Washington's Backward Retirement Policy: So Wrong, and Yet So Easy to Fix

We have more than enough money to protect Social Security. It's just going to the wrong people: private savers.

800 elderly retired vacation ocean picture.jpg

Reuters

In his 1998 State of the Union Address, facing the prospect of budget surpluses for the first time in decades, President Bill Clinton had a simple plan: "Save Social Security first." He wanted to dedicate future budget surpluses to the Social Security trust funds, pushing back for decades the day when it would run out of money. In 2000, presidential nominee Al Gore took up the refrain with a memorable, and occasionally mocked metaphor: the "lockbox."

Well, that didn't happen. The latest projection by the Social Security Board of Trustees is that the trust funds will be exhausted in 2033. At that point, payouts will be limited to the amount brought in by payroll taxes--which means that everyone's benefits will fall by about 25 percent.

This looming threat is often cited as a reason why we need to "reform" Social Security, which is code for cutting benefits. Most recently, President Barack Obama proposed changing the calculation of cost-of-living adjustments, which amounts to a progressively larger benefit cut as you get older. The problem, however, is that Social Security is the only significant source of income for many older Americans, and its net benefits are falling anyway due to increasing taxes and higher Medicare premiums (which are deducted from Social Security).

Against this backdrop, it's a mistake to look at Social Security in isolation. We have to look at our overall retirement security "policy." And when we do that, it's obvious that we're throwing billions of dollars away.

That money is being wasted on tax subsidies for "private" retirement accounts such as 401(k)s and IRAs. In 2012, these subsidies added up to $199 billion, or about 1.3 percent of GDP. (See Toder, Harris, and Lim, Table 5.) The motivation to protect these accounts isn't totally crazy. Since we want people to save for retirement, we offer tax breaks for doing so.

More Tax Breaks, But Not More Savings
There are two major problems with these subsidies.

The first is that they go overwhelmingly to people who don't need them -- like my wife and me. As two university professors living in Western Massachusetts, where the cost of living is low, we make more than we need to support our lifestyle. We max out our defined contribution plans every year, and because we're in a relatively high tax bracket (28%, I think), we save thousands of dollars a year on our taxes. This is the problem with most subsidies that are delivered as tax deductions. Their cash value depends on the amount you can deduct and on your marginal tax rate. In this case, fully 80 percent of retirement savings tax subsidies goes to households in the top income quintile. (See Toder, Harris, and Lim, Table 5.)

The second problem is that these tax incentives don't work. They don't cause people to save more. In my case, the amount we save is just our income minus our consumption, and our consumption isn't affected by the tax code. If there were no tax subsidy, we would save the same amount and just pay more in taxes. And it's not just us. A recent and widely discussed paper by Raj Chetty, John Friedman, Soren Leth-Petersen, Torben Heien Nielsen, and Tore Olsen looked at what happened when the Danish government reduced tax subsidies for retirement savings by rich people. The short answer is that decreases in retirement savings were almost perfectly matched by increases in non-retirement savings. The overall effect, they estimate, is that for every dollar in tax subsidies, total savings go up by one cent. The other ninety-nine cents is just a handout to people who would have saved anyway.

Presented by

James Kwak, an associate professor at the University of Connecticut School of Law, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.
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James Kwak is an associate professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. He blogs at The Baseline Scenario and tweets at @JamesYKwak.

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