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Americans know that Social Security is in trouble. But it’s not because Americans haven’t paid enough taxes; it’s because of wasteful spending in Washington, D.C. Despite that, researchers at Boston College have developed a radical proposal to tax IRA and 401(k) savings to fill the funding gap for Social Security. At the Cato Institute, Adam Michel explains why that’s such a terrible idea. He writes:
A recent proposal by Andrew Biggs and Alicia Munnell suggests repealing the tax exemption for employer‐sponsored retirement plans and IRAs and using the new revenue to address the majority of Social Security’s long‐term funding gap. The authors’ argument rests on their conclusion that the almost $190 billion annual tax increase on Americans’ retirement savings would not meaningfully change individuals’ incentive to save.
There are many reasons to object to the Biggs‐Munnell analysis, its impact on Social Security, and the implications for the federal budget. However, the crux of their argument—that tax‐advantaged retirement accounts “do little to increase retirement saving”—is an overconfident misinterpretation of the academic literature that does not acknowledge the broader economic benefits of private saving.
The overwhelming evidence is that tax‐advantaged accounts significantly increase private savings. Over time, even small increases in private savings can contribute to a larger capital stock, additional labor supply, and a bigger economy. The private benefits to additional saving, combined with the broader economic benefits, outweigh any temporary government losses, even if the lower revenue does not induce a one‐for‐one increase in private savings.
The balance of the evidence suggests that raiding Americans’ private retirement savings to prop up Social Security would significantly reduce private retirement savings and slow capital accumulation necessary to sustain a growing economy.
Saving in Theory
The US income tax levies multiple layers of tax on an individual’s savings. Wages are first taxed by the income and payroll taxes. The return on any income saved is then taxed again through taxes on corporate income, dividends, capital gains, and transfers at death. These taxes on investment returns reduce the after‐tax value of delaying current consumption for future consumption.
Tax‐advantaged saving accounts, such as 401(k)s and IRAs, reduce some of the income tax system’s savings penalty by eliminating capital gains and dividend taxes on funds invested for retirement. By raising after‐tax returns, tax‐advantaged accounts could reduce personal savings by allowing people to consume the same amount in retirement at a lower savings rate (called the income effect), or the accounts could induce additional savings and less pre‐retirement consumption to take advantage of the larger returns (substitution effect). Empirical estimates of these effects attempt to measure how much 401(k) balances represent “new savings,” as opposed to simply transfers of assets that would have been saved regardless of the tax benefit.
The empirical measurement of the personal savings response is only one part of the analysis. Policymakers should also care about a tax’s total economic cost or deadweight loss. Taxes on investment returns do not have to affect current savings to reduce future consumption. An individual’s well‐being is not determined by their savings per se but by the consumption the savings afford them. If the income and substitution effects cancel out and savings remain unchanged, a tax on capital gains that lowers a saver’s after‐tax return still mechanically reduces future consumption and thus has a deadweight cost.
Harvard economist Martin Feldstein explains that without changing personal savings, such taxes on capital can also reduce “labor supply broadly defined, including not only the number of hours worked but, more importantly, the incentive to acquire human capital, the choice of occupation, and the amount of effort.” By reducing lifetime consumption, capital taxes can have significant economic costs without a measurable effect on the amount saved. In other words, even if the observed effect of 401(k) accounts is as small as critics claim, repealing the tax treatment would be economically damaging.
Complicating matters further, tax‐advantaged accounts with contribution limits only change marginal decisions for savers who save less than the annual account limits and would otherwise face capital gains taxes.[1] The first capital gains income threshold kicks in at $47,025 in 2024 for single taxpayers ($94,050 for married filing jointly). According to Vanguard account data, only 15 percent of Americans hit their contribution limits in 2022. At least one‐third, and likely many more, of Vanguard participants who are subject to the capital gains tax contribute less than the annual maximum and thus benefit from the marginal saving incentive. If policymakers are worried about diminished marginal investment incentives, the solution is simple: eliminate contribution limits.
The final theoretical challenge is that reducing taxes on retirement savings comes at a fiscal cost to the government, which could offset the gains from increased personal savings. In the absence of other changes, the lower tax revenue requires additional government borrowing. The savings literature often assumes that any increase in private savings is offset by the government’s dissaving, which crowds out domestic investment. While this assumption is partly true, in an open economy with easy access to global credit markets, a significant share of federal debt is financed with international investment and thus does not crowd out domestic investment. In a fully open economy, a decrease in the after‐tax return for domestic savers would also not significantly affect the capital stock but would increase domestic ownership of US assets. While the degree of domestic investment crowd out and international capital openness are the subject of ongoing debate, simply comparing tax expenditure costs with increases in private savings is not sufficient to learn anything meaningful about how tax‐advantaged accounts affect national or net savings.
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