Should the Tax Laws Be Reformed to Encourage Saving?

Tax laws shape the financial decisions of individuals and households. The structure of the tax code can create incentives that influence whether income is spent immediately or set aside for future use. This dynamic affects an individual’s ability to achieve long-term financial goals and impacts the overall health of the national economy.

A nation’s collective savings rate provides the capital necessary for business investment, innovation, and growth. When individuals save, they contribute to a pool of resources that can be deployed to build factories, develop new technologies, and create jobs. The debate over how tax policy should treat savings is a recurring theme in economic and political discourse.

Current Tax Incentives for Saving

The U.S. tax code contains provisions designed to encourage individuals to save for retirement, healthcare, and education. These incentives offer preferential tax treatment to money placed in designated accounts, making it more advantageous to save than to spend. The mechanisms vary, but they generally involve deferring taxes on contributions or earnings, or making withdrawals tax-free.

Retirement Accounts

The most prominent savings incentives are for retirement. Employer-sponsored plans, such as the 401(k), allow employees to contribute a portion of their wages before taxes are calculated, which reduces current taxable income. The money within the 401(k) grows tax-deferred, and taxes are owed when funds are withdrawn in retirement. For 2025, the general contribution limit for these plans is $23,500, and those age 50 and over can make an additional catch-up contribution of $7,500.

Individual Retirement Arrangements (IRAs) offer another path for tax-advantaged saving. A traditional IRA functions similarly to a 401(k), where contributions may be tax-deductible. The funds grow tax-deferred, and withdrawals in retirement are taxed as ordinary income. For 2025, the IRA contribution limit is $7,000, with a $1,000 catch-up for those 50 and older.

In contrast, the Roth IRA uses after-tax dollars for contributions, so there is no upfront tax deduction. Its primary benefit is that contributions and all investment earnings can be withdrawn completely tax-free in retirement, provided certain conditions are met. Both traditional and Roth IRAs have income limitations that can phase out the ability to contribute or deduct contributions.

Health Savings Accounts

Health Savings Accounts (HSAs) offer a “triple-tax advantage.” To be eligible, an individual must be enrolled in a high-deductible health plan (HDHP). Contributions to an HSA are tax-deductible, the funds can be invested to grow tax-free, and withdrawals are also tax-free if used for qualified medical expenses.

This combination of benefits makes HSAs a versatile tool. For 2025, the contribution limits are $4,300 for an individual and $8,550 for a family, with an additional $1,000 catch-up contribution for those age 55 or older. The money in an HSA is not subject to “use-it-or-lose-it” rules and rolls over from year to year.

Education Savings Accounts

The tax code also provides incentives for education savings, most notably through 529 plans. While contributions to a 529 plan are not deductible on a federal tax return, the money grows tax-deferred. Distributions are federally tax-free if used for qualified education expenses, which include college costs, up to $10,000 per year for K-12 tuition, and expenses for certain apprenticeship programs.

Each state sponsors its own 529 plans, and many offer a state tax deduction or credit for contributions. Recent changes allow for penalty-free rollovers of up to a lifetime maximum of $35,000 from a 529 account to a Roth IRA for the beneficiary. This option is subject to several requirements, including rules about how long the account must be open.

Proposed Models for Tax Reform

Dissatisfaction with the current system’s complexity and perceived inequities has led to numerous proposals for tax reform. The core objective of these proposals is to make saving more accessible and attractive to a wider range of households. These reform models range from enhancing existing accounts to overhauling the tax system itself.

Expansion of Existing Accounts

One straightforward reform proposal involves increasing the annual contribution limits for existing tax-advantaged accounts. Proponents argue that current limits, such as the $7,000 cap for IRAs in 2025, are too restrictive for individuals who want to save more aggressively. Another proposal is to eliminate or raise the income phase-outs that restrict access to accounts like the Roth IRA, making them available to all taxpayers.

Introduction of Universal Savings Accounts

A more innovative proposal is the creation of Universal Savings Accounts (USAs). These accounts would be funded with after-tax dollars, similar to a Roth IRA, but their defining feature would be flexibility. Individuals could contribute a set amount annually, and all investment earnings would grow tax-free. Withdrawals could be made at any time, for any reason, without tax or penalty, creating a simple and liquid savings vehicle.

Structural Changes to Incentives

Some reform proposals suggest replacing tax deductions for savings with a flat-rate refundable tax credit. A deduction’s value is tied to an individual’s tax bracket, providing a larger benefit to high-income earners. Under a credit system, every saver would receive the same government contribution for their savings, regardless of income. For instance, a 25% credit would mean that for every $1,000 contributed, the government would deposit an additional $250 into the individual’s account.

Fundamental Tax System Overhaul

The most sweeping reform proposal involves shifting the entire federal tax base from income to consumption. Systems like a national sales tax or a Value-Added Tax (VAT) tax money only when it is spent. This change would effectively make all savings tax-deferred by default, as income saved and invested would not be taxed until it is used for consumption. This approach would eliminate the tax on returns to saving and investment.

Economic and Fiscal Implications of Reform

Any change to tax incentives for saving would have effects on the economy and government finances. The goals of such reforms are to increase personal and national savings, which can fuel investment and long-term growth. However, the actual outcomes depend on how individuals and markets respond.

Impact on National Savings Rate

A central question is whether savings-oriented tax reform generates new savings or simply encourages people to shift existing assets from taxable to tax-advantaged accounts. Economic theory suggests that lowering the tax on returns to saving should encourage more of it, but the evidence is mixed. The net impact on the national savings rate depends on whether any increase in private saving is offset by a decrease in public saving from a larger government deficit.

Impact on Government Revenue

Expanding tax incentives for saving almost invariably leads to a reduction in government tax revenue, at least in the short term. Increasing contribution limits, creating new tax-free accounts, or switching to a credit system would reduce the amount of income subject to tax. This revenue loss must be accounted for, either through spending cuts, tax increases elsewhere, or increased government borrowing. The direct fiscal cost remains a hurdle for any proposal to expand savings incentives.

Impact on Capital Formation and Investment

An economic argument for encouraging saving is that a higher national savings rate increases the supply of funds available for capital formation. When the pool of domestic savings grows, it can lead to lower interest rates and make it cheaper for businesses to invest in new equipment, technology, and facilities. This process is a driver of productivity and long-term economic growth. This outcome is contingent on the savings being new and not just shifted assets.

Distributional Effects of Savings-Oriented Tax Policy

The design of tax incentives for saving has implications for how the benefits are distributed across households with different income levels. The question of who benefits most from these policies is a persistent theme in the debate over tax reform. The structure of an incentive directly influences its value to different taxpayers.

Analysis of Current System

The current system of tax incentives disproportionately benefits higher-income households. This is because the largest incentives, such as the deductions for 401(k) and traditional IRA contributions, are more valuable to those in higher marginal tax brackets. A deduction that reduces taxes by 37 cents on the dollar for a top earner only reduces taxes by 12 cents for someone in a lower bracket. Furthermore, higher-income individuals have a greater capacity to save and are more likely to take full advantage of contribution limits.

Analysis of Proposed Reforms

Different reform proposals would have different distributional outcomes. Simply increasing contribution limits for existing accounts would likely direct the vast majority of the additional tax benefits to high-income earners. This approach would do little to encourage saving among those with lower or middle incomes.

In contrast, replacing tax deductions with a flat-rate, refundable tax credit would have a more progressive effect. A credit provides the same dollar-for-dollar benefit to every saver, making it a more powerful incentive for those in lower tax brackets. A refundable credit would be particularly beneficial, as it would allow even those with no income tax liability to receive a government match for their savings.

Universal Savings Accounts could offer benefits to middle-income families by providing a flexible savings vehicle. However, critics argue that without income limits, USAs could also become a tax shelter for the wealthy to shift existing assets. A shift to a consumption tax is often criticized for being regressive, as lower-income households spend a larger portion of their income.