August 23, 2012
401(k) Tax Break May Be Weak Incentive
Typical American households approaching retirement age had just $42,000 saved in 401(k)s and IRAs in 2010. This raises the question: Does the federal tax incentive designed to spur savings even work?
In what one retirement expert called “landmark” research, a new study has found that employers’ automatic enrollment and other employee mandates are far more effective ways to increase retirement savings than the federal tax exemption granted for retirement-fund contributions.
Harvard University Professors Raj Chetty and John Friedman, together with Soren Leth-Petersen and Torben Nielsen at the University of Copenhagen, tested the impact of both types of incentives on an enormous sample of 4.3 million people in Denmark. Chetty said the findings also hold implications for the United States.
They found that every $1 increase mandated for retirement savings – in this case, by a temporary Danish policy that required workers to contribute 1 percent of their earnings to government pension savings accounts – spurred 86 cents in additional savings by individuals. In contrast, the Danish government’s tax subsidy, which is very much like our own 401(k) tax break, spurred only 20 cents more in savings.
“This is a landmark study,” Dartmouth College professor Jonathan Skinner said about the paper, presented during the Retirement Research Consortium’s conference in Washington in early August.
The savings boost spurred by the Danish savings mandate, in effect from 1998 through 2003, is analogous to U.S. employer programs with automatic features, Chetty said. Such programs might automatically enroll workers in a 401(k) or raise employees’ savings as their earnings increase.
Some 42 percent of U.S. employers now automatically enroll employees in 401(k)s, giving them the option of dropping out. Research has also shown that automatic enrollment is more effective than trying to push employees to actively sign up for these savings programs.
To test the impact of tax subsidies, the researchers examined a different government policy: a 15-percent reduction in the tax break for high-income Danes who contributed to their capital pension retirement savings accounts – what would amount roughly to a partial reversal of 401(k) tax breaks in the United States. They found that contributions by high earners fell sharply when the tax break was reduced but that individuals were simply moving those funds to other types of savings accounts. In other words, saving overall was not very responsive to the tax incentive.
It’s important to note that this focus on “total savings” is critical to the researchers’ findings. They wanted to measure a change in savings in all of an individual’s various accounts, rather than savings that merely shifted among accounts in response to each policy.
“[T]he impacts of this [tax subsidy] reform on total savings are very limited,” the paper said. Chetty cautioned that further research, using data from the United States, is needed before one can draw definitive conclusions for U.S. policy, but the Denmark findings suggest that tax subsidies may not be the most effective way to raise retirement savings in this country.
At the research consortium, Chetty previewed the results of a forthcoming working paper, which is expected to go live on the National Bureau of Economic Research’s website in a few months. The Center for Retirement Research, which sponsors this blog, is a consortium member.
Full disclosure: The research cited in this post was funded by a grant from the U.S. Social Security Administration (SSA) through the Retirement Research Consortium, which also funds this blog. The opinions and conclusions expressed are solely those of the blog’s author and do not represent the opinions or policy of SSA or any agency of the federal government.