Bring Back Those IRA Days
Economic growth is underwritten by savings, and Americans haven’t been doing at all well when it comes to providing for future growth. A dismally small fraction of personal earnings is set aside as savings; for some years now the rate has stayed below 5%. What can be done to expand the savings pool and so provide more capital for productive investment? One proposal is to discourage consumption by putting a special tax on many of the things we buy. An alternative approach is to reward savings with tax advantages. The government did that earlier this decade by making Individual Retirement Accounts tax-deductible for everyone. For many people, though, that advantage disappeared with the 1986 tax law. Now there’s a proposal to again broaden the tax advantages of IRAs.
At present, the only people eligible for fully tax deductible IRAs are those with incomes under $25,000 ($40,000 for couples) who aren’t covered by company pension plans. Partial deductibility is allowed for people making up to $35,000 ($50,000 for couples). Sen. Lloyd Bentsen (D-Texas), chairman of the Finance Committee, would let all taxpayers, regardless of income or enrollment in a pension plan, contribute up to $2,000 a year to an IRA and avoid current taxation on half that sum. In addition, Bentsen would allow penalty-free withdrawals from IRAs to finance first-time home purchases and college expenses. The cost to the Treasury, he says, would be $1.2 billion in the first year of the plan, rising to $4 billion after five years.
That’s not a modest loss, but on the other side of the equation offsets could be expected. If the economy grows more vigorously than expected because more capital becomes available for investment, then government tax revenues would rise. If interest rates are nudged down even slightly because the savings pool has expanded, the government’s debt-servicing costs should fall.
Bentsen’s IRA proposal was conceived as a Democratic alternative to President Bush’s effort to have capital gains taxed at a lower rate than ordinary income. That idea has attracted some bipartisan support in the House and won narrow endorsement from the Ways and Means Committee. It has also come under strong attack because most of the tax benefits would go to the well-off. Bentsen’s plan is, of course, not lacking in political calculation, since its appeal would be to the broad middle class, but that doesn’t disqualify it. The important question is whether increasing the tax advantages of IRAs would spur greater savings and so help economic growth. The evidence is that it would.
In 1986, the last year fully deductible IRAs were available to all workers, the accounts drew $38 billion from 15.5 million couples and individuals. In 1987, with tax deductibility sharply curtailed, only $14 billion was contributed by 7.4 million taxpayers. A recent study commissioned by Merrill Lynch Consumer Markets concluded that 80% of IRA contributions were “new” money, meaning money that wasn’t simply transferred from other existing savings. We don’t know if IRAs are necessarily the best way to encourage greater personal savings. But they do seem to be a proven way, and given the compelling need to increase the savings rate it seems to us that they’re an idea well worth trying again.
