The rich get their Roths.
Disclaimer: The following tax-wonking is more for my benefit than for that of any readers. I'm fairly confident of the information, but feel free to notify me of any errors that you see.
In the debate over the taxation of investment income, liberal economists tend to argue that, if favourable tax treatment of investment income is to occur, the tax benefits of saving should be directed at individuals with relatively low income, whose marginal contribution decision to a saving account takes place at a low dollar value (corresponding to their relatively low dollar value of income).
This can be done in one of two ways: (1) by conditioning the tax treatment of contributions to saving on the financial or demographic characteristics of the contributors themselves; or (2) by offering favourable tax treatment only at the low levels of investment income feasible for the non-rich. Combinations of these approaches can be and often are also used: the amount of saving eligible for favourable tax treatment can vary by the contributor's income, health or age status.
However, some rightwing economists argue something close to the opposite: it's actually more efficient to give favourable tax treatment only to very high dollar levels of investment contributions, i.e. to those made disportionately by the rich. The basic reasoning is that (a) the saving of the rich has a disproportionately large effect on the economy and (b) the marginal saving decision of the rich (i.e. the amount of saving at which the value of contributing an additional dollar to saving is just equal to the value of consuming it now) takes place at a relatively high contribution level.
To explain the latter point: suppose the income tax rate I face is 15% and I'm planning to save $12,000 of my income this year in a regular non-tax-prefered saving account. If the government implements a policy that allows me to write off the first $2000 of that saving from my current taxable income, then it will have only a small effect on my saving decision through my slight ($300) increase in after-tax income. But if the government institutes a policy that allows me to write off any contribution I make to my saving above $12,000, then every additional dollar I contribute to saving suddenly has a lower cost in terms of current consumption (instead of $1, it costs me only $0.85) -- which will probably induce me to save quite a bit more.
Traditionally in the US, the structure of Roth IRAs has conformed more to the former (liberal) theory than to the latter (conservative) one: that saving incentives should be designed to encourage a more equal distribution of wealth holdings than just to stimulate the total gross amount of saving being done by the private sector. Roth IRAs are a very lucritive way of saving, because contributions are taxable in the year they are made (i.e. they are not tax deductible), but eligible withdrawals (after retirement or disability or for homebuying) are not taxable. The result is that the interest earnings on Roth IRAs end up untaxed. Worse, from an equity point of view, the likelihood of their being untaxed increases with the certainty the individual faces in his lifecycle path -- the unlikelihood of having to make early withdrawals. By contrast, regular IRAs and Canadian RRSPs are tax deductible in the year they are made, but are taxable as earned income in the year they are withdrawn. The result is that both the principle and the interest end up being taxed -- though they may be taxed at lower rates in a progressive income tax system if withdrawals are made in periods of otherwise low earnings.
The progressivity of Roth IRAs comes from the fact that they are limited to people having what we might consider upper-middle-class earning status or less. Currently, a single filer need an earned income of $110,000 or less to be eligible to contribute. In other words, Roth IRAS are not presently a way for the super-rich to avoid paying tax on investment earnings. Shockingly, the Republicans want to change all that by allowing anybody -- regardless of income -- to convert regular IRAs to Roth IRAs starting in 2010.
Though it's being called a gimmick, it looks to me (without reading the details) like a fairly pure way around the income-limit on contributing to Roth IRAs. Under the policy as described, the rich can simply make a contribution to their regular IRA starting in 2010, then redirect it to their Roth IRA, paying imcome tax on it when it moves, in 2011, and so on going forward. Even if this tactic is prohibited, recall that the Bush tax cuts have greatly increased the contribution limits on regular IRAs over the next few years. This makes for a larger pot of money that can be shifted into the Roth IRA tax shelter starting in 2010. All that's left is for the Republicans to push for raising contribution the contribution limits into Roth IRAs in the future.
By definition, this amounts to a giant tax cut to the wealthy. There are also budget effects. As Kevin Drum points out, one effect is to make short term budget deficit projections look nicer, because of the income tax that gets paid when the population of US millionaires switches their holdings from regular to Roth IRAS in the first few years after 2010. (In this way, it works a lot like the 1997 capital gains tax cut, which pushed the federal budget across the lines into surplus, as stock holders, free from the full capital-gains tax burdan, rearranged their portfolios and paid out the reduced taxes on the profits from their stock sales.) But the long-run cost to the treasury is the interest earnings that accrue to the principle once it moves into the Roth IRAs.
There's no defence of such a plan to be made on equity grounds. To the extent that any additional private saving generated is offset by public dissaving as the treasury bleeds future revenues, there's no aggregate saving defence to be made either. But what about the "efficiency" or pro-growth grounds of, as Bush put it, "extend[ing] policies that have helped our economy flourish"?
Bear with me. What follows certainly isn't cutting-edge theory, and I'm sure models exist that can spin the effects positively. But using traditional economic theory, the growth argument is based on the idea that domestic (private) saving has a direct influence on the domestic capital stock -- the basic version of the supply-side stimulus. But in the global economy with liquid financial markets and a prevailing world interest rate, the relationship doesn't hold, because saving will flow to any international arbitrage opportunity. (This is not, of course, a very accurate description of the real world, but neither is the traditional domestic saving = domestic investment relationship on which a lot of pro-growth arguments were originally based.) The returns to capital will still increase domestic wealth, but only through the private wealth of the individual actually holding the capital.
As well, the greater wealth of those domestic rich owners of capital might cause them to consume more, stimulating domestic demand, i.e. the demand-side version of ye olde trickle down effect. And the US economy is in fact growing at a good clip -- even though domestic private saving, particularly household saving, continues to be historically low. But a pretty good case can be made that, right now, other than through the effect on employment, the additional returns of economic growth are accruing almost exclusively to capital and to "entrepreneurship" (i.e. upper-level management, also the main capital-holding class) -- not to labour.
Explaining why that is isn't my intention here. But suffice to say that, to the extent that the returns to growth benefit only the holders of capital, and that growth doesn't appear to be related in a very systematic way to domestic saving anyway, encouraging the current capital owners to hold and reap the returns to ever greater quantities of capital seems like basically useless public policy -- and downright destructive when the cost is in terms of public saving or public services. A serious (Democratic) Congress would be more interested in spreading the distribution of capital holding -- and hence returns -- across the entire population, thereby spreading that the positive micro-effects of holding wealth rather than trying to maximize the dubious macro effects of more saving by the rich. The liberal economists are right.
In the debate over the taxation of investment income, liberal economists tend to argue that, if favourable tax treatment of investment income is to occur, the tax benefits of saving should be directed at individuals with relatively low income, whose marginal contribution decision to a saving account takes place at a low dollar value (corresponding to their relatively low dollar value of income).
This can be done in one of two ways: (1) by conditioning the tax treatment of contributions to saving on the financial or demographic characteristics of the contributors themselves; or (2) by offering favourable tax treatment only at the low levels of investment income feasible for the non-rich. Combinations of these approaches can be and often are also used: the amount of saving eligible for favourable tax treatment can vary by the contributor's income, health or age status.
However, some rightwing economists argue something close to the opposite: it's actually more efficient to give favourable tax treatment only to very high dollar levels of investment contributions, i.e. to those made disportionately by the rich. The basic reasoning is that (a) the saving of the rich has a disproportionately large effect on the economy and (b) the marginal saving decision of the rich (i.e. the amount of saving at which the value of contributing an additional dollar to saving is just equal to the value of consuming it now) takes place at a relatively high contribution level.
To explain the latter point: suppose the income tax rate I face is 15% and I'm planning to save $12,000 of my income this year in a regular non-tax-prefered saving account. If the government implements a policy that allows me to write off the first $2000 of that saving from my current taxable income, then it will have only a small effect on my saving decision through my slight ($300) increase in after-tax income. But if the government institutes a policy that allows me to write off any contribution I make to my saving above $12,000, then every additional dollar I contribute to saving suddenly has a lower cost in terms of current consumption (instead of $1, it costs me only $0.85) -- which will probably induce me to save quite a bit more.
Traditionally in the US, the structure of Roth IRAs has conformed more to the former (liberal) theory than to the latter (conservative) one: that saving incentives should be designed to encourage a more equal distribution of wealth holdings than just to stimulate the total gross amount of saving being done by the private sector. Roth IRAs are a very lucritive way of saving, because contributions are taxable in the year they are made (i.e. they are not tax deductible), but eligible withdrawals (after retirement or disability or for homebuying) are not taxable. The result is that the interest earnings on Roth IRAs end up untaxed. Worse, from an equity point of view, the likelihood of their being untaxed increases with the certainty the individual faces in his lifecycle path -- the unlikelihood of having to make early withdrawals. By contrast, regular IRAs and Canadian RRSPs are tax deductible in the year they are made, but are taxable as earned income in the year they are withdrawn. The result is that both the principle and the interest end up being taxed -- though they may be taxed at lower rates in a progressive income tax system if withdrawals are made in periods of otherwise low earnings.
The progressivity of Roth IRAs comes from the fact that they are limited to people having what we might consider upper-middle-class earning status or less. Currently, a single filer need an earned income of $110,000 or less to be eligible to contribute. In other words, Roth IRAS are not presently a way for the super-rich to avoid paying tax on investment earnings. Shockingly, the Republicans want to change all that by allowing anybody -- regardless of income -- to convert regular IRAs to Roth IRAs starting in 2010.
Though it's being called a gimmick, it looks to me (without reading the details) like a fairly pure way around the income-limit on contributing to Roth IRAs. Under the policy as described, the rich can simply make a contribution to their regular IRA starting in 2010, then redirect it to their Roth IRA, paying imcome tax on it when it moves, in 2011, and so on going forward. Even if this tactic is prohibited, recall that the Bush tax cuts have greatly increased the contribution limits on regular IRAs over the next few years. This makes for a larger pot of money that can be shifted into the Roth IRA tax shelter starting in 2010. All that's left is for the Republicans to push for raising contribution the contribution limits into Roth IRAs in the future.
By definition, this amounts to a giant tax cut to the wealthy. There are also budget effects. As Kevin Drum points out, one effect is to make short term budget deficit projections look nicer, because of the income tax that gets paid when the population of US millionaires switches their holdings from regular to Roth IRAS in the first few years after 2010. (In this way, it works a lot like the 1997 capital gains tax cut, which pushed the federal budget across the lines into surplus, as stock holders, free from the full capital-gains tax burdan, rearranged their portfolios and paid out the reduced taxes on the profits from their stock sales.) But the long-run cost to the treasury is the interest earnings that accrue to the principle once it moves into the Roth IRAs.
There's no defence of such a plan to be made on equity grounds. To the extent that any additional private saving generated is offset by public dissaving as the treasury bleeds future revenues, there's no aggregate saving defence to be made either. But what about the "efficiency" or pro-growth grounds of, as Bush put it, "extend[ing] policies that have helped our economy flourish"?
Bear with me. What follows certainly isn't cutting-edge theory, and I'm sure models exist that can spin the effects positively. But using traditional economic theory, the growth argument is based on the idea that domestic (private) saving has a direct influence on the domestic capital stock -- the basic version of the supply-side stimulus. But in the global economy with liquid financial markets and a prevailing world interest rate, the relationship doesn't hold, because saving will flow to any international arbitrage opportunity. (This is not, of course, a very accurate description of the real world, but neither is the traditional domestic saving = domestic investment relationship on which a lot of pro-growth arguments were originally based.) The returns to capital will still increase domestic wealth, but only through the private wealth of the individual actually holding the capital.
As well, the greater wealth of those domestic rich owners of capital might cause them to consume more, stimulating domestic demand, i.e. the demand-side version of ye olde trickle down effect. And the US economy is in fact growing at a good clip -- even though domestic private saving, particularly household saving, continues to be historically low. But a pretty good case can be made that, right now, other than through the effect on employment, the additional returns of economic growth are accruing almost exclusively to capital and to "entrepreneurship" (i.e. upper-level management, also the main capital-holding class) -- not to labour.
Explaining why that is isn't my intention here. But suffice to say that, to the extent that the returns to growth benefit only the holders of capital, and that growth doesn't appear to be related in a very systematic way to domestic saving anyway, encouraging the current capital owners to hold and reap the returns to ever greater quantities of capital seems like basically useless public policy -- and downright destructive when the cost is in terms of public saving or public services. A serious (Democratic) Congress would be more interested in spreading the distribution of capital holding -- and hence returns -- across the entire population, thereby spreading that the positive micro-effects of holding wealth rather than trying to maximize the dubious macro effects of more saving by the rich. The liberal economists are right.
2 Comments:
I agree with your main point. While we're on the topic, one equity benefit of taxing the withdrawal, not the contribution, is that it mitigates some of the variance in rates of return for different investors.
i.e. the person whose investments tank gets a break on taxes, whereas the person whose investments went through the roof faces a bigger tax bill - instead of them both, all else equal, paying the same amount of taxes on their savings.
So it's fairer this way - espcially if you buy into the theory of efficient markets, in which the variation in rate of return is primarily a function of luck.
In my view, there's a problem with all this gimmicky wonky tax policy. No regular person with kids to take care of, a full time job, and who does their own taxes is going to think about stuff like this.
If they are lucky enough to have disposable income to save, they're simply going to make a decision to save or not, and then do it.
To me that is the elegance of the 401k plan. It happens, and you don't have to have any disciple, after the first decision to do it. I think the best way to improve it is to simply make it an opt-out plan instead of an opt-in plan.
Not to neglect current events and the Republican attempts to further fatten the pockets of the rich.
Liberals (I am one of them) have this bad habit of taking ideas that conservatives propose with alterior motives, and then talk about how to make them do what they are being sold to do. But that just gives the idea credibility. (There's no such thing as bad publicity!)
It seems to me, the best come-back to insincere proposals like this one is to take the stated purpose at face value, and propose the actual best plan to achieve that purpose, rather than entain the plan.
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