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Suppose taxpayers were given a new option under the tax law for retirement funding. The new option requires that they forgo a current tax deduction for pension plan contributions. Any contribution would accumulate in the pension fund free of tax, and distributions from the plan to beneficiaries would also be tax free.

The unual rules provide for current tax deductibility of pension plan contributions and full taxation of pension plan distribution plan distributions at ordinary tax rates. The tax rates at which contributions reduce taxes and the tax rates at which distributions increase taxes may differ because they occur at different points in time.

a. Who would prefer the new option?

b. What would likely happen to taxes collected by the government in the short run? In the long run?

c. What would likely happen to the aggregate amount of savings undertaken through pension accounts?

d. How would the the new option comapre with one in which pension plan contributions give rise to current tax deductions and pension paln distributions are taxes at the same rate at which deductions were taken?

e. How would the new option compare to plan with the following?

1. Pension plan contributions give rise to current tax deductions.

2. Pension plan distributions are taxed at the ordinary tax rates that apply at the time the distributions are made.

3. Distributions are taxed at a rate above (below) the rate at which contributions are deductible and taxpayers receive a tax credit or pay additional tax equal to the difference in tax rates multiplied by the pension plan contributions.

Explanation / Answer

a.

Taxpayers would prefer the new option, since their benefits become tax free.

b.

Tax collection by the government in the short-run would become low because of sudden effect.

But it would be normalized in the long-run, because there would be more funding in pension. It leads to improvements and expansions, which turns into more tax collection.

c.

Aggregate amount of savings through pension would increase, because the tax-free pension would become attractive among the beneficiaries.

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