Recently President Bush proposed a plan that calls for creating two types of personal saving accounts to replace Individual Retirement Accounts, or IRAs. Most employer-sponsored retirement plans would also be replaced by an Employer Retirement Savings Account. The president’s savings plan has everything that a supply-sider could hope for: It eliminates the double taxation of savings by effectively reducing the capital-gains tax rate to zero, and in true supply-side fashion, the implementation of the plan is loaded with incentives to induce people to voluntarily front-load the tax payments.
This latter feature should ease the concerns of the static deficit mongers (ie., savers will be incentivized to keep on saving). But this is not the case. Critics are saying that while the Bush savings plan will generate revenues in the present, it will reduce them in the future. Call this selective dynamic analysis. The critics concede that savings behavior will change — more Americans will save today — yet they do not anticipate higher savings, investment, and/or economic growth in the future. This is a strange analysis: if they concede that behavior will change today, why won’t they at least pay lip service to the possibility that there will be more growth down the road?
The Bush plan includes the creation of two new accounts. One, the Retirement Savings Account (RSA), would let individuals contribute as much as $7,500 a year. There is no limit on income of the contributor, but one cannot contribute more than their wages. For married couples filing jointly the maximum contribution is $15,000 even if one of the spouses stays at home. There’s no tax deduction, but earnings and payouts are tax-free when withdrawn after age 59, or after a disability or death.
The other account, the Lifetime Savings Account (LSA), is more interesting. The LSA allows anyone to contribute up to $7,500 a year regardless of income or age. As with the RSA there is no tax deduction and earnings and distributions are tax free. The one difference between the LSA and the RSA is that the LSA has no early withdrawal or other penalties. People could withdraw their money at any time for any purpose and not face taxes or penalties on that money. Add new Employee Retirement Savings Accounts (ERSA) and taxpayers will be able to put away another $15,000.
In order to fully take advantage of all the features in the president’s plan many people will have strong incentives to convert their IRAs into the new accounts. Recall that IRAs back-load the taxes while the new accounts front-load them. Thus, the switch will produce an increase in current tax revenues.
The critics point out that the switch will result in more revenues now and less revenues later. These are the same people who use static analysis to score tax proposals in order to derail them. Well, the administration found a way to play their game. The switch will raise revenues temporarily, allowing the administration to implement the program without running afoul of the static-revenue constraints. The point that gets lost in all this is that even the critics are now beginning to concede that the president’s proposal will change the behavior of American wage earners.
So, if Americans change their savings behavior, why won’t they increase the size of their savings?
Tax-free compounding has a powerful and significant impact on the effective tax rate faced by individuals. Simply put, the elimination of the double taxation of savings will increase an individual’s after-tax returns. This is a great incentive. Since the income will be taxed once, the personal income-tax rate will remain the same while the effective tax rate on savings will decline to zero. The numbers show that the Bush plan will greatly increase the return on savings and the incentive to save.
The press is also making a big deal about the front-loading of the taxes. Many financial articles stress that under the president’s savings plans the contributions will not be tax deductible. In other words, the president’s plan calls for people to pay the taxes up front, just like they would with a Roth IRA. What the newspaper accounts fail to mention is that if the contributions were tax exempt, then savers would have to pay the piper at the back-end when they retire.
From a total-return basis, it does not matter whether the government taxes the savings accounts at the end, as with an IRA, or at the beginning, as with a Roth IRA. The taxes produce the same after-tax returns for investors. The two taxes are equivalent.
The interesting part of the president’s program is that people will have an incentive to switch to the equivalent of a Roth IRA during their peak earning years. This is the opposite of what happened when the Roth IRA was introduced. The reason for the switch is that the elimination of the double tax on savings is more important to the saver than the increase in his personal income-tax rate during his peak earning years.
Opponents of the Bush plan correctly argue that in the short-run the new savings plan will mask the budget effects. The plan will generate temporary revenue gains for the government by encouraging people to convert their traditional IRAs, even though their tax bills will be bigger. This is an incredibly delicious feature of the plan. The president is playing by the static rules set by the bean counters. Since the scoring of the revenue effects is static, any increase in revenues will be scored as permanent, hence the masking of the budget effects.
And if Americans do respond to the plan, as they surely will, opponents will have to concede that Bush beat them by playing their static game better than they do — in which case they will be prompted to allow for dynamic scoring of the revenue effects of taxation. In short, the Bush critics are between a rock and a hard place.