In recent weeks, we have twice mentioned the influence the new Roth IRA accounts are having in driving the stock market to new highs. This sounds like the kind of cash-flow argument we always disparage. Money is gushing into mutual funds at an astonishing rate as people open the new IRA accounts and many convert from the old version to the new. But the real motive force is the dramatic supply-side effect of the new form, which backloads the benefits instead of front-loading them. That is, instead of getting a tax break for putting pre-tax income into an IRA, you now put after-tax income into a Roth IRA and its appreciation will not be taxed at the point you cash in. It not only can be cashed for retirement income at age 59˝, but also for college tuition or the purchase of a first home. What we have here is a giant tax loophole for the masses -- one that is pushing up the top of the stock market from the bottom.
This doesn’t mean for every $1,000 into a Roth IRA, the stock market capitalization rises by $1,000. In our supply model, where all growth is the result of risk-taking, $1,000 invested today in enterprises that would otherwise not get financed at all could produce capital assets of a hundred or a thousand times that amount. The reason the $1,000 does not get invested is because the potential after-tax rewards are not commensurate with the risks. By lowering the risks or raising the rewards, economic potential expands throughout the economic system. In the simplest example, people who make bread and people who make wine will be able to make more bread and more wine to trade with each other because the transactions can be financed. The Roth IRA is not taking “money” out of consumption and directing it toward investment. It is allowing production that would otherwise not occur to be financed, with part of that production going into consumption of consumer goods and part into consumption of capital goods. The potential has been there, dammed behind a sluice gate. Chairman Bill Roth of Senate Finance, one of the original supply-siders of Kemp-Roth fame, simply persuaded Congress to lift the gate.
The reason we paid no attention was that the new IRA’s backloading means it has no immediate costs to the federal government and therefore was not scored as a revenue loser. It’s the one place tax cuts did not have to face static revenue analysis. There was no controversy. The government will not get revenue from the investments when they are liquidated, but that’s way down the line. The reason it is so valuable to the masses is that they have their smallest taxable incomes when they are starting out in life and their highest taxable incomes when they are ready to buy a home, pay tuition for their kids, or retire. Before, you got the tax break when it meant very little on the front end and got hit hard when you cashed in. Now, you invest income taxed at the lowest rate and cash in when there is no tax at all! In addition, you pay for all the political risk up front and never have to worry about it again. You need not worry that tax rates in 30 years will be swollen by inflation and will confiscate your wealth, or that rates themselves will be much higher.
The deal is so good that many people who hold the old IRAs are willing to pay the penalty that will permit them to switch. This is happening on a wide scale as people learn of these benefits by word of mouth. Those who are in higher income classes can not take direct advantage of the Roth IRA, but they can gift their children the amounts necessary to open them -- or anyone else they would like to help get started. This is the reason the stock market is feeling the benefits gradually. Unlike a change in income tax, which the market can discount fairly quickly because incomes are known, the market is now responding to individual decisions to take advantage of a completely new system. It now may occur to you, for example, to liquidate shares of Electro-widget Inc., which you believe will produce major capital gains five or ten years from now. You may have to pay taxes on gains already earned, but if you open an IRA account for your kids and direct the funds to Electro-widget Inc., the gains five or ten years from now will face no capital gains tax instead of the 20% you must now contemplate -- with some chance that inflation will return and cause your liabilities to rise further.
We noted earlier that this new Roth IRA is a variation on the Postal Savings System introduced in Japan in the 1950s, which then became an engine for capital formation. You deposit after-tax income in the account, which earns market rates of interest, which compound without annual tax bites. When you tap into your savings for any reason, as long as the amount is under some figure which I recall at the equivalent of $30,000 annually, there is no income tax. Because Japan has very high marginal income tax rates -- although at high threshholds -- the zero tax on postal savings has been one of the main sources of national capital. The system now holds well over $5 trillion, and if you have noticed in news accounts of Japan’s financial troubles this week, the government has been directing the Postal Savings System to invest in the stock market in hopes of boosting equity prices. Alas, the idea is a bad one, doomed to fail, and the System now holds fewer bonds paying nominal interest rates and more equities that have lost value overnight. The correct policy would be to leave the PSS alone and eliminate the capital gains tax, which would provide another engine for capital formation and send the Nikkei shooting up instead of losing 3%, as it did last night.
The Roth IRA variation on Japan’s PSS is all to the good. Each individual can direct his investment, to equity or to debt, depending upon an almost infinite set of circumstances. Larry Hunter, the chief economist at Kemp’s Empower America, formerly minority staff director at the Joint Economic Committee of Congress, describes the new Roth IRA as “a benevolent virus,” one that spreads only good as it reaches out. Where everyone else in the Republican Party has been arguing about whether we should have a flat tax or a sales tax or a VAT tax -- all reforms from the outside, in -- Roth has injected his virus so that it works from the inside, out.
How big can it get? It is limited by the income caps, but it can grow for a long time before those caps place real limits on its growth. It’s clearly conceivable that it will provide the instrument for salvation of the Social Security System. For one thing, the levels of economic growth that are possible with the capital formation it can foster may blow away the actuarial assumptions that show big deficits in another 20 or 30 years. For another, the backloaded IRA could accommodate automatic financing of a new Social Security option. That is, the law could be changed to permit an individual to fold his FICA tax into his Roth IRA as long as some portion goes into the SSI trust fund. In his testimony yesterday, House Speaker Newt Gingrich began making sounds along these lines. He would “lock in” the $8 billion budget surplus expected in the current fiscal year by setting up private retirement accounts, without changing the current system: “Everybody would have a safety net. Even if a person makes a terrible investment, or the stock market goes into a dive, that person would always have Social Security to fall back upon.” We thought there were plenty of reasons for the DJIA to reach 9000 this year. Now we look around and find another, one that should take it even higher.