Tax Incentives: Don’t Cap; Restructure

We need a special commission with a targeted mandate to review tax expenditures

Peter Diamond, a 2010 Nobel laureate in Economics, argued in the New York Times (11-19-12) that the way forward with the budget should not involve wide-ranging, politically-motivated supercommittees but rather narrowly-targeted commissions without sitting members of Congress.  These commissions would recommend specific targeted reforms that would receive a no-amendments, up-or-down action similar to the recommendations of Base Closure and Realignment Commissions.  Grand proposals that limit aggregate revenues or aggregate spending are likely to enshrine current inefficiencies rather than improve how the nation spends its money.

A good example of the limitations of the aggregate approach is the proposal to increase revenues by capping total income tax deductions.  This approach does not distinguish between those deductions that represent good policy and those that should be eliminated or re-structured.  One obvious area that warrants restructuring is the incentives for saving.  The current system that allows individuals to deduct contributions to retirement accounts provides the biggest benefits to people in the highest marginal tax brackets.  Not only does society have less concern about the saving of the wealthy, but studies have shown that these individuals may be merely reshuffling their assets into these accounts to take advantage of the tax breaks. 

Experts have suggested replacing existing tax deductions for retirement savings with a government matching contribution.  That is, workers’ contributions to retirement plans would no longer be tax deductible and any employer contributions would be treated as taxable income.  Under one proposal, the government would make a 30-percent matching contribution for contributions of up to $20,000 per person into a 401(k) account and up to $5,000 into an IRA (see Gale, Gruber, and Orszag, 2006).  These limits would be indexed for inflation.  As under current law, earnings would continue to accrue tax-free, and withdrawals at retirement would continue to be taxed as regular income.  While the proposal would be roughly revenue neutral for the federal government, it would provide – unlike the current system – the same matching grant per dollar of saving to low-wage workers as to the higher paid.  

While the proposed restructuring offers a much better allocation of tax incentives – targeting more to those people who most need to save – it side steps the question of whether the government needs to spend as much as it does in order to get people to save for retirement.  That is, does the proposed change need to be revenue neutral?  

In all probability, employers would retain work-based saving plans even with smaller tax advantages.   Em­ployers view 401(k) plans as a useful mechanism for attracting a better class of worker.  People who value 401(k)s are more careful with company equipment, take fewer sick days, and are generally more produc­tive.  And employers could see such plans as a way to promote an orderly retirement process, since employees, whose productivity has declined, can stop working only if they have adequate resources.  In fact, employer-based pensions originated without any tax advantage.

With automatic enrollment, employees would probably be just as likely to contribute if the matching contribution were 20 percent rather than the proposed 30 percent.  But I don’t really know for sure. 

The problem is that neither the issue of the structure of the tax incentive nor the appropriate level will be considered if the approach is simply to cap deductions.  Designing efficient tax incentives is a complicated task that requires people with expertise discussing alternatives in a calm environment.  We need a special commission with a congressional mandate to review tax expenditures, and the recommendations of that commission should get an up or down vote.  Real, careful progress will impress voters and the markets much more than sweeping changes that may or may not hold over time.