The Impact of Tax Incentive Structure on Taxpayers' Retirement Savings Decisions

Abstract

We investigate whether and how the structure of retirement savings incentives influences their relative attractiveness to taxpayers, independent of their effect on after-tax returns. To that end, we examine taxpayers’ preferences between defined contribution retirement plans with back-loaded (i.e., Roth) and front-loaded (i.e., traditional) tax incentives. In three experiments, we find limited evidence that individuals appropriately weight temporal tax rate changes, the primary factor differentiating after-tax returns across incentive structures, in their plan preferences. In contrast, we find consistent evidence that the incentive structure’s relation to taxpayers’ broader attitudes and preferences significantly impacts plan preferences. Overall, we find evidence that generally held attitudes and preferences lead to a systematic preference for back-loaded retirement plans even in situations in which taxpayers know that a back-loaded plan is economically dominated by a front-loaded plan. The results have implications for policymakers and others considering how best to encourage retirement savings.

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“…14 14 The four items comprising Financial Sophistication combined into a single factor with an eigenvalue of 1.747, explaining 43.7% of overall variance. Factor loadings and variance explained are comparable to the prior literature (Calvet et al 2009; Cuccia and Doxey 2022). …”

“…Participants who complete the study are paid a $1 fixed fee, along with a $1 bonus. The median completion time is 13 minutes, resulting in an hourly wage equivalent of $9.22, which generally meets or exceeds levels observed in prior accounting studies (Cuccia et al 2022; Farrell et al 2017; Rennekamp 2012; Stinson et al 2021).…”

“…17 17 This may reflect the nature of our sample population, as our screening criteria requires past investment in individual stocks and, therefore, some degree of familiarity with financial markets and institutions. Compared to descriptive statistics reported in Cuccia et al (2022), who study a more general population, our participants exhibit less variation across most of the components of Financial Sophistication . …”

“…wage equivalent of $9.22, which generally meets or exceeds levels observed in prior accounting studies (Cuccia et al 2022;Farrell et al 2017;Rennekamp 2012;Stinson et al 2021).…”

“…To evaluate the role of relative financial sophistication among participants, we ask individuals to report their household income, formal education level, their self-assessment of personal financial knowledge, and the number of classes they have completed in finance, accounting, economics, and tax. Following prior works (Calvet et al 2009;Cuccia et al 2022), we create a composite variable of these four items through PCA (Financial Sophistication). 14 Next, Hsee et al (2015) and Park and Sela (2017) propose that individuals differ across the degree of rationalism they apply to their financial decisions.…”