Issue Brief: Savings Incentives Work

Targeted retirement saving vehicles such as Individual Retirement Accounts (IRAs) and 401(k) plans have boosted private saving since 1980, according to a new National Bureau of Economic Research study by Professors James M. Poterba of MIT, Steven F. Venti of Dartmouth College, and David A. Wise of Harvard University. The availability of IRAs and 401(k)s has generated new saving and helped to keep the declining U.S. personal saving rate from falling as low as it would have otherwise.

The Structure of U.S. Personal Saving

Employer-provided pension plans (defined benefit and defined contribution) have been the dominant retirement saving vehicle for U.S. households throughout much of the postwar period, according to Professors Poterba, Venti, and Wise (PVW). During the 1980s, however, a number of specialized programs designed to encourage household saving were introduced or expanded, and in some cases, subsequently restricted. These programs, principally IRAs and 401(k)s, offer many of the same tax benefits as traditional employer-provided pensions.

While a variety of regulatory and tax changes reduced the appeal of traditional pension arrangements during the 1980s, IRAs flourished in the early half of the decade while 401(k)s expanded thorughout the eighties. IRAs were significantly liberalized by the Economic Recovery Tax Act of 1981, which permitted taxpayers to make annual tax-deductible contributions to IRAs subject to a limit of $2,000 per earner and $250 for a nonworking spouse.

A second retirement saving program, known as the 401(k) plan after that section of the Internal Revenue Code, grew in importance throughout the 1980s. These plans were established by 1978 legislation, but they expanded rapidly only after the Treasury Department clarified their operation in 1981. The plans are established by employers. They allow employees to contribute before-tax dollars to 401(k) accounts and employers can "match" employee contributions. Like IRAs, assets in 401(k) plans accumulate tax free and income from these plans is taxed only when the funds are withdrawn.

Participation in IRAs and 401(k)s

IRAs became very popular in the early 1980s, and at their peak in 1985 more than sixteen million taxpayers contributed nearly $40 billion to these accounts (see Figure 1). The changes imposed in Tax Reform Act of 1986 reduced the incentives for some households to contribute by eliminating deductible contributions for higher-income taxpayers and by reducing marginal tax rates on capital income accruing through traditional channels. Single taxpayers with incomes less than $25,000 and joint filers with taxable income less than $40,000 could make fully deductible contributions. Single filers with income above $35,000 and joint filers with incomes above $50,000 could not make tax-deductible contributions. By 1990, fewer than six million taxpayers reported IRA contributions of just under $10 billion.

The 401(k) plans grew rapidly during the past decade. Between 1984 and 1989, the number of plans more than quadrupled, and the number of participants more than doubled. Contributions increased faster than the number of participants, even though the Tax Reform Act of 1986 reduced the maximum contribution from $30,000 to $7,000 per year, indexed for inflation (see Figure 1). The number of employees making 401(k) contributions is now substantially larger than the number of IRA contributors. These plans are available at virtually all large firms, and are diffusing through smaller firms as well.

IRAs, 401(k)s, and New Saving

To estimate whether a household's contributions to IRAs and 401(k)s represent new saving, the authors examine changes in median balances in these two savings vehicles and compare them to changes in median holdings of other financial assets. Table 1 shows the median holdings of all financial assets and median balances in targeted saving plans, by individuals with and without IRAs, and with and without 401(k)s, in 1984, 1987, and 1991. In 1984, the median IRA balance of households with IRAs was $4,500. The median of non-IRA financial assets, excluding stocks and bonds, was $6,550 ($9,400 including stocks and bonds). By 1991, the median IRA balance for households with an IRA was $10,500, and the median non-IRA balance was $7,867 ($10,900 including stocks and bonds).

In contrast, the median financial assets for households without IRAs was only $1,500 in 1991, including holdings of stocks and bonds, and was only $800 seven years earlier. The low level of median asset holdings indicates that a majority of households save very little. The finding that median non-IRA financial assets change very slowly for both groups of households is important evidence that IRAs have a positive impact on personal saving.

The broad pattern of results for 401(k) families is similar to that for IRAs (see Table 1). Households without 401(k)s have very low levels of total financial assets, and their assets change little over the period 1984-1991. Families with 401(k)s show a large increase in total financial assets from 1987 to 1991. The summary statistics in Table 1 provide important evidence on the question of whether longer "exposure" to IRAs, or 401(k)s, results in higher levels of saving. Non-IRA, non-401(k) assets do not appear to decline as either IRA and 401(k) assets increase. There were large increases between 1984 and 1991 in the total financial assets of families with both IRAs and 401(k) accounts, but little change in their non-401(k) financial assets. There were also substantial increases in the total financial assets of families who had IRAs only or 401(k)s only, but no decline in their non-IRA or non-401(k) financial assets.

It is difficult to argue that these differences are due to some type of unquantified differences among households.

Conclusions

Individual saving through targeted retirement saving accounts-IRAs and 401(k)s in particular-grew rapidly during the 1980s. While aggregate measures of personal saving show a sharp decline in the late 1980s, following the Tax Reform Act of 1986 and the fall in IRA saving, the 401(k) component of saving was rising, forestalling what could have been an even sharper decline in personal saving. Contributions to targeted saving accounts currently account for approximately one-third of the flow of personal saving measured in the National Income and Product Accounts. Studies of asset accumulation patterns for those who do, and do not, contribute to these plans suggests very little substitution between saving in these plans and other forms of personal saving. This suggests that most of the contributions to these plans represent saving that would not otherwise have occurred, PVW concluded.

Note

1. James M. Poterba, Steven F. Venti, and David Wise, The Effects of Spread Saving Programs on Saving and Wealth, NBER Working Paper 5287, October 1995.

Ways and Means Chairman Archer Releases Center Capital Gains Studies

The Honorable Bill Archer (R-TX), chairman of the House Ways and Means Committee, hosted a press conference on October 24 to release three new analyses of the economic impact of capital gains tax cuts.

These analyses were sponsored by the ACCF Center for Policy Research, the economic research affiliate of the American Council for Capital Formation, and are part of a series of Center-sponsored research projects in 1995 focusing on the economic growth elements of the tax provisions under consideration by Congress. In addition, the Center earlier underwrote research on the positive impact of repeal of the alternative minimum tax and expansion of individual retirement accounts. This timely research has helped shape the debate in Congress this year on the need to enact tax provisions to promote strong and sustainable economic growth and job creation.

The Center-sponsored studies released by Chairman Archer demonstrated that the reductions in capital gains taxes proposed in the Contract With America Tax Relief Act of 1995 (H.R. 1215) would provide a substantial boost to the economy. Macroeconomic analysis undertaken for the Center by the prominent economic forecasting firm of DRI/McGraw-Hill, for example, showed that the capital gains tax cuts in the Contract would, over the 1996-2005 period:

• Increase fixed investment by a total of 7.8 percent;
• Raise GDP by a total of 1.7 percent;
• Expand the capital stock by 6.0 percent;
• Increase labor productivity by 1.9 percent;
• Reduce the cost of capital by almost 12 percent;
• Increase federal tax revenues by almost $23 billion.

Also, an average of 233,000 additional jobs per year would be created during the 1998-2000 period

The Seven-Year Balanced Budget Reconciliation Act (H.R. 2491), passed in mid-November by both houses of Congress, includes most of the capital gains provisions offered by the Contract With America. H.R. 2491 provides: (1) a 50 percent exclusion for capital gains of individuals resulting in a maximum capital gains tax rate of 19.8 percent; (2) a 28 percent capital gains tax rate for corporations; (3) a capital loss deduction for the sale of a principal residence; (4) small business stock provisions for individuals and corporations; and (5) indexing of capital gains for assets acquired on or after, and principal residences held on January 1, 2001. These provisions, along with measures to substantially reform the alternative minimum tax and expand IRAs, make up the economic growth centerpiece of the congressional budget package.

U.S. tax rates on capital gains are currently among the world's highest. The Center-sponsored studies concluded that lagging saving and investment would get a much-needed boost if capital gains taxes on individuals and corporations were reduced substantially, as provided in H.R. 2491. Start-up companies and small businesses would also benefit from lower capital gains tax rates since taxable investors are a major source of seed money for entrepreneurs.

At the October 24 press conference, Chairman Archer commended the ACCF Center for Policy Research for the valuable contribution its research on the effects of cutting capital gains taxes had made to the 1995 tax policy debate. Dr. Margo Thorning, the Center's director of research, joined Chairman Archer to discuss the Center's research on the economic consequences of capital gains tax cuts.