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Commentary

Tax Reform Could Mean a Push Toward Roth

Budget-scoring rules could mean that tax reform is likely to include incentives or mandates toward post-tax contributions, writes Morningstar's Director of Policy Research Aron Szapiro.

With a new Republican president, Capitol Hill Republicans are talking seriously about passing a major tax reform package. If they do, what can ordinary investors expect? While much is uncertain, due to arcane budget rules I think we can expect a shortsighted emphasis on Roth-style retirement savings.

Major tax reform is tough; the last successful effort was in 1986 and before that in 1954. Recent history has not revealed much enthusiasm among members of Congress for the tough choices involved in a large tax code overhaul. Indeed, last session, Representative Dave Camp's tax reform bill never got much momentum. But, many experts think this year might be the year.

Republicans have offered some clear high-level principles for any tax reform, such as reducing marginal tax rates while shrinking deductions and credits, but they have largely left retirement specifics out of their official plans. For example, House Speaker Paul Ryan's "Better Way" plan would lower the number of tax brackets from seven to three and reduce the marginal tax rates on those brackets, all while making changes so that just 5% of taxpayers could continue to itemize their returns. Further, the Better Way plan would try to encourage savings and investment in general—not just in retirement accounts—by reducing taxes on investment income.

Retirement Policy Important to Any Tax Reform Plan
Still, changes to the tax treatment of retirement savings almost have to be part of tax reform, even if there are few clear details yet. That's because the "tax expenditures" on retirement contributions are among the highest in the tax code, more than $100 billion annually. What's a tax expenditure? That's the amount the government "spends" by letting people or corporations reduce their taxes for various expenses. The largest tax expenditures are for healthcare and mortgage interest, followed by traditional contributions to retirement vehicles such as 401(k) plans.

Of course, the retirement tax expenditure is a little different from other tax expenditures because the government will collect revenue on retirement savings someday. After all, traditional retirement savings are taxed in the future when people draw them down for retirement. Nonetheless, the way that these tax revenues are scored by the Joint Committee on Taxation (and Congressional Budget Office) mostly don't include these future government revenues because of the 10-year budget scoring window.

10-Year Budget Scoring Doesn't Work for Retirement
The 10-year scoring window is just want it sounds like: Congress evaluates the effects of changes in the tax code based on revenue projections for the next 10 years, and typically no further. This makes a lot of sense for most policy evaluation. The people at the Congressional Budget Office and the Joint Committee on Taxation cannot accurately predict further than 10 years into the future (or even 10 years into the future), making such efforts ridiculous. At the same time, at least trying to force policymakers to continue the medium-term impact of their legislation is important. So, 10-year scoring generally makes sense.

A notable exception of this is retirement policy where 10-year scoring can have major distortionary effects on policymaking. 

The reason is that 10-year scoring will show large tax expenditures for traditional retirement contributions and not for Roth contributions. Any shift toward Roth, in which the taxes are paid immediately on contributions, will generally create more revenue inside the 10-year window. Any shift toward traditional contributions will decrease revenue. Since Congress wants more revenue to offset other tax changes, Roths will win the day.

Look for Expansion of Roth-Style Contributions
Policymakers looking around for ways to raise money to offset lower marginal tax rates are likely to look to expanding Roth-style contributions. There is also a precedent for this kind of approach. Although Dave Camp was not able to advance his tax reform package in 2014, it may well be a blueprint for the details of the next tax reform bill. His package would have sharply increased Roth contributions with a blunt instrument: new contributions to IRAs could only be Roth, and most participants in employer-sponsored plans would be required to designate contributions amounts in excess of $8,750 to Roth accounts

This emphasis on Roth is terribly shortsighted, and it could set the U.S. government up for huge decreases in revenue in the future when all those Roth distributions escape taxes. This policy preference is driven by arcane scoring rules, and it might not be very good for savers. Many lower-income people rely on the immediate tax benefits to make contributions to their accounts. Further, many workers may have lower incomes in retirement, making traditional contributions more sensible.

At a time when few are willing to make predictions about policy, I think it is very likely that if Congress pursues tax reform, 10-year budget scoring will make Roth contributions too appealing to ignore.

This article has been corrected to update the size of tax expenditures for retirement contributions and to clarify Representative Dave Camp’s tax reform proposal.