Tax policy is often viewed as the primary method to encourage efficient financial behaviors among the population at large. Top economists may debate the extent to which taxation should be utilized to support positive economic objectives and reduce harmful ones, but it is generally agreed that tax policy should create some incentives for people to build wealth. In practice, however, current policy concentrates on helping middle and upper-income taxpayers, but real opportunities for low-income taxpayers are limited.
Take, for example, the mortgage interest deduction-which reduces a taxpayer’s taxable income and yields either a larger federal tax refund or increased equity for the taxpayer. The mortgage interest deduction does not benefit the large majority of low income taxpayers since they ordinarily do not itemize their deductions. In fact, a mere 30 percent of taxpayers itemize their deductions, with most “itemizers” being upper-middle and high-income households. As recently reported by the New York Times, approximately two-thirds of the total mortgage interest deduction benefit goes to taxpayers in “[the income] group in the 80th through the 99th percentiles.”
The lower rates on capital gains-which yield more savings and investment monies thus building wealth also flow disproportionately to high-income taxpayers. This group often earns the majority of their income via long-term investments, which are subject to a 15 or 20 percent rate-a rate that is much lower rate than those faced by low and moderate-income taxpayers who earn more than $34,500 a year in earned income. Strikingly, in 2013, an estimated 94 percent of the tax benefit from capital gains rates went to taxpayers with actual income of over $200,000 with 75 percent going to millionaires.
However, the Saver’s Credit (formerly known as the Retirement Savings Contributions Credit) is one tax incentive that is designed to foster the wealth building among low-income filers. The Saver’s Credit provides a tax break for low and moderate-income filers who make voluntary contributions to eligible retirement plans. Unfortunately, the Saver’s Credit is often complicated to understand, inefficiently advertised to the public and does not result in a tangible benefit to a large segment of qualified filers. As a result, many eligible people to not know about the credit and do not take advantage of it.
In its current form, the Saver’s Credit fails to achieve its original objective: to facilitate savings and retirement planning for low-income taxpayers. But the Saver’s Credit could be rescued, and its overall effectiveness could be increased dramatically through several structural modifications. The need to act immediately is clear because low and moderate-income taxpayers are the most likely consumers to need large-scale additional savings to meet adequate living standards in retirement. This is underscored by the fact that both Medicare and Social Security cannot sustain their projected long-run programs as they are currently financed. The end result of doing nothing will be a larger, low income population that is both ill-prepared and poorly motivated for retirement.
Saving the Current Saver’s Credit: Three Modifications to Increase Effectiveness
1. CONVERT THE SAVER’S CREDIT FROM A NON-REFUNDABLE CREDIT TO A REFUNDABLE CREDIT:
The most problematic shortcoming of the Saver’s Credit is that it’s a non-refundable credit. Thus, a low-income filer can only receive it if she has a tax liability to offset. If she does not, the taxpayer forfeits the credit. For example, if a taxpayer had $ 500 withheld from her paycheck and owes exactly $ 500 at the end of the year (and she has made retirement contributions during the year), she would not receive the credit. Since many low-income filers have no tax liability, a disproportionately large number do not receive any financial benefit from the Saver’s Credit
In a sampling of taxpayers by the Tax Policy Center, it is readily apparent that the credit does not result in any tax savings for many low-income filers. The study showed that 57 million taxpayers had incomes under the credit threshold, but only 20 percent could receive the credit. Moreover, only 64,000 filers-essentially one out of every thousand-could receive the maximum possible benefit allowed by virtue of the Saver’s Credit rules. The simplest way to correct this structural defect is to make it refundable, allowing the low-income filer to receive a credit check when her tax liability is at zero.
2. ALLOW THE SAVER’S TAX CREDIT TO BE TRANSFERABLE FROM YEAR TO YEAR
An additional structural shortcoming of the Saver’s Tax Credit is that it’s non-transferable. If a taxpayer is unable to use it in the current tax year, she cannot transfer it to the next tax year. This is a problem because most eligible taxpayers utilize other tax credits (not related to savings) that will exhaust their tax bill. Moreover, the frequent inability of a taxpayer to forecast if she will have any tax liability to offset- is a serious disincentive for low income filers to even bother with the Saver’s Credit. Enlarging the scope of the Saver’s Credit by allowing it to be transferable from year to year would be an effective way to correct this problem.
3. INCREASE THE VISIBILITY OF THE SAVER’S TAX CREDIT
In addition to the credit’s structural shortcomings, the Saver’s Credit does not have enough public visibility. The majority of taxpayers who qualify for the credit are not receiving it and only 20 percent of taxpayers with income under $50,000 are aware that the credit exists according to a detailed study after its enactment. Furthermore, it’s been shown that the “lack of knowledge [about] the credit” has “substantially decreased” the number of credits claimed. According to another study, 34 percent of eligible filers failed to claim nearly $ 500 million in credits and 43 percent of the claimed credits were-in fact-limited by tax liability. However, in addition to the fact that the Saver’s Credit suffers from a lack of visibility, many taxpayers who are aware of the Saver’s Credit do not fully understand how to receive the credit.
A significant outreach program should be established with simplified Tax Publications outlining the Saver’s Credit and these should be distributed locally. A related concern with the application of the Saver’s Credit is that filers cannot claim the credit using the 1040 EZ form (used by many low-income filers). To claim the Saver’s Credit, the filer must also submit a Form 8880 creating extra bookkeeping for low income filers and precluding many from taking advantage of it. More importantly, there is little reference to the Saver’s Credit in any of the forms. A revised 1040 EZ with a prominent notation of the Saver’s Credit would help alleviate this complication.
Why People Dislike the Saver’s Credit, Moving Beyond Political Arguments
The primary argument against the expansion of the Saver’s Credit is that it would result in an extraordinary cost to taxpayers in a climate that is becoming increasingly hostile to new and/or expanded tax expenditures. The Tax Policy Center estimates that making the Saver’s Credit refundable would cost approximately $29.8 billion over 11 years, or slightly less than $3 billion annually.
As such, a large-scale tax reform package that raises revenue and eliminates unnecessary deductions, exemptions and loopholes while simultaneously raising additional revenue, would be the optimal way to pay for it. A large-scale proposal of this nature may likely include the elimination of the deduction for interest paid on home equity loans in accordance with the National Commission on Fiscal Responsibility and Reform Plan (the Simpson-Bowles Plan), coupled with additional mortgage interest deduction restrictions. Of course, in deciding whether to increase or decrease a given tax expenditure, the paramount concern is in ensuring that the remaining tax expenditures provide the greatest benefit to filers who will actually utilize it and provide for the greatest social good.
In light of this, there are several reasons why modifying the home equity interest deduction may be a less restrictive way to cover the costs of converting the Saver’s Credit. First, there is a large population of low-income taxpayers who have not yet purchased their first residence. They would not be impacted by the reduction in the home equity interest deduction or additional mortgage interest deduction restrictions as they would fall below the monetary limitations. As such, there would be no negative impact on the housing market whatsoever for this population.-Second, current interest rates remain low and, as a result, the mortgage interest deduction, according to a recent report by the Tax Policy Center, although still impactful, has less effect on housing costs and expenses, so “[limiting] it would have less effect on housing prices.”–Third, with the mortgage interest deduction still being permitted in great degree (with a $500,000 limitation), those taxpayers that would be affected are of such high income that they would be the least likely to be deterred (many have paid off their home mortgages) from making large scale home purchases.-Large home purchases are important and economically beneficial as well; hence, its effect on these large scale home purchases would have to be studied in great detail.-Fourth, as for the limitation on home equity loans, moderate and high income taxpayer home owners would still maintain much of their mortgage interest deduction via first and second mortgages (up to $ 500, 000). Together with the current relatively low interest rates, they would likely be able to refinance their home equity loans if needed.
Although such tax expenditure modifications may seem severe to those select few who currently utilize both the mortgage interest deduction and the current Saver’s Credit, studies have established that only an estimated 2.6 percent of tax returns would be impacted. An added benefit to a 50 percent matching credit, if utilized in a large-scale reform package as is often mentioned, is that it would result in the reduction of tax liability for approximately 10 percent of taxpayers while increasing it for less than 1 percent, with lower income taxpayers receiving the largest benefit.
Notwithstanding the concerns associated with the current Saver’s Tax Credit, philosophical and policy arguments against making it refundable and/or enlarging it exist beyond those arguments solely focused on paying for it. For example, the position that adding another refundable credit to the current tax system simply serves to enlarge an ever-expanding welfare system “for the masses” driving it towards permanency.-The argument continues that increasing refundable tax credits to a higher level acts as a disincentive to work and that reducing dependence will never happen without removing refundable credits and exemptions.
However, the Saver’s Credit’s very purpose is inapposite to welfare and it is dissimilar to the majority of refundable tax credits that do not correspond to actual tax dollars sacrificed by the taxpayer, and which do not have any correlation to a reduction in future need. In order to qualify for the Saver’s Credit, the low income taxpayer must make a contribution to a designated tax-preferred account, which will increase their savings, enhance their personal financial security and build wealth while simultaneously reducing the potential that they will require “welfare ”at some later time (notably, if left untouched, these savings will compound greatly).
Enabling taxpayers to receive a refundable credit as a consequence of their increased savings (similar to moderate and high-income pensions incentives) helps to establish a profound savings mentality and would serve to reduce the overall reliance on Social Security at retirement age as has occurred in other countries. The corresponding reduced reliance on Social Security could help pave the way for much needed entitlement reform. Importantly, this should appeal to conservative and progressive tax theorists in equal measure.
Lastly, opponents of any expansion of the Saver’s Credit may raise the concern that taxpayers who are aware of the Saver’s Credit eligibility rules and the potential for a cash refund payment beyond their tax liability may “bunch” their adjusted gross income just below the “notch” in order to receive the higher credit rate-The argument continues that the steep decline in the credit rates, pursuant to income limitations, provides an additional incentive for income bunching-Indeed, a detailed analysis of the Saver’s Credit indicates that there is an increased potential of bunching by taxpayers in order to receive the credit.
However, a more likely scenario is that the added benefit of the bolstered Saver’s Credit, if advertised properly, would serve to encourage those on the margins who have determined that participating in the labor market and/or maximizing their wages (by increasing their working hours) is not of relative benefit to them. Indeed, there are many low income taxpayers on the threshold of making a decision to save a portion of their paycheck, or increase their working hours or put their children in day care, etc., and it has been shown that these taxpayers have been positively (and deeply) affected by “government matches” of their retirement savings.
Most importantly, just as the Earned Income Tax Credit has helped to reduce poverty while simultaneously helping to “expand the number of [taxpayers] contributing to the economy by causing many additional Americans to participate in the labor force and causing others to work more hours,” as reported by Looney and Greenstone of The Brookings Institution and MIT respectively, a refundable Saver’s Credit would help lift even more out of poverty while simultaneously motivating them to increase their earnings. These taxpayers would likely put themselves in the best possible position to increase their earnings so that they could take advantage of all of the retirement savings options that a properly designed and adequately advertised Saver’s Credit would provide.
Harry M. Baturin, Esq. teaches at Georgetown University in their Summer and Special Programs. He is also an Adjunct at Delaware Valley College in their Graduate Policy Studies Program. He is a Managing Trustee of a Charitable Trust and has a background practicing in non-profit, estates and business and taxation law at Baturin and Baturin Law Offices, established in 1917. He was a Guest Instructor at the Penn State University Dickinson School of Law for the Elder Law Seminar with Professor Katherine C. Pearson, Esq., an Instructor at the Delaware County Community College, and clerked at the Philadelphia Law Department covering tax and real estate issues prior to practicing.
No, how about wealth redistribution?
A well written article on an overlooked subject, with a bipartisan approach. Well-done.
From, Modern Teacher