What If We Ended 401(k) Tax Breaks to Save Social Security?

Better Spent on Social Security?

As Biggs and Munnell point out, the 2023 Social Security Trustees Report projected that, over the next 75 years, Social Security faces an actuarial deficit of 1.3% of gross domestic product. Over the same period, the Congressional Budget Office estimates a larger shortfall of 1.7% of GDP.

"As discussed, the U.S. Treasury's 2020 estimated net present value of the retirement tax expenditure was about 0.9% of GDP, and the CBO's estimate for 2019 was similar," Biggs and Munnell note. "In addition, including the effects of foregone payroll tax revenues would bring the total up to 1.3% of GDP, according to the CBO. Rollbacks of the ineffective retirement saving tax preference could fill a substantial portion of Social Security's long-term funding gap."

In the shorter term, the revenue gains from reducing or eliminating the retirement tax preference would exceed the net present value figures estimated by Treasury and the CBO, because even if the tax preference were immediately eliminated today, the federal government would continue to collect income taxes on retirement plan benefits that were subject to the tax preference at the time the contributions were made.

"Reallocating the proceeds from eliminating or reducing the retirement tax expenditure to Social Security could help Democrats and Republicans bridge the decades-long divide over whether to maintain Social Security's solvency by raising taxes or reducing benefits," Biggs and Munnell conclude. "Redirecting the tax expenditure to Social Security would reallocate existing funds that do not significantly improve retirement income security to a program that indisputably does."

The Counter-Argument

In their rebuttal, the GMU researchers emphasize that they have the "utmost respect for Biggs and Munnell and regard them as friends and colleagues," but they believe the plan laid out above would fail to address the serious challenges within Social Security itself — in addition to significantly weakening retirement savings outside of the Social Security program.

"Consider the traditional metaphor of the three-legged stool of retirement security," the GMU team writes. "The three legs consist of Social Security, employer-sponsored retirement programs, and individual savings. All three together are supposed to provide a stable and secure retirement. The Biggs-Munnell proposal would effectively cut two legs off the stool — the employer retirement programs and indi­vidual savings — thus creating a pogo stick of retirement policy."

As the GMU authors argue, the money that individuals set aside in their private or workplace retirement accounts is typically income that has already been taxed (in the case of a Roth-style account) or which will be taxed in the future once withdrawn (in the case of a traditional 401(k) or IRA).

"Taxing the returns on these savings again would amount to a second layer of taxation on the same income," they warn. "To say that it will be extremely disruptive of Americans' saving is an understatement. … If savings are excessively taxed — and double taxa­tion would surely qualify as excessive — they are heavily discouraged, leading to lower levels of investment and a slower rate of economic growth. Biggs and Munnell downplay this concern with the finding that the current exemptions do not encourage savings. However, there are reasons to question this claim."

According to Rugy, Blahous and Fichtner, many low-income workers actually expect higher standards of living in retirement than while working — not because their retirement benefits are lavish but because their working income is so modest.

"To doubly tax individual savings so that politicians can avoid moderating the rate of growth of Social Security costs would destroy the remaining incentive or capacity for countless families to save anything at all," they argue. "The bottom line is that the starting point of the Biggs-Munnell paper, that tax deferred-saving accounts are essentially a government spending program for the rich, one that we may as well spend in a different way, is fundamentally flawed."

The authors further argue the Biggs-Munnell proposal "incorrectly categorizes tax-deferred saving accounts as subsidies for the wealthy, glossing over their essential function of preventing double taxation of savings for all Americans."

Moreover, they conclude, the idea of using these funds to bail out Social Security would not only undermine the program's self-funded nature but also exacerbate generational inequities, placing an unfair financial burden on younger generations.

Arguing Against a 'Bailout'

Rugy, Blahous and Fichtner go on to argue that Social Security has its problems and challenges, but it also has some cardinal virtues — one of them being that it's not permitted to spend more on benefits than the resources collected for its trust funds, the vast majority of which consist of payroll taxes paid by participating workers.

"Individually, one's Social Security benefit is a direct function of one's earnings subject to the Social Security tax, and collectively, the program may not pay more in benefits than workers are deemed to have funded with their contributions," they emphasize.

"This is the critical distinction that separates Social Secu­rity from welfare both politically and substantively," they write. "Largely because of this feature, workers' Social Security benefits have historically been secure and reliable, without the persistent renegotiation of eligibility rules and benefit levels to which welfare programs are subjected."

To "bail out" Social Security with general revenues, regardless of the rationale, would effectively put an end to Social Security's continued functioning as an earned-benefit program, according to Rugy, Blahous, and Fichtner.

"Thereafter, there would be no rhyme or reason to the benefit levels that Social Security offers," they warn. "Once disconnected from the amounts of workers' contributions, benefits would simply be whatever politicians say they are. This would be the worst of both worlds from a policy standpoint, in that program spend­ing would effectively be unleashed from the constraints of self-financing, while at the same time workers' benefits would be less secure, since they could no longer be defended as earned. Social Security would simultaneously become more expensive and less reliable."

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