Tax Deferral: An Incentive to Save More Today

September 27, 2013

The U.S. federal tax code contains a number of provisions designed to encourage individuals to save for retirement. These provisions allow individuals to avoid or defer taxes if they choose to set aside a portion of their income for future consumption. When all of these provisions are combined, they are the second largest "tax expenditure" category as defined by the Joint Committee on Taxation, say Jeremy Horpedahl, an assistant professor of economics at Buena Vista University, and Harrison Searles of the Mercatus Center.

The exclusion of retirement savings from taxation causes some economic distortions. However, unlike some other tax expenditures, there is a strong economic rationale for not taxing savings.

  • Higher rates of investment lead to higher rates of economic growth, and it may be sound policy for the tax code to encourage this behavior, even after considering the economic costs.
  • Excluding retirement income from taxation may also make the tax system more efficient, even though most other tax expenditures reduce efficiency.
  • Although Keogh plans, IRAs and 401(k)s have important technical differences, the basic economic function is the same: contributions are made with pre-tax income and grow tax free, and the tax is paid in the future when withdrawals are made.
  • The more recent Roth IRA operates differently from the rest, as it is funded with post-tax dollars and only the gains are tax free, but the intended economic effect of encouraging retirement savings is the same.

In the end, people choose to save more because they probably will be in a lower income tax bracket during their retirement and also because they will be able to accrue the benefits of invested funds that would have otherwise been taxed away. Despite the complexity that this deduction adds to the tax code and some economic costs, this deferral brings the income tax function closer to a more economically efficient consumption tax. It also mitigates the problem of the double taxation of capital for the tax-deferred contributions.

Source: Jeremy Horpedahl and Harrison Searles, "The Tax Exclusion for Retirement and Pension Plans," Mercatus Center, September 17, 2013.

 

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