February 26, 2013

Limiting 401(k) Subsidies: Smart Deficit Reduction or Dumb Double Taxation?

A 28% cap on retirement deductions was just one of 15 proposals of the Brookings Institution’s Hamilton Project

Few view the blunt sequestration cuts set to begin on Friday as ideal policy, yet budget hawks worry that non-action on the deficit would leave in place a growing debt dynamic that has fostered only economic stagnation.

To that end, the Brookings Institution’s Hamilton Project convened a roundtable discussion of budget experts Tuesday in Washington to consider “innovative, pragmatic proposals for lowering the deficit by reducing expenditures or raising revenues.”

While the 15 proposals range from military procurement reform to restructuring Medicare, one of them at least drives to the heart of financial advisors’ work with retirement clients. Proposal No. 6 by Brookings fellow Karen Dynan looks to save $40 billion over 10 years by limiting the subsidy of tax-advantaged retirement savings plans such as 401(k)'s.

The essence of Dynan’s idea is that affluent investors would save for retirement anyway, without taxpayer incentives; consequently, the primary plank of her four-tiered proposal is to cap retirement savings-related deductions at 28%.

The Brookings scholar writes:

“The Tax Policy Center has estimated that entirely eliminating the tax preference for new contributions to defined contribution plans would raise about $30 billion from households in the top 5% of the income distribution, which is very roughly the fraction of households that would be affected by a deduction rollback.”

Because she proposes a 28% rate cap, the value to taxpayers would total about $7.5 billion per year. Since Dynan’s other policy plans are aimed at broadening credits and establishing programs for low-income Americans—which would cost some $3.5 billion annually—her proposal over all would generate $4 billion in annual savings, or $40 billion in deficit reduction over 10 years.

Unsurprisingly in Washington, where tweaks in tax policy rouses rapid reactions from those affected, Brian H. Graff, executive Director/CEO of The American Society of Pension Professionals & Actuaries (ASPPA), swiftly called Dynan’s proposal a double tax on 401(k) contributions that would induce business owners to shut down their plans and thereby reduce low-income retirement savings.

In a news release, Graff said “retirees already pay ordinary income tax on distributions from retirement savings plans. If this proposal went through, a small business owner in the 39.6% bracket would pay an 11.6% tax on contributions made to the 401(k) plan today, and pay tax again at the full rate when they retire.”

Graff added that while Dynan’s proposal acknowledges wealthy savers could move their funds to other savings vehicles, “what it fails to acknowledge is when that double-taxed person is a small business owner and it no longer makes sense for the owner to have a 401(k) plan, that owner probably won’t offer a 401(k) plan to the employees, either.”

The Hamilton Project’s 14 other policy proposals were no less controversial. Advisors will be particularly interested in proposals 7, 8 and 10, which would reduce individual tax deductions and exclusions; replace the mortgage interest deduction with a refundable credit; and institute an American valued-added tax (VAT). Those three proposals would reduce the deficit over 10 years by $1 trillion, $300 billion and $1.6 trillion, respectively.

The proposed VAT (proposal No. 10), at a rate of 5% with refundable credits to limit the tax’s regressivity, would be the biggest revenue generator on the list; the tax expenditure limitation (proposal No. 7) would have the second-largest impact.

Among the other deficit-reducing proposals are two that focus on Medicare and two that wield the budget ax at the Pentagon. Proposal 1 looks to bundle Medicare payments to doctors so that physicians assess one charge for the overall wellness of the beneficiary rather than for distinct individual services; Proposal 3 seeks to restructure the program’s cost-sharing features to, among other things, discourage excessive use of program benefits.

The defense-related proposals generate savings through changes in the military force structure (such as ground combat troop reductions) and procurement practices while limiting costs in the growth of military pay and health care costs.

Disability insurance reform and disaster relief programs are among the other budget areas under scrutiny in the Hamilton Project’s policy proposals.

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