Note: This post is a work in progress and comments are welcome. Everything that’s wrong in here is my own, and no one else is to blame.
In my paper with Stephen Zeldes I argue that a switch from Traditional tax-deferred to Roth retirement accounts would, over time, remove a $15 billion/year asset management fee subsidy [update – the number changes at every new draft. Right now it’s $19.5 billion. It’s never been less than 13 and never more than 20, though. As Ed Tufte says, this is a one-digit science]. While we are comfortable with our conclusion (which was also independently reached by Daniel Hemel of U Chicago Law), it is also true that Roth accounts have a notorious history of being introduced or expanded whenever current budgetary proposals are in need of some cosmetic action. In this post I try to understand why Rothification, defined as the increased usage of Roth accounts, is often attacked as a budget “gimmick.”
As part of the recent tax reform debate, Congress has been rumored to have considered proposals ranging from unlikely doom scenarios (the forced conversion of Traditional accounts into Roths) to decidedly mild ones (capping annual contributions to Traditional accounts). These rumors, and the associated fear-mongering, ultimately forced President Trump to issue a strongly worded denial: “There will be NO change to your 401(k).”
Although Trump tweets need not signify a shift in policy, I think it would be socially beneficial to have an honest, long-form debate on the topic. But I digress.
Those who scorn Rothification as a gimmick start by pointing out that a switch from Traditional to Roth should not increase government ability to spend or cut taxes, and then argue that in fact it is being used to do just that. Accordingly, allow me to define a “gimmick” as a budgetary action that permits the current administration to spend more money without either raising new money or a special approval process.1 In what follows I argue that under this definition a switch to Roth is not a gimmick because, although it need not raise any new tax revenues, it does raise money by liquidating an existing asset. If this money were used to pay down Treasury bonds, no one would call it a gimmick. I will also argue that using a one-time asset liquidation to “pay for” a permanent tax cut is an unsustainable gimmick. This gimmick works only because of the rather transparent pretense that the tax cut is temporary.
Rothification is, or could be, revenue-neutral
The fiscal consequences of a switch from Traditional to Roth accounts are best understood by initially assuming that the tax system consists of a simple flat tax: the government will take a fraction τ (tau) of your income. For instance, if your income is $100,000 and τ is 20%, the government will take $20,000. Thus, for now we are ignoring the fact that tax brackets exist, as well as the fact that people may fall in different tax brackets between work life and retirement. Also assume that assets in a retirement account accumulate a net return r. Now consider an individual choosing to allocate one dollar of pretax salary to her retirement account.
- If the account is Traditional, the government receives no immediate revenue and the individual contributes the whole dollar. Thirty years later, this dollar has grown to (1+r)30 dollars. When the money is paid out, the government nets τ·(1+r)30.
- If the account is Roth, the government receives τ upfront. Assuming that the government can invest no more and no less successfully than the individual, the future value of this current tax revenue in 30 years is also τ·(1+r)30.
Thus, at a first pass, the future value (or equivalently the present value) of government revenue is left unchanged, making Rothification revenue-neutral.
Of course, real-world taxes are progressive, and many individuals have lower income in retirement than they do during their work life. Rothification would make these individuals unable to shift income from high-tax-bracket years to low-tax-bracket years, and ultimately raise their total tax burden. This is a very important matter, but not the subject of this article. There are many ways to counter this effect, leaving both the total tax revenue and the distribution of tax burden roughly unchanged. For instance, the government could accompany a switch to Roth with either a reduction in low-bracket tax rates, or an increase in bracket cutoffs. Or, Hemel suggests, one could simply equalize the ex-post tax burden with a one-time charge or credit at the time of withdrawal. Still, suppose that the government does not act to counter the effect of Rothification (e.g., it cuts high-bracket tax rates, or no tax cuts at all); the effect is to bring in real revenue via a real reduction in the progressivity of the tax code. Where is the gimmickry?
Rothification relaxes the budget constraint
The basic argument goes as follows. The U.S. Congress has some rules in place that make it more difficult to pass bills that increase the budget deficit.2 However, since budget bills usually cover a 10-year window, a policy that increases revenues inside the 10-year window at the expense of future revenues outside the 10-year window appears to “produce revenue” and it can then be used to “pay for” other deficit-inducing measures such as a tax cut.
This intuitively appealing explanation leaves something to be desired. Is Congress procedure that easy to game? And if it is, why bother with Rothification when Congress has at its disposal a myriad other forms of budget gimmickry that are less labor-intensive and much, much less politically controversial?
The thing is, Congress procedure is not that easy to game. (Surprising, I know). In particular, there are two U.S. Senate rules that merit discussion.3 The basic gimmick argument seems to rely on the “PAYGO rule,” which requires a more cumbersome approval procedure for measures that increase total deficit in a 1,-, 5-, or 10-year window. However, the “Byrd rule” (a set of restrictions championed by former Senator Robert Byrd) also requires a more cumbersome approval procedure for bills that increase the deficit during a fiscal year after the fiscal years covered by the bill. The usual budget bill covers 10 years, and therefore the two rules combined require that a bill create no new deficits, period.4 Thus, it is not obvious that shifting revenue from the far future into the near future would relax budget restrictions.
And yet, every single time the introduction or expansion of Roth accounts has been proposed in the past, opponents have pointed to some other measure whose cost was being illusorily paid for with more Roth. The 1989 Packwood-Roth proposal would pay for capital gains tax cuts; the actual introduction of Roth IRAs paid for some of the tax cuts in the 1997 Taxpayer Relief Act;5 most recently, the 2009 introduction of a Roth option for the federal employees’ Thrift Savings Plan paid for certain other federal employee benefits. Why does Roth work?
The magic of Rothification is that it shifts revenues from the far future into the near future without creating a budget deficit in the far future, and therefore it does not run afoul of the Byrd rule. The reason why there is no deficit in the far future is that Rothification also shifts revenue from the really far future into the far future. And from the really, really far future into the merely really far future. And so on, ad infinitum.6
Is this the best, subtlest Ponzi scheme ever conceived? Or, since the generation that will pay the eventual price of Rothification does not exist, is this actually not a gimmick at all?
A Rorschach test for fiscal hawks
The answer is subjective. When individuals contribute money to Traditional accounts, the government is voluntarily forgoing some current tax revenue in exchange for the “promise” that it will collect this revenue in the future. This forgone revenue accumulates as a deferred tax asset; the government has a claim on some 20-25% of the current value of all tax-deferred retirement accounts. If we include individual accounts (IRAs), employer-sponsored defined contribution plans (401k, 403b, TSP, etc), and employer-sponsored defined benefit pension plans, this deferred tax asset is worth about $4 trillion. While the government does include these future revenues in its cash-based financial statement projections, the asset does not appear on its balance sheet, nor is it ever explicitly talked about.
If you are a fiscal conservative, you may like the idea of the government squirrelling away money in its own virtual “retirement account,” putting pressure on current budgets and inducing some degree of fiscal responsibility. To discontinue this practice and enjoy the temporary benefits of the savings accumulated by past administrations is worse than a gimmick—it is a reckless, irrational act.
On the other hand, this practice itself may well be construed as an irrational, reckless self-imposed restriction on spending—a gimmick! The government is pretending to be poorer than it really is, as yearly increases in the value of the deferred tax asset do not show up as government surplus. This pretense can do real damage: vital spending programs are being forgone and taxes are too high. Moreover, ignoring the existence of a $4 trillion asset makes government indebtedness appear higher than it really is. In perfect, frictionless financial markets, only net indebtedness would matter; a government that expects more revenue later can simply borrow more now. But markets are not perfect or frictionless, and cash is king. If government debt buyers pay undue attention to headline debt figures, a higher apparent figure may be a threat to financial stability. As of December 2016, the U.S. public debt stood at $20 trillion or 108% of GDP. If we net out the $4 trillion of deferred tax asset, however, the figure drops to approximately 87%, safely below the Reinhart-Rogoff threshold of 90%.7
It depends on what you do with the money
There is one last missing piece of the puzzle.
Regardless of whether you are a hawk or a dove, I hope I convinced you that Rothification creates real, one-time fiscal slack by liquidating an existing asset that the government has accumulated over the years. The slack would be felt over a long transition period in which the deferred tax asset slowly evaporates until the last Traditional account is liquidated.
Whether you think the idea of liquidating government assets is good or evil depends on other factors, beside your degree of fiscal conservatism. (Not to mention that fiscal conservatism is highest when one’s party is in the opposition). Perhaps the most important factor is what is done with the money. If the government used the Rothification windfall to pay down debt, I suspect no one would call it a gimmick. Similarly, if the government were to use the money to build a vitally important new bridge, it would simply be substituting one asset for another. Moreover, the new asset (the bridge) is something more government-worthy than the old asset (stocks, bonds, and everything else that individuals hold in their retirement accounts).
Unfortunately, the typical motive for more Roth is the need to pay for temporary tax cuts. To avoid running afoul of the Byrd rule, these tax cuts must expire after 10 years, so that their budget impact disappears in the years beyond the budget bill. When the tax cuts are about to expire, some other politician—possibly from the other party—will face a “fiscal cliff,” and will have to make an unpopular decision between letting the tax cuts expire (“raising taxes”) and finding another way to pay for the unsustainable but now-permanent reduction in revenue (“slashing spending”). It is a politician’s dream—the gimmick of a lifetime.
- This definition is somewhat arbitrary, but to my knowledge no alternative definition exists in the academic, journalistic, or political “literature” on the topic.
- Refresher: Deficit is a flow – the yearly difference between spending and revenue. Debt is a stock – loosely speaking, the total cumulated sum of all past deficits.
- For more color on these rules and how they make it more difficult to approve deficit-inducing budget proposals, see the excellent Reconciliation 101 primer by the Committee for a Responsible Federal Budget.
- If the Senate approved a 1000-year budget bill, the PAYGO rule would cover years 1–10, and the Byrd rule would cover years 1001-infinity, thereby allowing for deficits in the years 11-1000. Of course this is a total banana republic move, akin to minting a trillion-dollar coin to avoid raising the debt limit, so it’s not going to happen. But yes, technically it could.
- Arguably, the act itself of introducing a Roth option without limiting the use of Traditional accounts constitutes a tax cut, because individuals still have all the same tax breaks as before plus Roth accounts, and therefore can only do better; under this interpretation, tax cuts were paid for with another tax cut, in an extraordinary act of budgetary magic.
- To the best of my understanding, the math works exactly like this if new contributions are directed to Roth accounts. On the other hand, a forced Roth conversion of all existing accounts may still run afoul of the Byrd rule because revenue projections already include expected revenue from existing tax-deferred accounts, and such revenue would disappear in all years beyond the budget window, increasing deficits.
- Just kidding. A one-fifth drop in the (apparent) Debt/GDP ratio is a big deal, but I do not believe in arbitrary debt thresholds; and I have no evidence that Reinhart or Rogoff do, either. However, throughout the entire Reinhart-Rogoff controversy, neither the two authors nor their critics ever suggested crediting governments for their implicit future tax revenues from retirement accounts. This is an example of undue attention paid to headline debt figures. Similarly, there is controversy whether the headline debt figure should include $8 trillion of Treasury obligations held by the Federal Reserve, the Social Security Trust Fund, and other government accounts. Although essentially all published figures include this amount, excluding it would make my point even stronger: netting out the present value of future tax revenues brings debt down from 65% to 43% of GDP, a one-third drop.