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The Tax Exclusion for Retirement and Pension Plans

The Tax Exclusion for Retirement and Pension Plans

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The US federal tax code contains a number of provisions designed to encourage individuals to save for retirement. These provisions allow individuals to avoid or defer taxes if they choose to set aside a portion of their income for future consumption. When all of these provisions are combined, they are the second largest “tax expenditure” category as defined by the Joint Committee on Taxation. The exclusion of retirement savings from taxation causes some economic distortions, which we will discuss in this paper. However, unlike some other tax expenditures, there is a strong economic rationale for not taxing savings. Higher rates of investment lead to higher rates of economic growth, and it may be sound policy for the tax code to encourage this behavior, even after considering the economic costs. Excluding retirement income from taxation may also make the tax system more efficient, even though most other tax expenditures reduce efficiency.
The US federal tax code contains a number of provisions designed to encourage individuals to save for retirement. These provisions allow individuals to avoid or defer taxes if they choose to set aside a portion of their income for future consumption. When all of these provisions are combined, they are the second largest “tax expenditure” category as defined by the Joint Committee on Taxation. The exclusion of retirement savings from taxation causes some economic distortions, which we will discuss in this paper. However, unlike some other tax expenditures, there is a strong economic rationale for not taxing savings. Higher rates of investment lead to higher rates of economic growth, and it may be sound policy for the tax code to encourage this behavior, even after considering the economic costs. Excluding retirement income from taxation may also make the tax system more efficient, even though most other tax expenditures reduce efficiency.

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02/27/2014

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No. 105February 2012
MERCATUS CENTER AT GEORGE MASON UNIVERSITY
 
MERCATUSON POLICY
The Tax Exclusion forRetirement andPension Plans
 
By Jeremy Horpedahl andHarrison Searles
T
he US federal
tax code contains a num- ber of provisions designed to encourageindividuals to save for retirement. Theseprovisions allow individuals to avoid ordefer taxes if they choose to set aside aportion of their income for future consumption.When all of these provisions are combined, they are the second largest “tax expenditure” category as defined by the Joint Committee on Taxation.The exclusion of retirement savings from taxationcauses some economic distortions, which we willdiscuss in this paper. However, unlike some othertax expenditures, there is a strong economic ratio-nale for not taxing savings. Higher rates of invest-ment lead to higher rates of economic growth, andit may be sound policy for the tax code to encour-age this behavior, even after considering the eco-nomic costs. Excluding retirement income fromtaxation may also make the tax system more effi-cient, even though most other tax expendituresreduce efficiency.When an employer chooses to compensate employ-ees with contributions to a retirement or pensionplan, rather than with wages, that compensation isnot taxed in the current year. Instead, the incomewill be taxed in the future when employees chooseto withdraw it, presumably when they are in a lowertax bracket. Similarly, investment income in tax-pro-tected plans, such as dividends and capital gains, isnot taxed until it is withdrawn.Traditional employer-sponsored, defined-benefitpensions were the rst major plans of this type to be excluded from taxable income, but over the yearsmany other similar kinds of retirement savingshave also achieved tax exclusion. Important addi-tions were Keogh plans for the self-employed, con-tributions to Individual Retirement Arrangementsor Accounts (IRAs) beyond employer-sponsored
 
2 MERCATUS ON POLICY SEPTEMBER 2013
plans, and dened-contribution plans set up by theemployer, such as 401(k)s. While these programshave important technical differences, the basic eco-nomic function is the same: contributions are madewith pre-tax income and grow tax free, and the tax ispaid in the future when withdrawals are made. Themore recent Roth IRA operates differently from therest, as it is funded with post-tax dollars and only thegains are tax free, but the intended economic effectof encouraging retirement savings is the same.These exemptions result in a loss of revenue for thefederal government. The Joint Committee on Taxa-tion estimates that in FY 2013, about $117.2 billion inincome tax revenue was not collected from the “netexclusion of pension contributions and earnings,”and the Congressional Budget Ofce has a slightly higher estimate of $137 billion once the forgonepayroll tax revenue is included.
1
While much of thattax revenue is simply deferred, rather than avoided,the lost payroll tax revenue (i.e., Social Security andMedicare taxes) which employers would have paidon wages is completely forgone. These estimatesplace the exclusion of retirement savings as the sec-ond largest tax expenditure, behind only the taxexclusion of employer-provided health insurance.
2
DO TAX INCENTIVES INCREASE SAVINGS?
 A primary question
on the tax exclusion of retire-ment savings is whether they encourage individu-als to save more than they otherwise would. Theprimary economic benets associated with this taxexclusion can only be achieved if savings increase onnet. The macroeconomic benet of an increase in netsavings is greater long-run economic growth frommore capital accumulation. The potential benet toindividuals is the long-run increase in savings if, for behavioral reasons, they will save too little from theirown perspective.
3
While the same result might beachieved by mandating more saving for retirement,perhaps by increasing Social Security taxation and benets, the tax exemption may be a more attractivepolicy because it does not involve direct taking andgiving but merely encourages citizens to provide fortheir future retirement.For there to be an increase in net saving, savers actu-ally have to decrease their current consumptionand standard of living in lieu of future consump-tion and standard of living. Because of this condi-tion, the incentives provided by the tax deferralmay not encourage genuine savings. Instead, it may merely encourage deposits and contributions intothe account in ways that don’t require reducing one’spresent standard of living. Some individuals proba- bly would have saved for retirement even without thetax incentive; thus, looking at the aggregate amountdeposited in these accounts is misleading. As a result,we need to investigate how much savings increasedas a specic result of the tax benet.
The Journal of  Economic Perspectives
devoted a symposium to thisquestion with contributions from the leading schol-ars in this debate. While the empirical evidence ismixed, there does seem to be strong evidence thatthere is some net increase in savings from tax incen-tives, even if the magnitude is debated.
4
OTHER TAX EXCLUSION CONCERNS
While it is
important to know whether a taxexclusion has a positive effect on savings, that aloneis not enough to justify a tax policy. The costs of the economic distortions introduced by the policy must also be considered. One cost may be that indi- viduals put their savings in forms that are differentfrom what they would choose independent of theseincentives. Individuals with savings in the form of 401(k) accounts have much less freedom to choosetheir investments than those with savings in tradi-tional brokerage accounts, and those with traditionaldened benet pensions have essentially no choicein how their assets are invested. This could lead toserious principle-agent problems between employ-ers and employees, with employers or their chosen brokerages not making the best investment decisionsfrom the perspective of the employees. Another concern is that most of the benets of thetax treatment of retirement savings accrue to thosewith the highest incomes. Toder, Harris, and Lim of the Tax Policy Center estimate that about 80 percentof the benets for tax incentives for retirement sav-ings go to the top income quintile.
5
Those in the topincome quintile almost always benet the most fromtax expenditures, largely due to the fact that they pay the most taxes; however, the 80 percent benetfor this category of tax expenditures is higher thanother major categories, such as the mortgage interestdeduction (about 68 percent goes to the top quintile)and healthcare-related tax expenditures (about 42percent goes to the top quintile).
 
MERCATUS CENTER AT GEORGE MASON UNIVERSITY 3
CAN A LOOPHOLE MAKE THE TAX SYSTEMMORE EFFICIENT?
While tax expenditures
or “loopholes” are gen-erally regarded as making the tax system less ef-cient overall, the exemption for retirement savingsmay be an exception. In fact, this exemption may make the tax system more efcient both by making the current system function more like a consumptiontax and by partially correcting the double taxation of capital within the current tax code.Since individuals can choose when they wish torealize the tax by delaying consumption, this may  very well be a desirable feature of tax incentives forretirement savings. A tax on consumption is gener-ally more economically efcient than one on incomesince it does not discourage production.
6
The Con-gressional Budget Ofce even admits that it may notmake sense to count this category as a tax expendi-ture: “because a consumption tax would exclude allsavings and investment income from taxation, theexclusion of net pension contributions and earningswould be considered part of the normal tax systemand not a tax expenditure.”
7
However, this desirable feature is only obtained by adding yet another layer of complexity to the incometax. If a consumption tax is what is desired, thenproponents should make their goal changing theincome tax into a consumption tax rather than cre-ating unnecessary complexity within the system thatwe have. Nevertheless, we may consider this layerof additional complexity a second-best solution ina world where most federal revenue is still derivedfrom taxes on income. A second efficiency benefit of this tax exemptionis that it serves as a partial correction for the cur-rent double taxation of capital income in the UnitedStates. With the highest corporate tax rate in thedeveloped world, the United States must be particu-larly attentive to the impact of its tax system’s effecton capital formation.
9
Currently, capital income istaxed when corporations earn income, and the sameincome is taxed again when it is paid to individuals inthe form of dividends or capital gains. The exclusionof taxes on retirement income, specically dividendsand capital gains, means that the double taxation iseliminated for some capital income. In the absenceof a corporate income tax, this tax exemption may make less economic sense, but given current corpo-rate taxes in the United States, it has a sound eco-nomic logic.
DISTRIBUTION OF TAX BENEFITS FROM RETIREMENT AND PENSION EXCLUSION

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