Tax incentives for retirement saving don`t work (what does?)

Most countries, if not all, encourage saving for retirement by taxing retirement savings in private pension plans more favourably than savings in alternative vehicles. The goal is to increase how many people save for retirement and how much they save and with that enable them a better life in retirement. 

Most countries apply a variant of the “Exempt-Exempt-Taxed” (“EET”) regime to retirement savings, where both contributions and returns on investment are exempted from taxation while benefits are treated as taxable income upon withdrawal. There are also other regimes (EEE, TTE, …), but I won’t bore you with them. The main question remains, do tax incentives actually increase retirement savings and at what cost?

Do they work? Not really.

There is a growing body of literature confirming the effect of tax incentives on retirement savings is very limited and also very expensive. According to John Friedman, retirement saving incentives in the US reduced in 2016 the government revenue by $180 billion, which is just over 5 percent of the total federal tax revenue. He finds tax subsidies for retirement saving have a limited effect on how much households actually save and that an increase in savings is in most cases attributed to shifting assets from taxable accounts to retirement accounts, which does not increase the total savings rates, as incentives largely benefit wealthy households who would save anyway. 

A very vivid example of how tax incentives have a limited effect on retirement saving is my home country of Slovenia, whereas in most countries, the government incentivizes private retirement saving. If you save on your own the contributions reduce your income tax base and you get part of the contributions back the next year. For example, if you invest in a pension fund annually €2.000 and are in the highest tax bracket, you get refunded €1.000. Not bad, right and for sure lots of people take advantage of this fantastic tax incentive. Not really, as approximately only 2% of all employees in Slovenia have individual retirement plan. For sure the tax incentive is not the only one to blame for this low number, but it also clearly demonstrates that in the last 19 years, that the tax incentive exists, it convinced almost no one and the percentage of savers did not change over time. You can read more on private pension plans in Slovenia in my LinkedIN article.   

The same findings are confirmed by a large sample study from Denmark that finds tax incentives for retirement accounts, which rely upon individuals to take an action to raise savings, mainly induce individuals to shift assets from taxable to retirement accounts. They estimated that fewer than 20 percent of people respond to changes to tax incentives and that each $1 of government expenditure on incentives increases total saving by only 1 cent. On the other side they find policies that raise retirement contributions if individuals take no action – such as automatic employer contributions to retirement accounts – increase savings rates substantially. Automatic contribution policies also have lower fiscal costs, generate relatively little crowd-out, and have the largest impacts on individuals who are paying the least attention to saving for retirement.

What works?

Automatic enrolment in retirement saving is a great example of behavioral economics in action, where workers are defaulted into saving, but can always opt out. The United Kingdom is a great example of a successful implementation of automatic enrolment in retirement plans which was phased in from 2012, and now after 8 years it is still going strong with opt-out rates of only 9 percent. To date it has helped over 10 million people to start saving for retirement making it a great success. 

Some US states are also following the lead with implementations of state-sponsored retirement savings plans in which employees are automatically enrolled. Oregon’s plan called OregonSaves began in 2017, Illinois began its programme in 2018 and California started its  CalSavers programme at the end of 2018. Even better, more and more states are following their lead. Results so far from all the state plans are very encouraging and many new employees are now covered by retirement plans making a huge impact on their future life quality, showing jet again it’s not about tax incentives, but about designing smart retirement plans incorporating the latest findings from behavioral economics and with the help of modern information technology sky is the limit.