stop participating in their 401(k) plans or IRAs, to contribute less for retirement saving, to invest more conservatively, or to withdraw funds early.

At the same time, the nation’s medium- and long-term fiscal outlook is unsustainable, even with the recent debt-limit legislation. The retirement of the baby boomers, the aging of the population, and health care inflation will place increasing pressure on Social Security and Medicare (Auerbach and Gale 2011). Without reform, the Social Security trust funds will be depleted by 2036 (OASDI Trustees 2011) and will only be able to pay roughly three quarters of the benefits retirees have been promised. This will further weaken the retirement prospects of low- and middle-income households and make them more vulnerable to poverty in old age. As the Joint Select Committee on Deficit Reduction deliberates on medium-term budget options, consideration of reforms to strengthen the private retirement system would be appropriate and constructive, especially since any plausible long-term fiscal plan will involve some reductions in Social Security and Medicare benefits.

The Tax Policy Center estimates that the immediate, direct revenue loss associated with contributions to IRAs and 401(k) plans will exceed $1 trillion over the next decade, under current law. This figure is calculated as the product of contributions to such plans, multiplied by the marginal income tax rate applied to such contributions. It is presented to show the magnitude of the issue and the potential for revenue gain. It does not, however, represent a complete tax expenditure estimate for IRAs and 401(k) plans because it does not include the value of the tax treatment of accrued earnings (which would raise the figure) or the taxation of withdrawals (which would reduce the figure).

This paper offers a proposal to encourage additional retirement saving by converting the system of income tax deductions for retirement saving contributions to a system of flat-rate refundable credits, where the credits are deposited directly into the saver’s account. Stated simply, this proposal will make it viable for low- and middle-income households to increase their savings for retirement. The proposed reform has several notable features:

  • The proposal would enhance the retirement saving system. By improving retirement saving incentives for the majority of households, the proposal would help address traditional concerns about take-up and usage of retirement saving vehicles.
  • The proposal could help raise national saving. By promoting saving among households in the middle and bottom of the income distribution (those least likely to sufficiently save) the proposal would encourage new contributions from precisely the type of households for whom 401(k)s and similar plans likely represent net increases in saving, rather than a re-allocation of saving that would have been done anyway.
  • The proposal is timely. By improving retirement incentives for most households, it would help offset the pressure households face to reduce or eliminate their participation in retirement saving during a weak economy.
  • The proposal is consistent with long-term deficit reduction and could raise substantial amounts of revenue: a reform that converted current deductions to a tax credit worth 18 percent of a taxpayer’s retirement saving contributions would leave those in the 15 percent bracket unaffected. As discussed in more detail below, an 18 percent matching credit is the equivalent of a 15 percent deduction. Such reform would raise more than $450 billion in revenues over the next decade relative to current law.
  • The proposal is consistent with principles of broad-based tax reform and reducing tax expenditures.
  • The proposal is progressive. The proposal would help lower- and middle-income households significantly, decreasing their reliance on Social Security benefits as the primary source of retirement income, and it would distribute the benefits of retirement saving more equitably than the current system.
  • In alternative version of the proposal, a 30 percent credit would be revenue-neutral for the next decade relative to current law and would be even more progressive. This reform would reduce taxes for 26 percent of the population (mainly in the bottom 90 percent of the income distribution) and decrease tax deductions for 6 percent of the population (largely in the top decile).