Barry's Pickings | Published in October 2011

Deductions vs. Credits

Should we pay people to save?

By PLANSPONSOR staff | October 2011
Illustration by Kyle T. Webster

There is a complaint that the current system of retirement savings tax deductions goes only to "the rich" and a suggestion that the way to fix this problem would be to go to a system of refundable tax credits. Under a refundable tax credit system, even someone who pays no income tax would be paid by the federal government (given a "tax refund") to save.

Indeed, the current Saver’s Credit does something like that, although it’s not refundable, and applicable income limits are so low that very few people use it. One current tax credit proposal is to simply expand the Saver’s Credit and make it refundable. The Obama Administration has, in fact, advocated just that.

There are two problems with going to a tax-credit-based system. The first requires a discussion of some of the more fundamental issues at stake in the current tax and budget fight.

The most disturbing aspect of current tax policy—to me at least—is how much of the tax burden is borne by such a small percentage of Americans. Disregard all the Buffet-inspired nonsense about the "rich" being undertaxed or wanting to pay more taxes. The reality is completely different. Currently (these data are as of 2007), the top 1% of taxpayers pay around 41% of all taxes; the bottom 95% pay around 39%.

Half of American workers pay no income tax at all.

This state of affairs, by the way, is largely the result of the (much hated) Bush tax cuts.

As the tax burden has shifted, the argument for a progressive tax system has undergone a subtle change. The argument used to go something like: If a bridge has to be built, and we have to tax people to come up with the money to build it, then it is only fair that people who have a lot of money pay more for the bridge than people who don’t.

However, we’re not talking about bridge building anymore. The majority of the expenditures that "have to be" funded are transfer payments: whether the transfer is explicit—entitlements (Social Security, Medicare, Medicaid, etc.); tax credits to the low-paid ($116.2 billion of the 2009 stimulus was for $800 checks sent to low-paid workers); and all the programs that make up our welfare state; or implicit—various "investments" in teachers’ salaries, highway projects, and "green jobs."

So, we’re not talking about A and B chipping in to build a bridge. We’re talking about B and C getting together and deciding to take money from A and give it to B and C, where A, famously, is the forgotten man.

The question, in these circumstances, has changed. It’s not "Who should pay for the bridge?" It’s "Does A have any right to keep what she earned?" Or is our economy so fundamentally unfair that her earnings can routinely be re-allocated to B and C? The ground on which this battle—should A be allowed to keep what she earns?—will take place is our tax system and the extent to which it is deemed "progressive."

In this context, every proposal to means-test, to provide "tax cuts for the lower-paid" (e.g., the recent Social Security tax holiday), to continue the so-called Bush tax cuts for everybody but the "rich," pushes us further down the path of A paying more and more for B and C. The proposal to change the current system of deductions for retirement savings to one of refundable tax credits is just such a proposal.

The second problem is that, as I discussed in a prior column, because of the way the CBO scores the budget, the value of the retirement saving deduction "tax expenditure" is overstated. The deduction is counted, but future taxes that will be paid on distributions are disregarded if they are outside the 10-year budget window. To a large extent, that won’t happen with a refundable tax credit, because most of the benefici­aries of the credit are paying little or no taxes anyway. The tax credit is simply an expenditure—more properly, a transfer payment (from A to B and C), and it’s gone for good.

Tax credit 401(k)s are just another attempt to use the tax system to transfer wealth, with some budget hocus pocus thrown in. They probably will even call it a "tax cut."

Michael Barry is President of the Plan Advisory Services Group, a consulting group that helps financial services corporations with the regulatory issues facing their plan sponsor clients. He has had 30 years’ experience in the benefits field, in law and consulting firms.