Obviously, in the final period T, an unconstrained federal government will renege on its announced transfer scheme and the non-commitment outcome will result.
If the federal government does not renege on its announced transfer policy, then the expected present value of welfare is given by
From (17) and (18), we can view the federal government's problem as weighing the temptation to renege on its transfer policy against the cost, given the realization of the shock [[theta].sub.t] and given the levels of the regional public good selected in the preceding stage of period t.
Temptation to renege: [[GAMMA].sub.t] = [W.sub.t.sup.R] ([[theta].sub.t]) - [W.sub.t.sup.C] ([[theta].sub.t]);
From the analysis in section 2, the temptation to renege is obviously positive for all realizations of the shock [theta].
Conversely, as t approaches T, the cost of reneging may be quite small, and thus the incentive to renege may arise for a wide range of values for [theta].
Such a scenario arises in period t if there is no shock large enough to induce a type 2 government to renege on its announced transfer policy.
Consequently, as t approaches T, the incentive to renege may occur for a wide range of values of [theta], and hence [??] and [??] decrease over time.
Although it is impossible to fix a precise probability on whether Congress will actually renege, thinking through all the possible scenarios for individuals in different circumstances can help a financial planner devise a prudent strategy.
If it is certain that Congress will not renege, the analysis is simply a comparison of the contribution-year and withdrawal-year tax rates, which is a rule of thumb that many CPAs use.
The taxpayer anticipates maintaining the account for 20 years, an 8% annual return on the account's investments, a 30% withdrawal-year tax rate, and a 40% chance that Congress will renege. Exhibit 1 shows that, for a 20-year investment horizon and an 8% return, the assumed 40% reneging probability is greater than the 28% break-even probability is greater than the 28% break-even probability, indicating that a traditional 401(k) is the better choice.
If Congress were to renege on Roth accounts, however, the inclusion of the income tax in the taxable estate that occurs with traditional accounts would also occur with Roth accounts.
This article considers an additional source of uncertainty: the possibility that Congress will renege on the tax-free treatment of withdrawals from Roth IRAs.
Although the probability that Congress actually will renege on Roth accounts may be impossible to ascertain, the analysis here can help one to identify those circumstances where it may influence the decision between Roth and traditional accounts and those circumstances where it may not.