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June 3, 1991
"A Penny Saved isn't Really a Penny Saved"
San Jose Mercury News

By Timothy Taylor
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MORE THAN three-quarters of the U.S. Senate -- 77 members, to be exact -- is sponsoring legislation that attempts to increase the rate of U.S. savings by expanding individual retirement accounts, or IRAs. However, the measure isn't likely to pass, at least not this year, and isn't likely to achieve increased savings if it ever does pass. How can this be?

There's no dispute that offering larger IRA tax breaks can increase investment in IRAs. But remember, the public policy goal here is not to benefit one specific type of retirement account, but to increase overall national savings. By that standard, IRAs have not proven successful.

Many taxpayers are familiar with the basic idea of IRAs; you can put up to $2,000 a year (per adult) into a retirement account, deduct it from your taxes, and only pay taxes on the interest when you withdraw the money after retirement. There is "a penalty for early withdrawal," as the fine print says.

But the Tax Reform Act of 1986 placed restrictions on IRAs. Taxpayers whose income on a joint return is above $50,000 ($35,000 for a single return) can still put money in an IRA, but the deposit is no longer tax-deductible. However, the interest is still not taxed until the money is withdrawn, after retirement. The current proposal, co-authored by Democrat Lloyd Bentsen of Texas and Republican William Roth of Delaware, would again allow taxpayers to take an immediate deduction for money saved in an IRA.

Or as an alternative, taxpayers could choose an IRA which would offer no up-front deduction, but would not tax any of the interest on money left in the account more than five years.

The Bentsen-Roth legislation would also sweeten the pot by allowing IRA deposits to be withdrawn without penalty for designated purposes like a down payment on a home, tuition, or large medical bills.

The main political problem faced by the proposal is that bigger tax breaks cost money: in this case about $5 billion a year. With estimates of this year's federal budget deficit hovering around $300 billion, the Bush administration has already announced its opposition to expanded IRAs.

So far, Bentsen and Roth have focused only on the tax-break goodies. But under the new budget legislation passed last fall, they must specify how they propose to foot the bill for their expanded IRAs. When the costs of the proposal become concrete, it's safe to predict that support will falter.

It may seem obvious that expanding IRAs will increase savings, but as the song says, it ain't necessarily so. In fact, it isn't even likely to be so.

The first problem is that if the richer, tastier IRAs are financed by deficit spending, then even if they lead to more private savings, they may not expand the nation's overall public and private savings.

The second problem is a bit trickier. If IRAs again become tax-deductible for the middle-class and wealthy, many taxpayers will shift funds from other forms of savings (say, stock market mutual funds) into IRAs. The amount saved in retirement accounts may increase, but the total amount saved needn't rise at all.

In fact, the total amount saved may even decline. Imagine that you have a target of having $250,000 saved up on the day of your retirement at age 65. Because the IRA tax break makes it easier to reach your goal, you can choose to save less now, and still reach your target.

The empirical evidence here is suggestive, although certainly not definitive. When widespread IRAs were first offered in 1981, U.S. households saved 7.5 percent of personal income.

By the time IRAs were restricted in 1986, the savings rate had fallen to 4.1 percent. Then the savings rate rose slightly, reaching 4.5 percent in 1990. On that evidence, it's pretty tough to prove that more generous IRAs increase savings.

In addition, detailed studies of IRA contributors have shown that they tend to be wealthier than average, usually with other financial assets. Presumably, this would make it quite easy to transfer money from an existing account to an IRA. Bentsen and Roth and their 75 co-sponsors are correct that increasing the rate of U.S. savings is tremendously important. Savings provide funds for business investment, which in turn stimulates long-term economic growth. Yet the U.S. savings rate lags far behind international competitors like Japan and Germany. But the hard truth is that no one really knows how to increase household savings, and IRAs don't seem well-equipped for the job. The most certain way to increase investment funds for U.S. business is to get the hippopotamus of government borrowing out of the pool of available capital.

But cutting the federal budget deficit will require spending cuts and tax increases, not politically popular tax breaks.

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