Don't Gut 401ks and IRAs to Save Social Security

by Joshua Rauh and Stan Veuger

There are plenty of ideas out there for how to save Social Security, the government program that the lion's share of Americans rely on to finance much of their retirement. Most proposals involve various combinations of payroll tax increases, benefit reductions, and technical adjustments, with an important goal usually being to keep the program self-contained and not draw on general government revenues.

Many Americans rely not only on Social Security but also on tax-deferred saving accounts (TDAs) such as 401(k)s and IRAs, in addition to other saving they might have including home equity. Some researchers and commentators are now seeing that private system of retirement savings as something that should be drawn upon to help shore up the public one.

One particular recent proposal, by Andrew Biggs of the American Enterprise Institute and Alicia Munnell of Boston College would eliminate or reduce the tax advantages of accounts like 401(k)s and IRAs and use the additional government revenue to shore up Social Security. The remainder of this post offers a laundry list of reasons why that is a bad idea.

To start, the proposal would break down the barrier between Social Security and the general budget. This potentially opens the floodgates to an endless flow of funds from the general fisc to the Social Security trust fund—as is already the case for Medicare Part B and its associated trust fund.

The plan would also take a major step backwards from one of the only saving graces of our income tax system—the fact that at least some savings are tax deductible. Not taxing income that is saved helps avoid the double taxation of those who choose not to consume their income immediately—and the injustice of their double taxation while otherwise similar but more spendthrift individuals are only taxed once.

Economists have long pointed out that consumption taxes are relatively attractive in that they do not unnecessarily distort decisions about work and human capital accumulation as the income tax does. Consumption taxes also do not discourage saving or skew investments like as the taxation of interest, dividends, and capital gains does. Allowing those earning income to deduct amounts that they save and allowing that income to grow tax free until they actually want to spend the money (at which point the consumer pays both the income tax and the sales tax) approximates this efficient consumption tax.

In attempt to assuage this concern, Biggs and Munnell focus narrowly on the question of whether tax-preferred saving accounts actually increase savings, and assert based on their reading of the research that there is no such effect. Of course, even if a household’s savings remain the same, taxing the returns on those savings will have distorted its choice of when to consume.

But even setting those considerations aside, it is not at all clear that TDAs do not increase national saving. Biggs and Munnell rely heavily on a study that looks at a policy change in Denmark that made one type of TDA less attractive. In response, some but not all savers stop relying on this type of TDA, only to pivot toward a different kind, as one might expect. It is not at all clear how this evidence relates to net savings in the absence of TDAs altogether. In fact, the same study finds significant increases in total savings from employer contributions to TDAs and from mandatory contributions to retirement accounts: households did not offset these elsewhere.

Biggs and Munnell also argue that the tax expenditure associated with TDAs mostly benefits the wealthy. But to make this incidence argument work, we have to think through the counterfactual. The right counterfactual is “who will pay for Social Security shortfalls if this plan isn't implemented?” It strikes us as very likely that high-income taxpayers will be tapped to pay for the Social Security shortfall, either through taxation or by making Social Security benefits more progressive (as Andrew has recommended in the past).

Finally, people who save today will be less dependent on government programs in the future. They are building self-sufficiency and, more tangibly, assets that will count against their eligibility for government programs like Medicaid. Surely encouraging Americans to save for their own retirement is better policy than coming up with increasingly more complicated ways to backstop the safety net.