TAX POLICY, LUMP-SUM PENSION DISTRIBUTIONS, AND HOUSEHOLD SAVING ANGELA E. CHANG *

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1 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING TAX POLICY, LUMP-SUM PENSION DISTRIBUTIONS, AND HOUSEHOLD SAVING ANGELA E. CHANG * Abstract - The Tax Reform Act of 986 (TRA) imposed a ten percent penalty on lump-sum pension distributions that are not rolled over into tax-deferred instruments by younger recipients (under 55). This paper presents the first estimates of the tax sensitivity of rollovers, based on variations in the tax price introduced by the TRA. For higherincome recipients, a one percent increase in the tax price raises the probability of rollover by 0.4 percentage points; but among lower-income recipients, it rises by only 0.2 percentage points. Most recipients have low incomes and may be liquidity constrained, which explains the ineffectiveness of the penalty in raising rollovers. INTRODUCTION As of May 988, over 8 million workers had received a total of $42 billion in preretirement lump-sum distributions (LSDs) from their pension plans when they changed jobs. Over 85 percent of * Federal Reserve Bank of New York, New York, NY these workers did not roll over any of their LSDs into tax-deferred instruments, which are close substitutes of pension plans, but instead saved them in nontax-deferred instruments or simply spent them (Fernandez, 992). This low rollover rate has concerned Congress for two reasons: the fact that the spending of LSDs may reduce workers accumulated retirement savings, and the possibility that most recipients use the pension plans basically as tax shelters. To encourage LSD rollovers, Congress introduced in the Tax Reform Act of 986 (TRA) a ten percent penalty, in addition to the income tax, on the portion of LSDs not rolled over into taxdeferred instruments (Joint Committee on Taxation, 987). Individuals who receive LSDs after the age of 55 are exempt from this penalty. This paper presents the first estimates of the tax sensitivity of workers decisions to roll over their LSDs, 2 based on the response to the 986 changes in the tax treatment of the distributions. Past studies of rollovers have not examined the impact of taxes (Andrews, 99; Piacentini, 990). Hence, the main contribution of this study is to clarify whether a tax policy, such as the LSD 235

2 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 penalty, can be effective in preserving retirement savings. It also provides insights into how a penalty on consumption and non-tax-deferred investment affects household saving behavior in general, particularly the differences between lower- and higher-income households. The analysis shows that the tax penalty has a significant effect on the rollover decisions of higher-income recipients and, to a lesser degree, lower-income recipients. For the higher-income group, a one percent increase in the tax price raises the probability of rollover by 0.4 percentage points; but among lowerincome recipients, it rises by only 0.2 percentage points. Since most LSD recipients have lower incomes, the penalty has generated substantially more tax revenue than Congress anticipated: more than $.9 billion 3 versus $547 million during (Joint Committee on Taxation, 987). 4 Two approaches are taken to estimate the effect of taxes: () the difference-indifference approach based on comparing the rollover rates between younger and older recipients before and after the TRA, from which an indirect measure of the effect of taxes can be inferred; and (2) the traditional probit equations that include a measure of the marginal tax price of nonrollover. Each approach is subject to caveats. The former assumes the absence of nontax variables that increase rollovers among younger recipients relative to the older group, which may be a strong assumption if factors such as accumulated wealth and taste for retirement savings shift differently over time for the two age groups. In the traditional probit equations, the effect of taxes may not be identified from a nonlinear effect of income. Both approaches lead to the same conclusion that taxes impact the rollover decisions of higher-income recipients more than those of lowerincome recipients. The discussion starts with an overview of the receipt and the tax treatment of LSDs, followed by a description of the May 988 Current Population Survey (CPS), the primary dataset. The analytical methodology and econometric issues are considered, after which the results are examined. The paper concludes with a discussion of the policy implications and suggestions for future research. REGULATION OF LSD RECEIPT AND TAX TREATMENT Workers can receive pension benefits in the form of LSDs when they change jobs under two circumstances. About 80 to 90 percent of defined contribution (DC) pension plans and ten percent of defined benefit (DB) pension plans 5 allow workers to take their pension benefits as LSDs upon separation (Fernandez, 992). Second, employers may unilaterally cash out separated workers with accrued benefits less than the legal maximum limit, currently $3,500 (Fernandez, 992). Upon separation, workers who have the LSD option can allocate their pension money by () leaving it with their former employers for future withdrawal, (2) receiving checks for the LSDs and saving or spending the disbursements as they please, or (3) arranging rollovers into their new employers DC pension plans. 6 Workers who receive LSDs as a result of unilateral cashouts have similar choices, except they cannot leave the money with their former employers. Investing an LSD in tax-deferred instruments, such as employers pension plans or IRAs, is called a rollover. Saving an LSD in non-tax-deferred instruments or spending it is called a nonrollover. 236

3 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING Prior to 987, individuals paid income taxes on the amount of LSDs not invested in tax-deferred instruments, such as Individual Retirement Accounts (IRAs), insurance annuities, or their new employers pension plans. The TRA changed the tax price of nonrollovers by lowering the marginal tax rates for most levels of taxable income 7 and by imposing a ten percent penalty, in addition to the income tax, on the amount of LSDs not rolled over within 60 days of receipt (Joint Committee on Taxation, 987). Certain workers are exempt from the ten percent penalty, such as employees who are totally or permanently disabled or who have deductible medical expenses. For our purposes, the exception of interest is the exemption of workers who are 55 or older when they receive LSDs (Joint Committee on Taxation, 987). Figure illustrates the effects of the TRA on the tax price of nonrollover for younger and older recipients (55 or older), who are married and file joint returns; the changes in the tax price are similar for single recipients. For younger recipients at most levels of taxable income, the lower MTRs and the penalty had opposite effects on the marginal tax price of nonrollover; however, the net effect has been an increase in the marginal tax price on nonrollovers (Figure ). In fact, the tax price increased more for younger recipients 2 with lower incomes than for those with high incomes. In contrast, 2 FIGURE. Marginal Tax Price of Nonrollovers: Younger and Older Married Recipients Sources: Cooper & Lybrand (986, p. 2, 66), and ACIR (968, p. 22), and ACIR (987, p. 20). 237

4 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 older recipients generally face a lower tax price after 986. Thus, the TRA generated cross-sectional variation in the tax price, across age and income, as well as time-series variation. These sources of variation will be used to estimate the tax sensitivity of rollovers. CHARACTERISTICS OF RECIPIENTS AND ALLOCATION OF LSDs The analysis is based primarily on data from a supplement to the May 988 CPS, which includes questions about most recently received LSDs. The supplement questions were asked of 27,70 adults in the basic CPS sample who were employed for pay at the time of the interview. Like the basic CPS data, the supplement provides weights to make the sample representative of the U.S. population. About eight percent of the sample, or 2,62 workers, reported receiving at least one LSD from a prior job. This translates to a weighted figure of approximately 8.5 million workers who received a total of about $42 billion. Table shows that LSD receipt is not uniform across age or family income. Over half of the recipients are under 35 when they receive LSDs, and about 45 percent have family incomes under $30,000 (as of 987). Most younger and lower-income recipients receive LSDs that are less than $3,000 (Table 2). Overall, the average LSD is $5,989, while the median is $2,45 a discrepancy due to the fact that about 40 percent of the LSDs are less than $,000. The CPS includes information on whether recipients allocate their disbursements to various uses, but not the exact amounts. An overwhelming majority (86.5 percent) do not roll over any of their LSDs to tax-deferred TABLE DISTRIBUTION OF LSD RECEIPT Thousands Percent All recipients 8, Age at time of receipt: Under 35 5, , family income: Less than $0, $0,000 9,999, $20,000 29,999, $30,000 39,999 2, $40,000 49,999, $50,000 74, $75, Note: These are weighted figures based on 2,62 workers who reported receiving at least one preretirement LSD from a prior job, in the May 988 CPS supplement. instruments (Table 3), which corresponds to roughly 75 percent of the total amount. 8 In fact, about 4 percent save none of their LSDs. 9 A much higher percentage of recipients invest at least some of their disbursements in non-taxdeferred instruments (such as savings accounts) versus rolling them over. About 6 percent of recipients invest at least some of their LSDs: starting or buying a business, buying a house, 0 or paying educational expenses. About seven percent use their disbursements to pay expenses incurred during unemployment. Slightly over 25 percent allocate at least part of their LSDs to uses not specified in the CPS questionnaire. For the probit analysis, observations with missing family income and LSD amount are deleted from the sample. The analysis is limited to those who received LSDs between ; approximately the same number of years before and after the enactment of the TRA are considered, as a control for aggregate conditions. Table 4 lists the characteristics of the sample. The 238

5 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING Age at time of receipt: TABLE 2 DISTRIBUTION OF THE AMOUNT OF LSDs Amount of Distribution Under 35 $ 3, % 25.4% 0.7% 0.4% 5.2%.9% , , , family income: Mean Less than $0,000 6, $0,000 9,999 4, $20,000 29,999 4, $30,000 39,999 5, $40,000 49,999 6, $50,000 74,999 6, $75,000+, Recipient weighted $5,989 a 40.5% 22.4%.0% 3.0% 7.9% 5.2% Dollar weighted 2,45 b a Mean amount of LSDs. b Median amount of LSDs. Source: May 988 CPS supplement. $ 999 $,000 2,999 $3,000 4,999 $5,000 9,999 $0,000 9,999 $20,000+ TABLE 3 USES OF LSDs Recipients Amount Thousands Percent $Billions Percent Tax-deferred instruments:, Retirement programs Insurance annuities Savings accounts, Other financial instruments Start or buy a business Buy a house Buy a car Pay off debt, Pay educational expenses Pay expenses during unemployment Other 2, Notes: These are weighted figures based on the May 988 CPS supplement. The CPS does not provide the exact amount of LSDs allocated to various uses; thus, the median values of the range of the amount allocated to each use are reported above. If recipients reported more than one use, then they were assumed to have allocated a minimum of $ and a maximum of the entire amount of the LSD to each reported use. Summing these minimum and maximum figures across recipients yields a range of total amount allocated to each use. younger and older recipients differ in the average LSD size, demographic characteristics such as the percent of female and married recipients, and financial characteristics such as home ownership. These differences indicate that a meaningful comparison of the rollover decisions between younger and older recipients should, at the very least, control for such characteristics. 239

6 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 TABLE 4 CHARACTERISTICS OF RECIPIENTS, Younger Recipients Older Recipients Amount of LSD in 988 dollars 5,983 5,883 6,486,785 Age at time of LSD receipt Family income in ,05 3,548 30,366 32,485 Years of schooling completed Percent female Percent married Percent owned home in Percent contributed to IRA in Number of observations Notes: Figures are based on the May 988 CPS and do not cover all of 988. Younger recipients are those under 55 at the time of receipt. While the average characteristics for younger recipients are similar between and , the same cannot be said of the older group. For example, the average amount of LSD was considerably smaller in for older workers than during The percent of female and married older recipients differs substantially between the two periods, which may be due to the small sample of older recipients. ECONOMETRIC FRAMEWORK Two approaches are used to estimate the tax sensitivity of rollovers: the difference-in-difference approach, in which the change in rollovers before and after 986 among younger recipients, who are subject to the ten percent penalty, is compared to that of older recipients; and the traditional approach, in which a direct measure of taxes is related to rollover decisions. For both, the estimation procedure is based on the probit model, since the CPS does not provide data on the amount of LSDs invested in tax-deferred instruments. The observed discrete choice of recipient i to roll over at least some of the LSD is assumed to be the outcome of an unobservable process: S i = if s * > 0 i [ 0 if * si 0 where S i denotes the recipient s observed rollover decision and s * i, the unobservable desired amount of LSD rollover. S i has been defined as equal to one if a recipient rolls over at least some of the LSD, and zero otherwise. 2 The probability of observed rollover is modeled as 2 Pr(S i =) = Φ(β x i + γt i ) where Φ(. ) is the cumulative distribution function for a standard normal distribution. The variable t denotes the marginal tax price of nonrollover for each recipient, which equals the sum of the marginal federal tax rates (MTRs) and the tax penalty. 3 The penalty equals 0. for recipients under 55 after 986 and zero for all others. The vector x i includes the following characteristics of the recipients and the LSDs: () the LSD amount in 988 dollars, (2) age at the time of 240

7 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING LSD receipt, (3) family income in brackets (with $30,000 39,999 as the base group), (4) years of schooling completed, (5) gender, and (6) marital status. Four year dummies (with 984 as the base year) are included in the equations as a control for aggregate conditions. 4 Equation 2 is the traditional probit equation that relates a measure of the tax price to the rollover probability. A weakness of this approach is that the marginal tax price may not be identified from family income, since the former is a nonlinear function of income. 5 The changes in the tax price introduced in the TRA enable separating the effects of taxes from those of income, since recipients with similar characteristics faced different tax prices along dimensions other than income, depending on their age and whether they received LSDs before or after 986. The difference-in-difference approach can therefore be used to compare the rollover decisions of younger and older recipients, with the latter as the control group. All else being equal, rollovers should increase more among younger recipients relative to older recipients after 986. Due to data limitations, the sample of older recipients may not be the ideal control group, as will be discussed later. While the traditional probits and difference-indifference approaches are each subject to caveats, they lead to similar conclusions about the differential impact of taxes on low- versus high-income recipients. Computation of Tax Price The May 988 CPS presents several data limitations for computing the federal income tax rates, most notably the availability of family income only for 987. To estimate the family income and federal MTRs at the time of LSD receipt, I assumed that real family income at the time of receipt was highly correlated with family income in 987. Since MTRs apply to brackets of income, imputing them based on 987 income may approximate the true MTRs in the year of LSD receipt. The imputation may be reasonable, since the analysis is limited to 984 and 988 and the difference between the time of LSD receipt and 987 is at most three years. However, the degree of mismeasurement in the imputed MTRs may vary across years. If there is a positive time trend in family income, then the imputed MTRs for later years will be more accurate than those for 984. The mismeasurement may be worse for years prior to the TRA also because the tax brackets changed every $2,000 to $3,000 up to $45,000. Samwick 6 (993) finds substantial year-to-year variations in income, which implies that the imputed MTRs are less accurate for Changes in real income are especially pertinent to LSD recipients, who may receive their disbursements as a result of layoffs. Tabulations from the CPS data show that about ten percent of workers received LSDs and were laid off in Also, only seven percent of all recipients in the sample use their LSDs to pay expenses while unemployed (Table 3). These results suggest that most workers do not experience large, unexpected drops in income when they receive LSDs. The second data limitation is the availability of 987 family income in brackets. To compute MTRs, I assumed the 987 family income equaled the median value of the income brackets. Thus, if a recipient reported a

8 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 family income between $30,000 and 34,999, it was assumed to equal $32,500. Other assumptions are required to calculate MTRs: the marital status reported in 987 is the same in the year of LSD receipt; married recipients file joint returns; unmarried recipients with children file as heads of households; recipients take the standard deductions; and unmarried recipients take one personal exemption while married recipients take two. Dependent exemptions are based on the number of children reported in the May 988 CPS. The average marginal tax price for younger and older recipients, based on the imputed MTRs and the penalty, are presented below. Table 5 confirms the tax changes observed in Figure. The average marginal tax price falls for older recipients but rises for younger recipients after 986. The increase is larger for lower-income recipients under 55 than their higher-income counterparts. LSD option and (2) the decision to roll over a received LSD. With a sample of LSD recipients, the effect of taxes on the latter decision can be estimated but without accounting for their effect on the former, which may introduce a self-selection bias. Because individuallevel data are not available to separate workers with and without the LSD option, 8 econometric corrections for self-selection bias (e.g., Heckman s two-step procedure) 9 cannot be used. If taxes induce many workers to leave pension money with former employers, then the estimated effect of taxes on the rollover decisions of workers who received LSDs will be lower than the true effect for all workers with the LSD option. In other words, since leaving pension money with employers is equivalent to rollovers, my sample underrepresents the number of rollovers due to taxes, which implies that the reported estimates of the effect of taxes are biased downward. Sources of Self-Selection Bias Taxes impact rollovers through two channels: () the decision to exercise the TABLE 5 AVERAGE MARGINAL TAX PRICE OF NONROLLOVER Under or older Higher-income and under 55 Lower-income and under 55 Before TRA 0.29 (0.0) 0.3 (0.0) 0.36 (0.06) 0.22 (0.07) After TRA 0.32 (0.09) 0.26 (0.) 0.38 (0.07) 0.28 (0.07) Notes: Standard deviations are in parentheses. The base income category is $30,000 to $39,999. The lower-income group includes recipients with incomes below $30,000; and the higher-income group includes those with incomes above $39,999. Source: May 988 CPS supplement. A self-selection bias may also arise from the impact of LSD receipt on retirement decisions. If workers retire early as a result of receiving LSDs, the tax estimates may be biased upward since the CPS sample includes only individuals who were employed in May 988. Older recipients who decide to retire early are probably more likely to roll over at least part of the LSDs than other recipients who are working. Moreover, such early retirees probably bear a lower tax burden than younger recipients, since they are exempt from the penalty and face lower MTRs (assuming they have lower incomes than younger recipients). This combination of a high rollover rate and a low tax burden implies that including the early retirees in the sample would reduce the size and significance of the tax coefficients. 242

9 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING TAX SENSITIVITY OF ROLLOVERS Aggregate Evidence Exact figures on income taxes paid on lump-sum distributions are not available from IRS Statistics of Income (SOI) publications. The IRS aggregates statistics for the ten percent penalty on premature IRA withdrawals with those for the ten percent penalty on nonrollover of LSDs. Based on these aggregate figures and data from the U.S. Treasury Individual Tax Model, I estimated the number of recipients who paid the ten percent penalty and the amount of revenue, assuming that for the number of taxpayers who paid the ten percent IRA penalty and the associated revenue were the same as in The estimates indicate that the penalty has not increased rollovers to the extent that Congress expected (Table 6). Hence, it has raised more revenue during than Congress had anticipated ($.9 billion versus $547 million). 2 Younger versus Older Recipients The impact of the penalty can also be inferred by comparing the rollover rates of younger and older recipients before and after 986. Table 7 shows an increase in rollover rates among younger TABLE 6 REVENUE FROM THE TAX PENALTY 243 recipients but a decline among older recipients between and This disparity cannot be attributed solely to the penalty, given the positive time trend for the younger group and a negative trend for the older group since 98. An estimate of the change in rollovers relative to the change in the tax price based on Table 7 serves as a useful starting point for the analysis of individual-level data. By comparing the difference in rollover rates between the two age groups over time, the effects of time-invariant factors that are specific to each age group and time-series shocks that are common to both groups can be taken into account. Thus, the difference-in-difference estimate reflects the effects of only the time-varying factors that are specific to each group, including the ten percent penalty. 22 The implied tax effect can be computed as the ratio of the difference-in-difference of rollover rates to the difference-indifference of the average marginal tax prices. 23 Relative to older recipients, who were not subject to the penalty, younger recipients experienced an increase of 9. percentage points in rollover rates between and and an increase of eight percentage points in the average marginal tax price. This implies a tax derivative of.; however, the difference-in-difference of rollover rates is not precisely estimated, with a standard error of 3 percent. Number Paid Actual Anticipated Penalty Revenue Revenue TABLE 7 (Thousands) ($ Millions) ($ Millions) , , Sources: U.S. Treasury Individual Tax Model File and SOI publications (number paid penalty and actual revenue); U.S. Joint Tax Committee (anticipated revenue). ROLLOVER RATES BY YEAR OF RECEIPT AND AGE GROUP All Younger Older Before % 3.9% 2.5% Source: May 988 CPS Supplement.

10 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 To test whether the different rollover trends for younger and older recipients are due to demographic and financial characteristics, equations with the following specification are presented: 3 Pr(S i =) = Φ(β x i + δ LESS55 + δ 2 POST86 + δ 3 (LESS55)(POST86)) where x i includes characteristics of the recipients and the LSDs. 24 LESS55 equals one for younger recipients and zero otherwise, and POST86 equals one for LSDs received after 986 and zero otherwise. If rollovers increased more among younger recipients relative to the older group, controlling for demographic characteristics and LSD size, then δ 3 will be positive. Table 8 shows that the interaction term is not statistically significant for the full sample and the lower-income group, who comprise the majority of all recipients. This is consistent with the evidence from the aggregate data that the penalty did not substantially raise the overall rollover rates after 986. The coefficient for the interaction term is significant at the 0 percent level for the higher-income group, which suggests that rollovers rose among younger recipients with high incomes after 986, who actually experienced a smaller increase in the marginal tax price of nonrollovers than younger recipients with lower incomes. The probability of rollover also tends to increase with LSD size, 987 family income, and age at the time of receipt. The implications of these results for different models of saving behavior are discussed later. Assuming the interaction term reflects only the effect of taxes, the derivative of the rollover probability with respect to taxes can be computed as the ratio of the estimated marginal probability 25 of the interaction term to the difference-indifference of the average marginal tax price (across age groups and time periods). 26 The implied tax derivative 27 is 0.75 for the full sample, which is lower than the earlier estimates based on Table 7. This indicates that changes in demographic and financial characteristics and the LSD size, which are not controlled for in Table 7, partially account for the increase in rollovers among younger recipients after the TRA. An obvious caveat to the estimated tax derivative is the statistical insignificance of the interaction term for the full sample. The implied tax derivative for the higherincome group is much larger (3.56) and more precisely estimated; a one percentage point increase in the marginal tax price increases the rollover probability by over three percentage points. A ten percent penalty would therefore raise the rollover probability by over 30 percentage points. Expressed as a semielasticity, 28 a one percent increase in the marginal tax price leads to a.3 percentage point increase in the rollover probability among higher-income recipients. The penalty represents a 27.8 percent increase in the marginal tax price for younger recipients with higher incomes (Table 5) and would raise their rollover rates by 36 percentage points between and , if the penalty were not offset by lower marginal tax rates in the TRA. The estimates in Table 8 should be interpreted cautiously. The sharp contrast in demographic and financial characteristics and LSD size between the 244

11 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING Explanatory Variable Real amount of LSD ($ thousands) TABLE 8 DIFFERENCE-IN-DIFFERENCE ESTIMATES Full Sample Marginal Coefficient Probability 0.0 ** (0.004) ** (0.00) Lower Income Marginal Coefficient Probability 0.02 ** (0.005) ** (0.00) Higher Income Marginal Coefficient Probability (0.005) ** (0.00) If less than 55 years old: LESS * (0.26) 0.4 ** (0.06) 0.28 (0.30) 0.07 (0.06) 0.79 ** (0.37) 0.27 ** (0.) If LSD received after 986: POST (0.39) 0.02 (0.0) 0.39 (0.45) 0.09 (0.0) 0.7 (0.57) 0.8 (0.6) (LESS55)*(POST86) 987 family income: Less than $0, (0.4) 0.9 (0.29) 0.06 (0.0) 0.04 (0.07) 0.39 (0.47) 0.3 (0.30) 0.08 (0.0) 0.06 (0.06).09 * (0.59) 0.32 * (0.7) $0,000 9, ** (0.7) 0.09 ** (0.04) 0.47 ** (0.7) 0.09 ** (0.04) - - $20,000 29, (0.5) 0.02 (0.04) 0.2 (0.6) 0.03 (0.03) - - $40,000 49, (0.8) 0.04 (0.04) (0.8) 0.05 (0.05) $50,000 74, (0.22) 0.04 (0.05) (0.22) 0.07 (0.06) $75, ** (0.20) 0. ** (0.05) ** (0.20) 0.5 ** (0.06) Implied tax derivative Implied tax semi-elasticity Sample size Log likelihood * Statistically significant at the ten percent level. ** Statistically significant at the five percent level. Notes: The dependent variable equals one for recipients who rolled over any of their LSDs and zero for all others. Standard errors are in parentheses. The equations include variables for years of schooling, whether female, and whether married. The base category for family income is $30,000 to $39,999; recipients in this category are included in both lower- and higher-income equations. The tax semi-elasticity denotes the increase in the rollover probability per one percent increase in the marginal tax price. two age groups in Table 4 and the different rollover trends for the two age groups in Table 7 suggest that older recipients may not be the ideal control group against whom to compare the rollover decisions of younger recipients. Also, the interaction term is not identified if there are any age-specific nontax variables that changed over time and that increased the rollovers of the younger group relative to the older group. In this case, the interaction term may reflect the effect of these variables and not necessarily that of the penalty. 245

12 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 A related caveat is that changes that coincide with job separations may be linked to age and income. For example, the length of unemployment spell (if a layoff triggered the LSD) and wages and pension coverage on the new job could affect rollover decisions. If such factors evolve differently for younger and older recipients, then the interaction term would capture their effects on rollovers. Lastly, the interaction term ascribes the same effect of the tax changes to every recipient in each age group, although we know that the increase in the marginal tax price of nonrollover depended on income as well as age. Estimating separate probit equations for the two income groups addresses this issue to some degree; however, results based on probits with a variable for the marginal tax price of nonrollover may be more accurate. Estimates of the Tax Sensitivity of Rollovers Table 9 presents estimates from probit equations that test directly the effect of taxes on rollover decisions. For the full sample and both income groups, the marginal tax price of nonrollover has a statistically significant effect on the rollover probability. The marginal probability of the tax price 29 is.7 for the higher-income group versus 0.73 for the lower-income group. Tax semielasticities may be more meaningful, since the two income groups faced different marginal tax prices before the TRA. For the lower-income sample, the tax semi-elasticity is 0.9; 30 while a one percent increase in the marginal tax price raises the rollover probability of the higher-income group by 0.43 percentage points. These estimates imply that the penalty would have increased rollover rates from 3.7 percent in to 22.3 percent in for lower-income younger workers and from 7.5 to 29.5 percent for higher-income younger workers. 3 For the latter, the predicted rollover rate nearly matches the actual rate during (28.6 percent), although lower marginal tax rates offset much of the increase in the marginal tax price from the penalty, resulting in an increase of only 5.6 percent (Table 5). Assuming rollover of entire LSDs, the penalty would have raised the total amount of rollover by over $ billion during 987 to May 988 among the higher-income younger recipients. 32 For the higher-income group, the estimated tax semi-elasticity is lower than the result in Table 8. This would be expected if the interaction term (LESS55)(POST86) captures the positive effect of omitted nontax variables on rollovers. The estimates in Table 9 should be interpreted cautiously, since the tax variable may reflect a nonlinear effect of income and not solely the effect of taxes. Nonetheless, the main conclusion is the same as in Table 8: taxes impact the rollover decisions of higher-income recipients more than those of lower-income recipients. The findings in Tables 8 and 9 are counter to the standard Life-Cycle Hypothesis, which predicts that taxes, the real amount of LSDs, and the age at the time of receipt would have little effect on the probability of rollover, as long as an LSD is basically a change in the timing of income receipt. However, the findings are consistent with an extended version of the hypothesis, in which consumption decisions are made under uncertainty about future income and individuals prefer to maintain some liquid assets. Since tax-deferred instruments such as IRAs are generally less liquid than non-tax-deferred instruments, 33 as uncertainty increases, workers may prefer the latter. 246

13 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING TABLE 9 ESTIMATES OF THE TAX SENSITIVITY OF ROLLOVERS Full Sample Lower Income Higher Income Explanatory Variable Coefficient Marginal Probability Coefficient Marginal Probability Coefficient Marginal Probability Real amount of LSD ($ thousands) (0.005) (0.00) (0.008) (0.002) 0.00 (0.006) (0.002) 987 family income: Less than $0, (0.37) 0.0 (0.09) 0.24 (0.4) 0.05 (0.09) - - $0,000 9, (0.2) (0.05) 0.0 (0.24) 0.02 (0.05) - - $20,000 29, (0.7) 0.02 (0.04) 0.04 (0.8) (0.04) - - $40,000 49, (0.9) 0.0 (0.05) (0.2) 0.02 (0.06) $50,000 74, (0.24) 0.03 (0.06) (0.27) 0.04 (0.08) $75, (0.23) (0.05) (0.28) (0.08) Years of schooling 0.02 (0.02) (0.006) (0.03) (0.006) 0.00 (0.03) (0.009) If female (0.) (0.03) 0. (0.4) 0.02 (0.03) 0.04 (0.5) 0.0 (0.04) If married 0.9 (0.6) 0.04 (0.04) 0.02 (0.9) (0.04) 0.23 (0.23) 0.06 (0.06) Age at time of receipt 0.02 ** (0.006) ** (0.00) 0.03 ** (0.007) ** (0.00) 0.02 ** (0.008) ** (0.002) Marginal tax price of nonrollover 3.69 ** (.26) 0.87 ** (0.30) 3.49 ** (.55) 0.73 ** (0.32) 4. ** (.88).7** (0.53) Tax semi-elasticity Sample size -Log likelihood * Statistically significant at the ten percent level. ** Statistically significant at the five percent level. Notes: The dependent variable equals one for recipients who rolled over any of their LSDs and zero for all others. Standard errors are in parentheses. The equations include year dummy variables. The base category for family income is $30,000 to $39,999; recipients in this category are included in both lower- and higher-income equations. The tax semielasticity denotes the increase in the rollover probability per one percent increase in the marginal tax price. 247

14 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 If job separations increase uncertainty about future income, then workers who are laid off may prefer not to roll over their LSDs until they are more certain of their future prospects. They may be more likely to roll over larger LSDs namely, the portion that exceeds the desired amount of liquid assets. If younger and lower-income workers face greater uncertainty about their future income or are less likely to have accumulated the desired amount of liquid assets, the probability of rollover would increase with age and family income. The results are also consistent with two other models of saving behavior: saving under liquidity constraints and the behavioral model of saving. Liquidity constraints may be especially relevant within the context of LSDs, since most recipients are younger and lowerincome workers (Table 2) who are more likely to be liquidity constrained. They may also account for the positive effect of LSD size on the probability of rollover. Larger LSDs are more likely to exceed the desired level of consumption by liquidity-constrained recipients, who would presumably roll over the excess amount. The behavioral model of saving emphasizes the categorizing of bundles of money into three different mental accounts : current income, assets, and future income. 34 The model assumes that individuals have the lowest marginal propensity to save bundles of money categorized as current income and the highest marginal propensity to save money categorized as future income. The positive effects of LSD size and age on the probability of rollover are consistent with the behavioral model. Recipients are more likely to classify larger LSDs as assets or future income than as current income. Similarly, older recipients may be more concerned about retirement income and more likely to classify LSDs as assets or future income than younger recipients. This model, however, does not adequately explain the positive relationship between family income and the probability of rollover. Conclusions Congress has often attempted to raise personal saving with tax penalties on consumption. 35 For example, they imposed a ten percent tax penalty on early IRA withdrawals in 982, when IRAs became available to all workers (Ozanne, 992). In 986, Congress imposed a ten percent tax penalty on the amount of LSDs not rolled over into tax-deferred instruments by recipients under 55 years of age. Based on individual-level data from the May 988 CPS, this paper presents the first estimates of the effect of taxes on rollover decisions. Probits based on the difference-indifference approach show that among higher-income recipients, the prob-ability of rollover increased more for younger recipients relative to older recipients after 986. This result is used to infer an indirect measure of the tax semi-elasticity: a one percent increase in the tax price raises the probability of rollover among the higher-income group by.3 percentage points. A similar increase in rollover probability is not observed for the lower-income group. The estimates based on the difference-in-difference approach should be interpreted cautiously, since they assume the absence of nontax variables that increased rollovers of younger recipients relative to the older group. 248

15 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING The traditional tax price equations also indicate that taxes impact the rollover decisions of higher-income recipients more than those of the lower-income group. A one percent increase in the tax price is estimated to increase the rollover probability by 0.4 percentage points for the higher-income group and 0.2 percentage points for the lowerincome group. If not offset by lower marginal tax rates, the penalty would have increased rollover rates from 3.7 percent in to 22.3 percent in for the lower-income younger workers and from 7.5 to 29.5 percent for the higher-income younger workers. For the latter, the penalty might have raised the total amount of rollovers by over $ billion during 987 to May 988, if the penalty were not compensated by lower marginal tax rates. There are several caveats to these estimates. Due to data limitations, the measure of the marginal tax price of nonrollovers is subject to measurement error. The data are also not available to separate the effects of wealth, accumulated retirement savings, or changes in income or pension coverage that coincide with job separations from those associated with income and taxes. The differential impact of taxes by income is a robust result, which is consistent with the presence of liquidity constraints for lower-income recipients. Once adequate data become available, an examination of the importance of liquidity constraints may provide more accurate estimates of the tax sensitivity of rollovers. As the trend toward defined contribution pension plans continues, more workers will receive LSDs. Most will be young, lowerincome workers who will use their LSDs to finance current consumption, thereby reducing their accumulated retirement savings. The combination of the increasing prevalence of LSDs, the spending of most LSDs, and the tax penalty s insignificant effect on the rollover decisions of lower-income recipients suggests that the nonrollover of LSDs will continue to be a policy concern in the near future. ENDNOTES I would like to thank Peter Diamond, Jonathan Gruber, James Poterba, John Turner, Paul Yakoboski, participants at the Harvard MIT Public Economics Seminar, and three referees for helpful comments. Daniel Feenberg provided invaluable help with the U.S. Treasury Individual Tax Model File (984 89). Financial support while at MIT from the National Science Foundation, Bradley Foundation, and MIT World Economy Laboratory is gratefully acknowledged. Views expressed are entirely my own and do not necessarily reflect the official position of the Federal Reserve Bank of New York or the Federal Reserve System. All dollar figures are in 988 dollars, unless otherwise noted. 2 This paper does not examine the rollovers of LSDs received after age 59 2, which are called normal or retirement distributions. In 990, preretirement and normal LSDs accounted for about 60 and 25 percent of all LSDs and about 38 and 34 percent of the total dollar amount, respectively (Yakoboski, 994). 3 This figure is an estimate from the U.S. Treasury Individual Tax Model dataset for and the IRS Individual Income Tax Returns for The revenue potential may have motivated a change in the collection of the penalty, whereby workers who receive LSDs after January 993 are subject to a 20 percent withholding tax (IRS Taxpayer Service; Janssen, 992; Schultz, 992). This tax, which was included in the July 992 bill that extended unemployment benefits, was expected to pay for part of the cost of those benefits. 5 DB plans typically pay benefits upon retirement, even to workers who leave before retirement. 6 Most pension plans do not allow rollovers from other pension plans. 7 For example, in 986, the top marginal tax rate for married taxpayers filing joint returns was 50 percent; in 987, 38.5 percent; and in 988, 33 percent (Coopers & Lybrand, 986; Statistical Abstract of the United States). 8 A range of the amount of rollovers was inferred based on the number of uses reported. If recipients reported more than one use for the LSD, then they were assumed to have allocated a minimum of $ 249

16 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 and a maximum of the entire amount to each reported use. Summing these minimum and maximum figures across recipients produces a range of the total amount rolled over. The median value of the range of rollovers is $9.4 billion, or about 22 percent of the total amount of LSDs. 9 I defined saving as allocating any of an LSD to financial instruments or retiring debt. 0 This can be considered saving for retirement, since the value of the house can be used to obtain financial resources via instruments such as home equity loans and reverse mortgages. However, Venti and Wise (989) show that the elderly are reluctant to reduce housing equity, which suggests that financing consumption during retirement may not be the main motivation for buying a house. The sample includes data for less than two years after the passage of TRA (about 8 months). 2 S i can also be defined as equal to one for recipients who roll over all of their LSD and zero otherwise. The probit results using this measure of S i are similar to those presented in the paper, as are the results from ordered probit equations (where S i equals two for rollover of the entire LSD, one for partial rollover, and zero for no rollover). The similarity in the results is not surprising, since 79 percent of recipients who roll over any of their LSDs actually roll over the entire amount. 3 I also estimated probit equations on the full sample with the marginal tax rates and the tax penalty as separate variables. Based on the results from likelihood ratio tests, the null hypothesis of same coefficients for the two variables cannot be rejected at the five percent level. 4 The year dummies are generally not statistically significant, with the exception of the 988 dummy which is significantly positive. 5 Feenberg (987) gives a clear discussion of the identification issue. 6 Based on a sample of heads of households from the Panel Study of Income Dynamics, Samwick estimates that the standard deviation in income due to permanent shocks is about 4 percent and 2 percent due to transitory shocks. 7 This figure is based on workers who received LSDs in 987 or 988, for whom the CPS provides enough information to infer if they received LSDs as a result of quits or layoffs. Results for this group indicate that layoffs in 987 had no significant effect on rollover decisions. 8 A Gallup survey conducted during February June 99 indicates that only 7 percent of the 327 individuals in the sample (between the ages of 8 and 54) who had the LSD option chose not to exercise it. David Wray at the Profit Sharing Council kindly provided the survey results. 9 For a description of the procedure, see Maddala (983). 20 The bias from this assumption is ambiguous. If the revenue from the IRA penalty continued to rise during as during or if more premature IRA withdrawals were made in to take advantage of lower tax rates, then the estimated revenue figures are too high. However, IRA participation declined dramatically after 986 (Engen, Gale, and Scholz, 994) and, possibly, the number of premature IRA withdrawals. This would imply a downward bias for the estimates of the revenue from the LSD penalty. 2 Figures from the CPS indicate that about 926,000 LSD recipients paid $360 million in tax penalties in 987. Figures for 988 are not available from the CPS, since it does not cover all of The estimates are equivalent to those from an ordinary least-squares (OLS) equation with a dummy variable for whether a recipient is under 55, a dummy for whether the LSD was received after 986, and an interaction term of these variables. Of course, the OLS standard errors must be corrected for heteroscedasticity. For a discussion of difference-in-difference estimation, see Gruber and Poterba (994). 23 The implied tax derivative is calculated as the ratio of the difference-in-difference of the rollover rate and the difference-in-difference of the average tax rates: 4 (S POST S PRE ) (S POST S PRE ) (t POST t PRE ) (t POST t PRE ) where is the rollover rate and is the S average POST y t tax rate among younger recipients POST y after the TRA (987 88). The superscript PRE denotes the period before the TRA (984 86), and the subscript O denotes the older recipients. 24 The results presented are from probits that do not include age as a continuous variable in x i. The conclusions are similar for equations that include both age as a continuous variable and LESS The marginal probability for a binary variable j, such as the interaction term, is computed as 5 y Y O O y Y O O Σ i [Φ(z i ) x = Φ(z i ) x =0 ] N j j where N is the total number of observations, Φ is the standard normal cumulative distribution, and z i equals β x i, or the estimated index for individual i. For a continuous variable, the marginal probability is computed as 250

17 TAX POLICY, PENSION DISTRIBUTIONS, AND SAVING 6 N Σ i Φ(z i )β j. This methodology is identical to that in Gruber and Poterba (994). It is analogous to the marginal effect interpretation of OLS coefficients (i.e., as the average of the effect on each individual). Another way to estimate the marginal probability is to evaluate Φ(z)β j = Φ(β x)β j, or at the means of the explanatory variables. The marginal probabilities computed in either manner are identical for almost all of the explanatory variables. The marginal probabilities as computed in equations 5 and 6 are continuous functions of the estimated probit coefficients, denoted as g j (.). Using a Taylor expansion (Greene, 990), the standard errors of the marginal probabilities are given by 7 s j = g j Σ g j where g j is the gradient of function g j (.) and Σ is the variance-covariance matrix of the estimated coefficients. 26 The difference-in-difference of the average marginal tax price of nonrollover is 0.08 for the full sample, 0. for the low-income group, and 0.09 for the high-income group. 27 The implied tax derivative is computed as the ratio of the marginal probability of the interaction term and the difference-in-difference of the average tax rates: 8 N Σ i [Φ(z i ) x = Φ(z i ) x =0 ] j j. (t POST t PRE ) (t POST t PRE ) y Y 28 The semi-elasticity equals: 9 Σ i [Φ(z i ) x = Φ(z i ) x =0 ] N j j (t POST y t PRE ) (t POST t PRE Y O O ) t PRE y O t PRE O O where the denominator is the difference in the percentage change of the tax price between younger and older recipients, as used in Feldstein (995). 29 The marginal probability of the tax price is computed as 0 N Σ i Φ(β x i )β t where β t is the estimated coefficient of the tax price variable. 30 The tax semi-elasticity equals N Σ i Φ(β x i )β t t where t is the average tax price. 3 The actual rollover rates for higher-income younger recipients were 7.5 percent during and 28.6 percent during The actual rates for the lower-income younger group were 3.7 percent during and 3.9 percent during Among younger recipients, the ten percent penalty represented a 45.5 percent increase in the marginal tax price for the lowerincome group and a 27.8 percent increase for the higher-income group. 32 Approximately.7 million higher-income younger workers received LSDs during 987 to May 988, and the average size of the LSDs was about $5,800. Thus, a 2 percent increase in the number of recipients who roll over their entire LSDs translates to over $ billion in the total amount of rollovers. As mentioned before, most recipients who roll over any of their LSDs actually roll over the entire distributions. 33 Engen, Gale, and Scholz (994) analyze how individuals may not view tax-deferred and non-taxdeferred instruments as close substitutes and may want to invest in both. 34 For a detailed discussion of behavioral models of saving behavior, see Shefrin and Thaler (988) and Thaler (99). 35 The LSD penalty may also discourage non-taxdeferred investments such as buying houses or paying educational expenses. REFERENCES Advisory Commission on Intergovernmental Relations (ACIR). Significant Features of Fiscal 25

18 NATIONAL TAX JOURNAL VOL. XLIX NO. 2 Federalism Edition. Washington, D.C.: ACIR, 986. Advisory Commission on Intergovernmental Relations. Significant Features of Fiscal Federalism 988 Edition. Volume I. Washington, D.C.: ACIR, 987. Andrews, Emily S. Retirement Savings and Lump Sum Distributions. Benefits Quarterly 7 No. 2 (2nd quarter, 99): Coopers & Lybrand. Tax Reform Act of 986. Washington, D.C.: Coopers & Lybrand, 986. Engen, Eric M., William G. Gale, and John Karl Scholz. Do Saving Incentives Work: Brookings Papers on Economic Activity (994:): Feenberg, Daniel. Are Tax Price Models Really Identified: The Case of Charitable Giving. National Tax Journal 40 No. 4 (December, 987): Feldstein, Martin. The Effect of Marginal Tax Rates on Taxable income: A Panel Study of the 986 Tax Reform Act. Journal of Political Economy 03 No. 3 (June, 995): Fernandez, Phyllis A. Preretirement Lump- Sum Distributions. In Trends in Pensions 992, edited by John A. Turner and Daniel J. Beller, Washington, D.C.: Government Printing Office, 992. Greene, William H. Econometric Analysis. New York: Macmillan Publishing Company, 990. Gruber, Jonathan, and James Poterba. Tax Incentives and the Decision to Purchase Health Insurance: Evidence from the Self-Employed. The Quarterly Journal of Economics 09 No. 3 (August, 994): Janssen, Dick. Don t Roll Over for This Payout Ploy. Business Week (August 7, 992): 4. Maddala, G.S. Limited-Dependent and Qualitative Variables in Econometrics. Cambridge: Cambridge University Press, 983. Ozanne, Larry J. Past Experience and Current Proposals for IRAs. In Personal Saving, Consumption, and Tax Policy, edited by Marvin H. Kosters, Washington, D.C.: AEI Press, 992. Piacentini, Joseph S. An Analysis of Pension Participation at Current and Prior Jobs, Receipt and Use of Preretirement Lump-Sum Distributions, and Tenure at Current Job: New Findings from the May 988 Current Population Survey Employee Benefit Supplement. Prepared for the U.S. Department of Labor, Pension and Welfare Benefits Administration. Washington, D.C.: Employee Benefit Research Institute, 990. Profit Sharing Council. Lump Sum Distribution Decisions. Survey conducted by Gallup organization Inc. Chicago: 99. Samwick, Andrew A. Risk-Sharing Through Private Pensions. Ph.D. dissertation. Massachusetts Institute of Technology, 993. Schultz, Ellen E. Pension Payouts Will Face a New Tax Trap. Wall Street Journal (July 3, 992): C, C8. Shefrin, Hersh M., and Richard H. Thaler. The Behavioral Life-Cycle Hypothesis. Economic Inquiry 26 No. 4 (October, 988): Thaler, Richard H. Quasi-Rational Economics. New York: The Free Press, 99. U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 986. Washington, D.C.: Government Printing Office, 987. U.S. Department of Commerce. Bureau of the Census. Statistical Abstract of the United States Editions. Washington, D.C.: Government Printing Office, U.S. Department of Commerce. Bureau of the Census. Data User Services Division. Current Population Survey, May 988: Survey of Employee Benefits (Computer File and Technical Documentation). Washington, D.C.: Bureau of the Census (producer), 989. Ann Arbor, MI: Inter-University Consortium for Political and Social Research (distributor), 990. U.S. Internal Revenue Service. Statistics of Income Division (SOI). Individual Income Tax Returns 986. Washington, D.C.: Government Printing Office, 989. U.S. Internal Revenue Service. Individual Income Tax Returns 987. Washington, D.C.: Government Printing Office, 990. U.S. Internal Revenue Service. Individual Income Tax Returns 988. Washington, D.C.: Government Printing Office, 99. U.S. Internal Revenue Service. Taxpayer Service Division. Keith Bond. Letter to author. September 9, 992. Venti, Steven F., and David A. Wise. But They Don t Want to Reduce Housing Equity. NBER Working Paper No Cambridge, MA: National Bureau of Economic Research, 989. Yakoboski, Paul. Retirement Program Lump- Sum Distributions: Hundreds of Billions in Hidden Pension Income. EBRI Issue Brief No. 46. Washington, D.C.: Employee Benefit Research Institute,

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