The collection of Federal Government incentives encouraging us to set aside money for retirement (private sector DC and DB plans, federal, state, and local pension plans, 403(b) and 457 plans, the Federal Thrift plan, individual and employer-sponsored IRAs and all non-IRA fixed and variable annuity reserves at life insurance companies) is the largest federal revenue loser according to those whose keep score.  As a result the National Commission on Fiscal Responsibility and Reform will undoubtedly consider this system in its deliberations about how to reduce the federal deficit.

If asked this is what I would tell the members.  The government’s system of incentives encouraging retirement savings is one of the most effective government programs we have.  The purpose of this system is to accumulate assets that can be used by American workers in retirement.  It has done so amazingly well. Over the 20 year period, 1990 through 2009, the amount of assets in these programs grew from $4 trillion to $16 trillion.  This amount dwarfs the approximately $2 trillion in the Social Security Trust Fund.  We have set aside more money and more money per capita than any other country in the world.
 
I would also point out that the system of tax incentives for retirement savings in US is extraordinarily inexpensive.  That is because the tax expenditures encouraging retirement savings are eventually repaid, unlike other tax incentives in the code where revenue lost is gone forever.  Because of this, the revenue losses to encourage retirement savings are, in reality, but a small fraction of the amount usually reported.

There are three other tax ramifications that are rarely included in the discussion about the cost of government incentives for retirement savings.  First, because retirement system distributions are taxed at regular rates, the government collects a significantly higher tax on equity generated capital gains and dividends than had such income been generated outside our system.  Since approximately 60 percent of the assets in the retirement system are invested in equities, this additional amount alone more than offsets the revenue loss from our retirement system tax deferral.

Second, without tax-deferred retirement distributions few would have sufficient income to trigger the tax on their Social Security benefits and this tax would generate but a fraction of what is currently being collected.  (There was $170 Billion in taxable Social Security Benefits in 2008.)  Further, this tax is increasing and will continue to increase because retirement plan distributions are and will continue to grow. Also, once Social Security benefits are taxable they are subject to normal income tax rates which are progressive.  This means those who have accumulated the largest retirement balances have their Social Security benefits taxed at a much higher rate.  For better or worse, this further reduces the net benefit of Social Security to the more highly compensated.

Third, the government reaps significant tax revenue from the way it treats those under the age of 59 1/2 who take in-service distributions, cash distributions when they change jobs or default on a plan loan.  Not only do these participants pay regular income tax they also pay an additional excise tax of 10 percent of the value of the distribution.  Because most of the early distribution amounts are from short term savers with relatively small balances, the tax benefit of their deferral is barely measurable, and certainly no where close to 10 percent of the total amount.  This generates many billions of dollars a year in additional federal revenue.  Over $5 Billion was collected in 2008.

To summarize, the system is doing exactly what was and is intended, and doing it very well.  I suspect there were few in the 1980s who would have thought we would have $16 trillion in the system at the end of 2009.  In addition, the system is extraordinarily tax efficient, perhaps even generating a tax profit for the government over the long run.