Tax-deferred 401(k) plans may be a better deal for low-income workers than economists thought, according to new research by my Tax Policy Center colleague Eric Toder and Urban Institute senior research associate Karen Smith.
While high-income workers may get a bigger tax break from their 401(k)s, they also face a short-term trade-off. That’s because their employers tend to offset their contributions to these plans by paying them less in wages. But Eric and Karen found while lower-wage workers get less of a tax benefit than their higher-paid colleagues, their wages fall by much less for every dollar their employer contributes to their retirement plan.
Until now, economists assumed salaries of low-wage workers fully offset employer payments to their (k) plans. But Eric and Karen found that may not be true for lower-wage workers. Thus, while they enjoy both their employer’s contribution and a modest tax reduction, their employer doesn’t reduce their cash wages to fully offset those benefits. Bottom line: Total pre-tax compensation for low-wage workers who participate in 401(k)s increases while it remains about the same for those making more money, who get all their benefits from tax-savings.
To understand what’s happening, think about this phenomenon in two pieces. First, the tax break: An employee’s contribution to her 401(k) plan is tax deferred. She pays no tax upfront on wages that she contributes, but is taxed when she withdraws the money after she retires. Usually, though, she’ll be paying tax at a lower rate since her income in retirement is likely to be lower.
Most important, she gets to earn money tax-free within the retirement plan. And that can be a big benefit.
However, the ability to exclude both contributions and earnings from income is much more valuable to someone in the 35 percent bracket than to a co-worker in, say, the 15 percent bracket.
The second part of the story is what happens to wages. The traditional theory has been that a dollar of fringe benefits (such as a retirement plan or health insurance) reduces wages by a dollar, leaving total compensation unchanged.
But by matching workers’ earnings histories to their retirement plan contributions and other fringe benefits as well as other worker charateristics, Eric and Karen found that wages for low-income workers hold up much better than those of high-earners when their employers increase their contributions to (k) plans.
And sometimes, the difference is dramatic. For example, if an employer increases its contribution by $1 for workers already in a plan, that extra benefit replaces only 11 cents of wages for a low-income woman but 99 cents if she is in a high-income family.
Why the difference? Eric and Karen figure it’s because many low-income workers benefit less from a dollar their employer contributes to their retirement plan than from an extra dollar of cash wages and thus place less of a value on their 401(k). For instance, their own contributions reduce their ability to pay for ordinary living expenses, employer contributions cut their future Social Security benefits (since they don’t count in Social Security benefit calculations) and, because they are in relatively low tax brackets, they gain little from their ability to defer tax on their earnings.
Eric and Karen acknowledge their results are preliminary. But their results tell policymakers that encouraging people to contribute more to to their 401(k)s could increase the total compensation of low-wage workers. And that’s an important message.
A new Tax Policy Center analysis finds that Mitt Romney’s tax plan would cut taxes for millions of households but bestow most of its benefits on those with the highest incomes. At the same time, it would significantly cut corporate taxes and add hundreds of billions of dollars to the deficit.
Compared to current law (assuming the Bush/Obama tax cuts expire as scheduled at the end of this year), Romney would cut taxes by $600 billion in 2015 alone. Relative to a world where those tax cuts remained in place, he would add about $180 billion to the deficit in that year.
In many ways, Romney’s tax plank is a fairly mainstream Republican offering. No major tax reform. Certainly no 9-9-9-like proposal to replace the current revenue system with a consumption levy. And while Romney is proposing huge tax cuts, they are more modest than those of his rivals. Newt Gingrich’s tax package, for instance, would add $1 trillion to the deficit in 2015. Still, a $600 billion tax cut is worthy of note.
For individuals, Romney starts by making permanent both the 2001 and 2003 tax cuts and the “patch” that protects millions of middle- and upper middle-income households from the Alternative Minimum Tax.
At the same time, he’d end President Obama’s 2009 stimulus tax reductions, including Obama’s more generous versions of the child tax credit and earned income credit—both aimed at helping low-income working families. He’d also repeal the tax increases included in the 2010 health reform law.
But Romney doesn’t stop there. He’d make capital gains, dividends, and interest income tax-free for those making less than $200,000 and repeal the estate tax (though he’d retain the gift tax).
He’d cut the corporate rate from 35 percent to 25 percent, make the research and experimentation tax credit permanent, and temporarily allow firms to continue to write-off the full cost of capital investment as soon as they acquire the property. Multinationals would get a temporary tax holiday for overseas profits they bring back to the U.S.
Compared to current law, about 44 percent of those making between $10,000 and $20,000 would get a tax cut that would average about $274. No one in that income group would pay more, but more than half would see no change in their tax bill.
Nearly all middle-income households would get a tax reduction. Among those making $50,000 to $75,000, the average tax cut would be about $1,800.
But much of the largess goes to those with the highest-incomes. Households making more than $1 million would get an average tax cut of almost $300,000, largely because, as owners of capital, they’d receive the bulk of the benefit of Romney’s very generous corporate tax reductions. While those making $1 million-plus pay about 20 percent of all federal taxes, they’d receive more than 28 percent of Romney’s tax cuts.
The story is a bit different if you start by assuming the Bush/Obama tax cuts are made permanent. Compared to that already-generous law, the average tax cut for all households shrinks from $3,500 to about $1,000 and a sizable number of low-income families would see their taxes go up.
For instance, about 15 percent of those in the $10,000 to $20,000 income group would get an average tax cut of about $140, but 20 percent would get hit with an average tax increase of $1,000, mostly because Romney would bring back the less generous versions of those refundable child and earned income credits.
About one-third of those in $40,000 to $50,000 group would get a tax cut that would average about $400, but about one-six would face a tax increase of nearly twice as much.
Almost everyone who makes more than $1 million would get a tax cut averaging roughly $150,000. As a group, they’d receive nearly half the benefit of Romney’s tax plan.
Romney says he’d rewrite the entire tax code–someday. But he doesn’t say how or when. Until he does, a Romney Administration’s revenue agenda would look a lot like President George W. Bush’s, just more so.
With Rick Santorum surging in Iowa, it is a good time to take a look at his tax agenda. While his revenue plan has received almost no attention, it plays a major role in his “faith, family and freedom” campaign. His playbook: lower rates for individuals and corporations, substantially cut taxes on capital, and increase the personal exemption for dependent children.
The Tax Policy Center has not yet formally modeled the former Pennsylvania senator’s tax platform. However, because it cuts rates significantly but does not eliminate tax preferences—and even expands a few—it would very likely add trillions of dollars to the federal deficit. Looked at from that prism, it is not so different from the ideas raised by most of his GOP rivals.
Like other Republican tax planks, Santorum’s would benefit corporations and high-income individuals. No surprise there. But unlike his rivals, he’d also cut taxes for many families with children.
Santorum is no bleeding heart, however. Even as he’d cut their taxes, he’d shred direct government spending for programs aimed at assisting these same households. As part of his plan to cut federal spending by $5 trillion over five years, he’d immediately slash many domestic programs to 2008 levels, and freeze for five years spending for social programs such as Medicaid, housing subsidies, food stamps, education, and job training.
Interestingly, by using tax expenditures to support these families, Santorum would likely add significantly to the number of households that pay no income tax. This is anathema to current Republican orthodoxy, although not something that would trouble Milton Friedman.
Specifically, Santorum would:
- Replace the current individual rate structure with just two rates—10 and 28 percent
- Lower rates on capital gains and dividends to 12 percent
- Triple the personal exemption for dependent children and keep the refundable earned income and child tax credits
- Retain tax preferences for charitable giving, mortgage interest, health care, and retirement savings
- Repeal the Alternative Minimum Tax
- Cut the corporate rate in half to 17.5 percent. Manufacturers would pay no income tax
- Allow full expensing for capital investment
- Increase the R&D tax credit to 20 percent
- Allow multinationals to bring foreign earnings back to the U.S. at a 5.25 percent tax rate but at a zero rate if they used the funds to buy “manufacturer’s equipment”
Santorum’s plan cleverly melds the interests of social conservatives and business. This should play well in future GOP primaries. If he somehow gets the nomination, he’ll still have to explain the huge hole he’d blow in the budget. But I don’t suppose he’s much worried about that now.