Who Benefits from the U.S. Retirement System?
Myth: The current tax system provides an “upside-down” incentive to save.
Fact: By taxing investment returns, an income tax discourages savings. By effectively taxing investment returns at a zero rate, tax deferral eliminates this disincentive and equalizes the inventive to save.
Those are among the findings of a new study
that challenges the notion that the tax deferral basis of the current U.S. retirement savings system is “upside down.”
Noting that tax expenditure estimates of the benefits of tax deferral have been widely used to motivate proposals to change the tax treatment of employer-sponsored retirement plans and IRAs, a new study by Peter Brady at the Investment Company Institute (ICI) notes that, using the same standard used to judge the progressivity of tax deferral in isolation, the U.S. retirement system as a whole, inclusive of both tax deferral and the Social Security system, is, in fact, progressive.
The analysis also refutes two often repeated and widely accepted myths. First, that the primary reason that workers with high lifetime earnings benefit more from tax deferral is that Social Security benefits replace less of their pre-retirement earnings and they rely more on employer-sponsored retirement plans and IRAs, than differences in marginal tax rates. Secondly, rather than providing an “upside-down” incentive, the current tax deferral equalizes the incentive to save by eliminating the disincentive to save inherent in an income tax.
The report cautions that a narrow focus on microprogressivity (that is, the progressivity of specific tax code provisions) is misplaced, and that if a comprehensive reform of the income tax is undertaken, it makes the point that it would be important to consider the effect of the complete tax reform package on the progressivity of the overall income tax. Brady also notes that tax provisions that address legitimate policy goals can be included in a progressive income tax even if the provisions are not, by themselves, progressive.
He further makes the point that specific tax provisions should be judged less narrowly and assessed by their impact on fairness, economic growth, and simplicity — and that on these criteria tax deferral scores well. “Allowing workers to set aside a portion of their compensation until retirement reduces the impact of the life-cycle pattern of earnings, resulting in a measure of taxable annual income that is a better indicator of a worker’s lifetime circumstances and resulting in a fairer tax system.” Further, he explains that tax deferral reduces the economic distortions by eliminating the disincentive to saving that is inherent in any income tax. Additionally, tax deferral is also simple for the IRS to administer and simple for workers to understand.
The bottom line? This study, says the ICI, “finds that the benefits of the U.S. retirement system are progressive. That is, as a percentage of their lifetime earnings, lower earners receive more in lifetime benefits from the combination of Social Security and tax deferral than higher earners receive.”