Do Mandates or Tax Subsidies Do a Better Job of Boosting Savings?

By :: September 4th, 2012

Most policymakers and economists agree that Americans don’t save enough. But which government policy does a better job encouraging saving and investment: tax subsidies such as 401(k)s, or mandatory savings systems such as traditional defined benefit pensions or auto-enrollment defined contribution accounts?

An important new study finds that if the goal is boosting total savings--as opposed to merely raising retirement savings—mandatory programs win hands down. Tax incentives do increase retirement savings, but largely by encouraging a limited number of sophisticated, high-income people to shift funds from taxable accounts to tax-subsidized retirement plans.

This conclusion isn’t new. For instance, my Tax Policy Center colleague Eric Toder looked at these alternatives in a 2009 paper

But the new research is especially important because it is based on a huge sample –45 million observations—and on a series of government policy changes that tested whether tax subsidies or mandates were more effective.

The downside is that the study was not done on changes in U.S. policy—it measured reforms in Denmark. In addition, the nature of the changes themselves may complicate the results. Still, it is powerful evidence of how these incentives work.

The authors—Raj Chetty and John N. Friedman of Harvard and the National Bureau of Economic Research, and Soren Leth-Petersen and Torben Nielsen of the University of Copenhagen— looked at a series of highly-targeted savings reforms  enacted in Denmark in the late 1990s.  Their paper was presented at the Retirement Research Consortium conference in August.

In 1998, Denmark adopted a mandatory pension savings requirement that remained in effect until 2003. In 1999, the government cut a tax subsidy for contributions to 401(k)-like plans by top-bracket taxpayers.   

When the government required people to contribute 1 percent of their gross earnings to a pension account, 90 percent of the direct impact of that mandate was reflected in total savings. By contrast, when the government trimmed the tax break for high-income people, their overall response was very small—they reduced total savings by only about 10 percent.

In effect, while high-income Danes contributed less to those retirement accounts that saw the tax subsidy cut, they put more into other pension plans that retained their tax benefit.

The results are powerful evidence of how mandates and tax subsidies can affect savings. But the study also raises lots of unanswered questions. Among them: Do Americans respond the same way as Danes and do the short-term effects found by the authors apply over the long-run?

At the RRC conference, Dartmouth economist Jon Skinner called the study a “landmark.” But in a response to a recent blog post about the results, Skinner argues this paper says nothing about the effectiveness of 401(k)s in the U.S.

Still, as U.S. policymakers think about incentives in the context of issues ranging from tax and health reform to long-term care insurance, they ought to keep these findings in mind. Tax subsidies don’t always accomplish what some policymakers hope they will. Remembering that lesson could prevent reformers from making some multi-billion dollar mistakes.      



  1. Michael Bindner  ::  4:09 pm on September 4th, 2012:

    These studies always leave out mandatory savings through social insurance, which are absolutely effective and yield the biggest resulting income because the rate of return is on the economy as a whole rather than the yield to government bonds.

  2. Michael Bindner  ::  4:10 pm on September 4th, 2012:

    Personal accounts in Social Security holding insured employer voting stock would be by far the most effective form of increased savings. This would, essentially, bring back pensions for most people.

  3. Tax Roundup, 9/5/2012: Laying it on thick for the fertilizer plant. « Roth & Company, P.C  ::  10:11 am on September 5th, 2012:

    […] I think spending less than you earn works even better:  Do Mandates or Tax Subsidies Do a Better Job of Boosting Savings? […]

  4. AMTbuff  ::  11:38 am on September 5th, 2012:

    “This conclusion isn’t new.”

    It’s not surprising either.

    Progressives oppose private Social Security accounts in large part because it was Bush who brought them to prominence. Had Clinton followed through on his pledge to “Save Social Security first”, this would not have been a partisan issue.

    Whatever form forced savings takes, there is a significant probability that the government will attempt partial confiscation of the savings when it runs short of money. Typical methods are imposing extra taxes (like the “success tax”) or forced investment in government debt that has a negative real rate of return (using the cover story that it’s to protect workers from market risk).

    If we could trust the government never to raid people’s savings, then forced savings would probably benefit the public. History shows that we can’t trust the government to keep its hands off funds that are set aside for future use. The Social Security Trust Fund is Exhibit A. Exhibit B is the 2008 confiscation of private retirement savings in Argentina.

    Right now we have the best forced savings plan I’ve ever seen: Convince everyone that the government is so irresponsible that the economy could collapse at any time. Fear promotes savings, and right now we have plenty of fear.

  5. Vivian Darkbloom  ::  4:20 pm on September 5th, 2012:

    Auto enrollment defined contribution accounts are not “mandatory”; they are default options. You can opt out of them.

    It should not be too difficult to develop a hierarchy of which policy would produce the most savings if one assumes a constant rate of tax. Here is what I think it would look like:

    1. Mandatory accounts with no opt out. If we consider social security to be a “savings”, it is mandatory (with a return on those savings better for some than others). Failure, for example, to pay self-employment premiums when due can result in civil and criminal penalties. That’s pretty robust. No wonder it is the most effective.

    2. Default enrollment options that are tax subsidized.

    3. Voluntary schemes with tax subsidy;

    4. Default enrollment options that are not tax subsidized;

    5. Voluntary schemes with no tax subsidy.

    The order of numbers 3 and 4 might be debatable, depending on the nature of the subsidy. “Tax subsidy” here would include subsidies for contributions, build-up and /or payouts (build up subsidies would include certain annuities and payout subsidies might include Roth IRA’s.)

    In this respect, when you subsidize something, you get more of it. If you reduce or eliminate the subsidy, you get less of it than when the prior subsidy was in effect. If one no longer gets a tax deduction for mortgage interest, for example, one is more inclined to forego that mortgage loan or take a smaller one. The cited study clearly demonstrates this behavioral response. It showed a 10 percent reduction in contributions to pension plans by high-income taxpayers when the tax subsidy was eliminated. And, that estimate is low due to the fact that those Danes had other schemes they could contribute to that provided the same or similar tax benefit as the one eliminated. Danes have every reason to seek out alternative deductible schemes because of their high marginal tax rates. While this example seems to show that the expected reduction in overall deductible contributions to tax deducible accounts was only 10 percent, the amount would have been much higher had the alternative routes for similar tax subsidized products also been closed (if all such routes had been closed, it would have been 100 percent).

    A reduction in tax rates should have an effect in the same direction; the *gross* amount of deductions should be reduced. The more tax expenditures that are eliminated, the better, in order to prevent the opportunities for taxpayers to seek alternative methods of tax reduction. This all speaks for lower rates and elimination of most deductions.

    This is something to keep in mind when scoring tax expenditure eliminations. It is not only the tax rate that matter; , it is also the assumptions regarding what the behavioral response will be (quite aside from macro effects). Those responses are very real, as this study demonstrates.

  6. Vivian Darkbloom  ::  4:56 pm on September 5th, 2012:

    (if all such routes had been closed, it would have been 100 percent).

    I should clarify this. Of course, if all routes to “tax subsidized” accounts would be closed, no one would contribute to them, as such, because they would no longer exist. Obviously, some taxpayers would continue to contribute to the same or similar accounts without the benefit of the subsidy. What percentage would do so is not clear, but what is clear is that it would be less than when the subsidy existed.

  7. Vivian Darkbloom  ::  5:04 pm on September 5th, 2012:

    “Right now we have the best forced savings plan I’ve ever seen: Convince everyone that the government is so irresponsible that the economy could collapse at any time. Fear promotes savings, and right now we have plenty of fear.”

    I think this also reflects an under-estimated effect of Federal Reserve policy that encourages ultra-low interest rates. The accepted wisdom is that such policy encourages spending rather than saving. I’m skeptical of that claim. I suspect many people save more money with artificially low interest rates because they believe they need to do save more in order to achieve whatever nominal savings goal they had. The amount needed to save to achieve that (nominal) monetary goal would be lower if interest rates were higher. This is certainly true with respect to pension funds.

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