As America hurtles toward the fiscal cliff, there’s an increasingly frantic search for ways to shore up the country’s deteriorating balance sheet. Republicans want to cut spending; Democrats would prefer to raise taxes on the wealthy. But a paper released today by Harvard and Danish researchers highlights just how much room there could be to generate more government revenue without sacrificing economic efficiency—in other words, the type of policies that both parties could conceivably learn to love.
The study analyzes the responses of Danish taxpayers to savings incentives—much like those that exist for American 401(k) and IRA accounts—and also behavioral “nudges” that automatically deduct retirement savings from workers’ paychecks. It turns out that savings incentives had scarcely any impact on the rate at which Danes accumulated nest eggs, while the nudges were very effective in making people save. These findings suggest that 401(k) plans and their brethren—which cost the U.S. government as much as $100 billion a year in lost revenue—don’t do much to further their stated objective of boosting retirement savings. Even if $100 billion wouldn’t go all that far toward solving America’s debt problems, it suggests that smart approaches to eliminating or improving government programs could quickly add up to fiscal solvency—and might help the two sides find common ground.
The reason we have tax shelters like the 401(k) is to change the relative cost of spending money today versus saving for tomorrow. Exempting retirement investments from taxation increases the saver’s return on his investment, so a rational cost-benefit calculation should lead most people to put something away for the future. In theory, such tax shelters should go some way toward correcting Americans’ problem of undersaving.
But these policies assume that, despite being impulsive spenders, we will respond like textbook economic agents by saving more when tax exemptions make saving cheaper—an unlikely proposition. Even if savers do put more money in a 401(k) as a result of tax incentives, they might simply do so by reducing their investments in other non-exempt accounts, rather than saving more overall. Whether tax shelters actually encourage higher savings is a matter for the data to decide.
The lack of necessary data on Americans’ incomes and savings is what motivated Harvard economists Raj Chetty and John Friedman to partner with researchers in Copenhagen, who had access to the complete tax records of every Danish citizen over the past couple of decades. What’s more, some recent changes in the Danish tax system allowed them to examine how taxpayers respond to shifts in tax-based incentives to save.
The study focuses on a Danish tax reform in 1999 that, for taxpayers in the highest tax bracket, reduced the subsidy for pension contributions by 13 cents on the dollar (or more precisely, 13 ore on the Danish krone). As a result, saving got more expensive for earners above the top bracket cutoff of 268,000 DKr (about $41,000), while remaining unchanged for those earning under the threshold. To assess the impact of savings incentives on pension contributions, the researchers examined the change in savings for high earners who lost their subsidy, using those below the cutoff as a control group.
It turns out that a little less than 85 percent of Danes affected by the change did nothing to respond to the shift in savings incentives—they put money in their pensions at about the same rate in 1999 as they did the year before. Even among the minority that did cut their pension contributions in response to the new rule didn’t save much less overall—they simply put more away in other investments. Based on these findings, the authors estimate that every dollar that the Danish government spends to encourage pension contributions generates only about a penny in extra savings.
