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Nudges seem to increase savings most

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Subsidies for retirement savings are among the largest tax expenditures in the US and other similar economies. The goal is to increase national savings and income security. But a recent study suggests that automatic enrolment or default policies that nudge individuals to save more could have a larger impact.

A new study has evaluated whether these subsidies are accomplishing this goal. Do tax subsidies encourage families to save more or do they induce them to shift money they would have saved anyway into tax-advantaged retirement accounts, with no net increase in savings? The conclusion is that it is open to question whether tax subsidies are the most effective policy to increase retirement savings. Automatic enrolment or default policies that nudge individuals to save more could have larger impacts on national savings at lower fiscal cost.

Results from Denmark generalized to the U.S.

Because of lack of high quality data on household wealth in the U.S, the study is based on data from Denmark, containing 45 million observations of household balance sheets from administrative tax records. The Danish data provide useful insights for policy in the U.S. for two reasons. First, the structure of retirement savings plans in Denmark is broadly similar to the U.S. Second, savings decisions within retirement accounts – where good data are available in the U.S. – are similar across the two countries. Therefore, it is likely that savings decisions outside retirement accounts – where the Danish data are of much higher quality – are similar as well.

A Danish reform in 1999 provided a quasi-experiment for the effectiveness of tax subsidies on retirement savings. The reform sharply reduced the tax subsidy for contributions to retirement accounts for those in the top income tax bracket in Denmark. It turned out that the subsidy change had only small impacts on total savings. Only 15% of individuals reduced retirement savings when the subsidy was reduced; the remaining 85% of individuals did not change their pension contributions at all. Moreover, the 15% who reduced their pension contributions shifted nearly all the money they withdrew from pensions to non-retirement accounts.

Combining these two effects, it was estimated that each $1 of government tax expenditure on retirement savings raised total national savings by just 1 cent.

Impacts of other policies

If subsidies have little impact on retirement savings, are there other policies that are more effective? Recent studies have shown that “nudges” such as automatic enrolment or defaults – which have no fiscal cost to the government – increase pension contributions. Again, however, it is unclear whether automatic contributions raise total savings or just induce individuals to save more in pensions while running down their balances in non-retirement accounts, leaving total savings unchanged.

The impacts of automatic contributions on total savings are studied using two quasi-experimental approaches. First, the individuals’ savings rates are tracked when they switch to jobs with higher or lower employer retirement contributions. These contributions are automatic in that they require no active choices by individuals. The increases in employer contributions are found to substantially increase total savings: most individuals do not change their savings in non-retirement accounts at all when their employers contribute more to their pensions. Second, the impacts of a mandatory government savings plan that required everyone to automatically contribute 1% of their earnings to a retirement savings account from 1998-2003 are studied. Again, this study shows that this policy raised total pension savings and did not reduce savings in other accounts.

Two types of people

Why are automatic contributions so much more effective at raising savings than tax subsidies? The answer is that there are two types of people in the economy: 15% are “active” savers who plan for retirement and respond to incentives, while 85% are “passive” savers who are not focused on their retirement savings and barely pay attention to policy changes. Tax subsidies induce active savers to shift assets across accounts but have no impact on passive savers’ behaviour. In contrast, automatic contributions raise the savings of passive savers. Passive savers tend to be less wealthy and financially prepared than active savers. As a result, automatic contributions not only have larger effects on aggregate savings than tax subsidies, but also do more to increase the savings rates of those who are least prepared for retirement. So - automatic enrolment or default policies that nudge individuals to save more could have larger impacts on national savings at lower fiscal cost.

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