Let’s Eliminate the Tax Code’s Bias Against Saving with Universal Savings Accounts

May 11, 2015

The current tax code is heavily biased against saving and investment. One way to limit this bias would be to create universal savings accounts where income that taxpayers save would face only one layer of taxation.

Currently, a dollar can face up to four layers of taxation when all is said and done: 1) it’s taxed when you earn it and pay an income tax; 2) it’s taxed when a business you invest in earns a profit and pays a business income tax; 3) it’s taxed when you realize returns to investment and pay taxes on capital gains and dividends; and 4) it’s taxed when you pass away or give it as a gift through estate and gift taxes.

A neutral tax system would tax each dollar of income only once. The current tax code includes a couple tweaks to lessen the harm of the multiple layers of taxation. It has rates on capital gains and dividends that are below rates for wage income, it has $5.4 million exemption for the estate tax, and it provides tax-neutral retirement accounts in the form of IRAs.

But while we’ve taken small steps towards (and some steps away from) a more neutral tax system, other countries have made leaps toward more neutral tax systems.

One great example is Canada. In recent years, Canada has cut its corporate tax rate from 42.9 percent down to 26.1 percent, partially integrated their corporation tax system, and has gone without an estate tax. Perhaps most interestingly, they recently created Tax-Free Savings accounts. From Cato’s Chris Edwards:

Prime Minister Stephen Harper’s government implemented Tax-Free Savings Accounts (TFSAs) in 2009, and they are creating a broad-based savings revolution north or the border. Here are the key features of the accounts:

  • Annual contribution limit of $10,000. Portions of the contribution limit not used in a year can be carried forward to future years.
  • Tax-free earnings. All earnings are tax-free and withdrawals can be made at any time for any reason, with no taxes or penalties. This feature greatly simplifies the accounts and increases liquidity, both of which encourage added savings.
  • No income limits. All adults can contribute to the accounts and withdraw from them at any time during their lives.
  • Ease of saving. Accounts can be opened at any bank branch or online, and they can hold bank deposits, stocks, bonds, mutual funds, and other types of assets.

TFSAs are great for all types of saving—saving to buy a home or a car, or saving to cover health expenses, unemployment, or retirement.

These types of accounts provide great flexibility for their users and see widespread use by Canadians of all income levels. In fact, Edwards points out that 80 percent of TFSA holders earn less than $80,000 a year and about half had incomes less than $42,000.

A parallel system in the U.S. that provides tax treatment similar to IRAs would deliver a big fix to the current tax codes bias against saving and investment. This type of treatment would eliminate one layer of taxation for every dollar saved. Universal savings accounts would be more than good tax policy; they would be a useful tool to help taxpayers save for a car, house, college for their child, their own retirement, or whatever other needs they may have.

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