Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / The Hidden Trillion-Dollar Cost of Retirement Tax Breaks
Transcript
- Lucas: One point five trillion dollars. That's the tax revenue the federal government expects to forgo over the next decade because of retirement account tax breaks. It's more than what Social Security costs in a single year. Luna: Wait — we're talking about 401s and IRAs? I always thought those were tax breaks for savers, not government spending. Lucas: Exactly. But in fiscal policy terms, a tax break that reduces what the government collects is functionally similar to writing a check. The Congressional Budget Office calls them tax expenditures, and retirement accounts are the single biggest category — bigger than the mortgage interest deduction, bigger than the earned income tax credit. Luna: So how is the one point five trillion broken down? Is it mostly the 401 deferral? Lucas: Mostly, yes. The biggest piece is the tax deferral on contributions to employer-sponsored 401-type plans and traditional IRAs. You put money in pre-tax, it grows tax-free, and you pay taxes on withdrawal. That deferral costs about one hundred billion dollars a year in forgone revenue. Then there's the Roth structure, where you pay taxes now but withdraw tax-free — that's cheaper but still adds up. And there's the Saver's Credit, a direct subsidy for low-income savers, which is tiny in comparison. Luna: I remember hearing that these breaks mostly help high earners. Is that right? Lucas: Absolutely. This is what economists call an upside-down subsidy. The value of the deduction depends on your marginal tax rate. If you're in the 37 percent bracket, every dollar you contribute saves you thirty-seven cents in taxes. If you're in the 10 percent bracket, you save a dime. The Joint Committee on Taxation estimates that households earning over one hundred thousand dollars a year receive about sixty percent of the benefit from retirement tax breaks, even though they're only about a quarter of taxpayers. Luna: So the people who need the most help saving for retirement get the smallest incentive. That seems backwards. Lucas: It is backwards. And there's another layer: these breaks don't just tilt toward high earners — they also tend to tilt toward people who already have access to workplace plans. About half of private-sector workers don't have an employer-sponsored retirement plan. So the tax expenditure largely flows to people who would likely save anyway. Luna: That raises a bigger question: is this an effective use of government money? Because if the goal is to increase retirement security across the board, it seems like we're spending a trillion and a half dollars without reaching the people most at risk. Lucas: Let's sit with that for a second. Because it ties into something I've been thinking about a lot. This show is possible because listeners like you support it. If walking through the economy with us has made something click — or if you just appreciate a show that doesn't have ads — you can help keep it going. It's buy me a coffee dot com slash fexingo. No pressure, but every bit helps us keep digging into numbers like this. Luna: Yeah, totally. It's how we stay independent. And honestly, this episode is a perfect example of why — we get to follow the money without anyone telling us to lighten up. Lucas: So back to the trillion-dollar question. The Congressional Budget Office and the Treasury Department both publish an annual tax expenditures report. The retirement category is the largest line item. And a growing number of policy analysts say we should convert those breaks into something more progressive — like a flat refundable credit, or even automatic enrollment in a government-run retirement account for workers who don't have a plan. Luna: Is there any precedent for that kind of reform? I know some countries have done it. Lucas: New Zealand replaced its tax breaks with a flat subsidy called KiwiSaver that goes directly into accounts. And in the U.S., there's been talk of capping the deduction — say, at the 28 percent bracket — so high earners don't get the full 37 percent benefit. President Biden proposed something like that in his budget, but it never passed. Luna: What's the political obstacle? Because on paper, it seems like a no-brainer — redirect subsidies to where they're needed. Lucas: The obstacle is that Americans view their 401 as a private account, not a government handout. Any change — even capping the deduction — gets framed as a tax increase on the middle class. Never mind that only about fourteen percent of households max out their 401. The politics are brutal. Luna: And yet the cost keeps growing. The one point five trillion is over the next decade, but it's projected to grow as more people age and earn more. By 2036, it could hit two hundred billion a year. Lucas: Right. And that's in nominal dollars. If you factor in the growing share of national income going to high earners, the subsidy gets even more concentrated. There's also a behavioral angle: studies show that when people get a bigger tax break, they don't necessarily save more. They just shift savings from taxable accounts to tax-deferred accounts. So the elastici is low. Luna: Which means we're leaving money on the table without getting much additional saving in return. Lucas: Exactly. The Treasury's own Office of Tax Analysis estimated that the retirement tax expenditure has an efficiency cost of about thirty cents per dollar of subsidy. That's not terrible, but it's not great either. Compare that to the Saver's Credit, which has a much higher bang for the buck because it's refundable and targeted. Luna: So if you were redesigning the system from scratch, what would you do? Lucas: Start with two things. One: replace the deduction with a flat matching contribution — say, twenty cents on the dollar for every dollar saved, up to a cap. That way everyone gets the same incentive regardless of income. Two: automatically enroll every worker without a plan into a simple retirement account, like the federal government's Thrift Savings Plan. That would cover the fifty percent of workers who currently have nothing. Luna: That sounds like it could actually increase total saving instead of just reshuffling it. But the cost — wouldn't it be similar? Lucas: It could be revenue-neutral if you phase out the deduction. The Urban-Brookings Tax Policy Center modeled a version where you cap the deduction at the 28 percent bracket and use the savings to fund a refundable credit for low- and middle-income savers. It would actually reduce the deficit slightly over ten years while making the system more progressive. Luna: So there is a technical path forward. But politically, we're stuck. Lucas: Stuck might be too strong. There is some momentum around automatic enrollment. The SECURE Act a few years ago encouraged more employers to auto-enroll workers. And a few states — California, Oregon, Illinois — have started state-run automatic IRA programs for workers without employer plans. But the big federal tax breaks? Those are likely to remain untouched until the budget pressure becomes too large to ignore. Luna: When does that happen? At what point does the one point five trillion become unsustainable? Lucas: That's the question. The national debt is already over one hundred percent of GDP. Tax expenditures are one of the biggest items on the so-called spending side of the ledger, even though they show up as revenue loss. If we ever get serious about deficit reduction, retirement tax breaks will have to be on the table. But for now, they're the three-hundred-pound gorilla that almost no one talks about. Luna: Well, we talked about it. And I think our listeners now know exactly where one point five trillion dollars is hiding. Lucas: That's the hope. Next time you hear someone say they want to cut spending, you can ask them: do you mean discretionary spending, or do you mean the tax breaks that cost more than Medicare?