What 401K Limits Say About Priorities

Alexandra F. Baldwin

About two weeks ago, I got an anonymous question from a reader for #AskAlex: Why does Trump want to take away my 401K? And I started to answer, but I found myself writing, and writing and writing and getting off on somewhat tangential issues about the tax code as a whole. It was gong to be a lot longer than is appropriate for that venue, so here you have it.

First, some basics that bear repeating because we often lose sight of them. We pay taxes for one reason: to fund government. We may disagree on what government should do and how it should do it, but we basically all agree that a government that enforces law and organizes our collective defense, at a minimum, is a necessary construct. We could pay for that by asking for donations, or we could pay for it by taxing the populace. Since donations are unlikely to work, taxes are usually the best alternative.

After that, we need to choose what kinds of taxes, and we have several options. They could be in the form of fees for specific government services (like your driver’s license fee, or the fees paid by Exxon to extract oil from public lands), fees collected related to the transfer of goods and services (import tariffs, sales tax), a levy based on the value of some personal property (real estate tax) or taxes on personal and corporate income.

How do we choose between those various types of taxes and then structure them? We typically use some combination of several factors to design our tax system: efficacy, fairness and social engineering. The taxes have to work well - charging tolls on a single road can not be the primary source of government funding, as it will not generate sufficient revenue and is too easy to avoid. The taxes should appeal to our generally held feelings of "fairness", even if we can’t really decide what that means with any sort of consensus. And finally, we sometimes use the tax code to drive behaviors. Taxing something (like cigarettes) makes it inherently more expensive and will lead to less of it, while offering tax incentives (like home mortgage interest deductions) will lead to an increase in that behavior. Economists can argue forever about how much of an impact taxes have on behaviors, but there is no disagreement about the theory.

What, then, does the US tax code tell us about government priorities? Which behaviors are being incented and which ones are being discouraged? This is often where the debate immediately jumps into the weeds, talking about child-credits and depreciation deductions, or even seemingly larger issues like employer-paid health insurance premiums or mortgage interest. But even those “big picture” items are missing the very biggest picture: we have built our tax system around income.

There aren’t really a ton of options for a broad-based tax that can fund our entire Federal behemoth, but our choice of income tax has real ramifications. We could certainly have arguments about “fairness”, but what is undeniable is that taxing income from labor will reduce the amount of paid labor offered by workers. If 1,000 workers all take home $30/hr, and you change the tax rate so they only take home $29, you will not have as many hours on offer in the next period (I am ignoring the marginal utility of labor at very, very high wage levels).

That effect is likely very small, but any economist who denies its existence is simply a liar. Probably more dramatic is the impact on raising the employer portion of payroll taxes. Charging an employer more to hire workers is going to lead to hiring fewer workers. Taxing something decreases the amount of that thing that we can expect to see in the economy. Taxing earned income means less labor. Less labor means less economic product, less wealth, etc.

That, to me, is the best argument for a national sales tax, or some other tax on consumption. It makes a similar, but not quite as effective, argument for wealth taxes instead of income taxes as well. Income is generated from the highest and best economic activity, productive labor, and taxing that labor discourages it. Just as an income tax discourages work, a consumption tax will decrease consumption, but the reactionary effects are different. Less work means more unproductive time, but less consumption does not mean less economic activity, it means more investment (or more imports or government spending, but ignore those for now).

There are a couple of other important distinctions here, too. First, we have chosen a graduated income tax that charges higher rates on higher levels of income. This is pretty well understood and very broadly accepted as appropriate. And second, we have chosen a tax structure that weighs most heavily against earned income, and not unearned income. This is not very well understood at all, and almost certainly at odds with generally held opinions of appropriateness.

As a very simple example, think of two people. The first is an anesthesiologist earning $400,000 and paying nearly 40% of the last dollar of her income in Federal Income taxes. The second is a passive investor earning about the same amount, but paying maybe 15% on her last dollar of income (also...different definition of income, but that is a whole other issue) or 15%-20% on the capital gains from any sales of the property providing the income.

The net result is that the people who generally pay the most punitive tax rates are not necessarily the wealthiest Americans (i.e., the people who *have* the most) but the highest-earning Americans (i.e., the people who *do* the most). To circle back to the previous idea, we are not only dis-incentivizing work through our tax code, we are most dis-incentivizing work most among our most productive people. And discouraging them from becoming useful things like anesthesiologists or physicists in the first place.

Even when we talk about the tax burden, the metrics we use are almost entirely related to taxes paid as a portion of what we earn, not as a portion of what we have. I tried to find a chart that measured the tax burden by wealth segments - not income segments - and found absolutely nothing. Not a single attempt at quantifying the tax burden by wealth.

Which, in a very long-winded way, brings us back to the question about President Trump and 401K’s. First,  the question is a somewhat hyperbolic statement: there is no one looking to repeal section 401K of the tax code and do away with tax-advantaged workplace savings plans. There is, however, growing support to limit the usage of these plans by dropping the cap on contributions, a move that amounts to a not-insignificant tax hike on higher-income workers. For a couple of reasons, that idea (and the general “soak the high-earners” philosophy) appeals to a good number of really disparate political interests in both the Progressive and Trumpian Populist camps.

{Also, note that, in my preferred world, we would do away with all deductions and credits and dramatically slash marginal rates. I can recognize that such a plan is nothing short of fantasy.}

Under current law, workers are allowed to contribute any portion of their earned income up to $18,000 into a 401K plan and avoid paying income tax on that money now (a Roth 401K works differently: you can contribute $18,000 and get no immediate tax relief, but the money is entirely tax free for life after that). Per Vanguard and the Bureau of Labor Statics, somewhere between 12-14 million workers contribute the maximum.

As discussed, Congress would lower that limit to, say $10,000. Class warfare proponents on both right and left cheer at this, noting that only maybe 5-6% of Americans currently contribute more than $10,000 and they are almost by definition wealthy people. So, “fair share” and all, let’s close this “loophole” and make those rich tax cheats finally contribute, eh?!

But thinking about what we talked about earlier, think about who this doesn’t impact. This isn’t actually a tax increase on the wealthy, it is a tax increase on high earners. While Trump is perfectly willing to raise taxes on high earners, he has (through cuts in business taxes and estate taxes) been a lot more generous in using the tax code to benefit the very wealthiest Americans. In Trump’s world, the passive real estate investor needs tax relief on his already tax-advantaged assets, while the household with a doctor married to a lawyer should be soaked as thoroughly as possible rather than encouraged to fund their own retirement.


Second, Trump is in some ways a pretty classic progressive. He generally believes in big government “doing something” rather than private solutions or personal responsibility. That’s why he was never going to repeal Obamacare, he was going to “replace it with something better”. On the retirement front, this idea leads to a bias away from helping large numbers of people be self-sufficient in retirement and towards reliance on government handouts. The idea that anyone who earns more than $100,000 annually for most of their life can retire with financial assets of several million dollars is terrifying to any modern progressive. If millions of Americans aren’t reliant on Social Security, how can they scare you into supporting ever higher taxes and an ever-expanding, centralized government?


Unlike most progressives, though, Trump is extremely sympathetic to the inheritance-class (I can’t, for the life of me, imagine why…). For most progressives, utopia is a nation run by the unchallengeable hand of the enlightened Ivy League ruling class. Trump is fine with this, so long as he is a part of a super-wealthy sub-class that is exempt from all rules applied to the masses.

That is, as best I can tell, Trump’s tax philosophy: a nakedly self-serving kind of plutocrat populism that dis-incents labor from the most productive members of society, dis-incents investment in that labor (education) and dis-incents self-sufficiency.  It includes small cuts for as many low-income people as possible to carry on the charade of “helping the working class” come election day, combined with massive cuts for asset owners like himself and his closest friends.  

He doesn’t feign much interest in wholly offsetting these cuts, obviously (and spending cuts are right out…), but he would like to make at least a token effort. And that means an even heavier burden on the people who already shoulder the heaviest tax burden: the working-wealthy who have higher earned incomes and benefit most from things like 401k deductions.  The plans beneficiaries, meanwhile, are mostly in the inheritance class, and in the circle of enlightened aspiring overlords who preach the value of government reliance above all else.

Just in case you were wondering who Trump's real constituency is.