As our friends in Washington pretend to fight over how they’re going to get passed the fiscal cliff, the media want to pretend that everything is on the table. In the last few weeks I’ve heard that mortgage interest deductions could get the ax, employer provided health insurance could get taxed, and my new favorite: the end of the 401k.
It’s not laughable because it’s a bad idea, but the argument presented in Slate sure makes me giggle. Here’s the idea: Denmark, like the US, provides a tax benefit for encouraging citizens to save for retirement. Our 401k allows us to defer taxes on the income until we cash out in retirement, reducing our taxes now. Denmark went through some tax changes that eliminated the benefit for some of the wealthiest citizens. Economists love situations like this because it’s like a real life experiment.
The tax benefit is supposed to encourage saving. So if the Danes got rid of the benefit and it didn’t affect saving then the US might get rid of it too. Makes sense, if the incentive doesn’t work as intended, get rid of it. Economists learned that in the case of the Danes, eliminating the tax benefit for retirement savings didn’t discourage saving among the wealthier compared to a control group of lower tax brackets that still had the benefit. Most everyone saved at a the same rate. Some reduced contributions to that account but added more to others. The study “proves” that a tax benefit that encourages saving doesn’t work.
That’s a crock. The only thing this study shows is that people won’t miss a tax benefit they didn’t need in the first place. Think mortgage interest deductions on your vacation home. One can’t draw any conclusions by acting like a lower tax bracket is an effective control group when it comes to savings habits and tax advantages.
Now, simply because you’re relying on faith for the point of the study, doesn’t mean it’s not right. Think about your own retirement savings. You aren’t doing it because of the tax benefit. Most everyone saves in a 401k for the employer contribution or the convenience of having it withdrawn from a paycheck. If the tax benefit went away, we’d all probably keep saving at the same rate if perhaps in other accounts. But I wouldn’t endorse eliminating the tax benefit of a 401k on everyone until better evidence supports it.
This article in Slate does touch on one of my favorite successes in retirement savings: nudging. Nudging is the idea of slightly pushing people in the right direction. If you really want people save more, you set up a default system for them that automatically saves. It’s something that is proven to work.
So we don’t know if the tax benefit has worked as intended. But before we go giving $100 billion (the tax revenue lost from not taxing 401k contributions) back to the government in new revenue let’s make sure we know it’s not working.