The tax treatment of funded pensions

Whitehouse, Edward Article The tax treatment of funded pensions Schmollers Jahrbuch – Zeitschrift für Wirtschaftsund Sozialwissenschaften. Journal of Applied Social Science Studies Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Whitehouse, Edward (2000) : The tax treatment of funded pensions, Schmollers Jahrbuch – Zeitschrift für Wirtschaftsund Sozialwissenschaften. Journal of Applied Social Science Studies, ISSN 1865-5742, Duncker & Humblot, Berlin, Vol. 120, Iss. 3, pp. 415-443, https://doi.org/10.3790/schm.120.3.415 This Version is available at: https://hdl.handle.net/10419/291964 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Schmollers Jahrbuch 120 (2000), 415-443 Duncker & Humblot, Berlin The tax treatment of funded pensions By Edward Whitehouse1 Abstract The tax treatment of pensions is a critical policy choice in the transition from a public sector, pay-as-you-go system to one in which all or part of pensions are provided through individual, privately managed pension accounts. A generous tax treatment will promote pension saving but may be costly in terms of revenues forgone and encourage tax avoidance. The distributional consequences may also be undesirable if higher income individuals are better able to take advantage of tax reliefs. In countries with mature funded pension systems - such as the Netherlands, Switzerland, the United Kingdom and the United States - pension funds are worth an average of 85 per cent of GDP. Private pensions account for a major part of privatesector savings flows, are an important supplier of capital to industry and play a large and growing role in providing retirement incomes. These figures alone mean that it is vital to give the tax treatment of pensions careful consideration. Zusammenfassung Beim Übergang von umlagefinanzierten Renten zu kapitalgedeckten Renten ist die steuerliche Behandlung der Renten eine zentrale Politikvariable. Eine steuerliche Bevorzugung kapitalgedeckter Altersvorsorge kann die Sparquote erhöhen, führt jedoch auch zu strategischer Steuervermeidung und Steuerausfällen. Darüber hinaus können auch die Verteilungswirkungen unerwünscht sein, wenn vor allem Personen mit höherem Einkommen Steuervorteile ausnützen können. Wenn kapitalgedeckte Renten einen großen Teil der Altersvorsorge ausmachen und - wie beispielsweise in den Niederlanden, der Schweiz, Großbritannien und den Vereinigten Staaten von Amerika das Vermögen der Pensionsfonds etwa 85 % des Bruttosozialprodukts ausmachen - sollte der steuerlichen Behandlung kapitalgedeckter Renten besonderes Augenmerk geschenkt werden. Im Aufsatz geschieht dies mit Hilfe eines internationalen Vergleichs. JEL-Classification: H 24, H 55 1 Thanks are due to David Lindeman and Robert Palacios of the World Bank, Andrew Dilnot and Richard Disney of the Institute for Fiscal Studies in London, Willem Adema and Mark Pearson of the OECD in Paris and Paul Johnson of the Financial Services Authority in London for their help and advice. The usual disclaimer applies, and the paper is a personal view. Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 416 Edward Whitehouse This paper is structured as follows. The first section considers a number of different possible ways of taxing pensions. Section 2 provides a descriptive overview of the tax treatment of pensions in a range of countries. Section 3 extends the analysis to compute a summary measure of the generosity of tax incentives, the marginal effective tax rate on pension saving. Section 4 considers the link between the taxation of pension funds and the tax treatment of the underlying assets, particularly equities and bonds, in which they invest. Section 5 examines the deductibility of contributions. Section 6 looks at the importance of pension funds and associated tax incentives in aggregate. Section 7 assesses the objectives for taxing pensions, the options and the arguments while section 8 concludes. 1. Possible pensions taxation régimes Three transactions constitute the process of saving via a funded pension scheme, each of which provides an occasion at which taxation is possible: • when money is contributed to the fund, normally by employers and employees; • when investment income and capital gains accrue to the fund; and • when retired scheme members receive benefits. If pensions are pay-as-you-go financed (i.e., out of current contributions) then the second point at which taxation may occur is lost. Given three points at which it is possible to levy tax, there are eight basic tax combinations. There are examples of many of these in practice, but some are more common and characterise theoretical ideals for the tax system. Table 1 illustrates four hypothetical régimes.2 The Table shows the net pension resulting from a contribution of 100 made five years before retirement. A proportional tax of 25 per cent and a rate of return on investment of 10 per cent per annum are assumed. The effect of inflation is ignored for the moment. The first régime exempts contributions from tax, does not tax fund income, but does tax the pension in payment. This can be termed an exempt, exempt, taxable (EET) system. The second involves saving out of taxed income, no tax on the fund's investment return and tax-free withdrawal of pension benefits, i.e., a TEE system. In this simple framework with a flat tax rate, these two systems are equivalent in effect. They both confer a post2 The table ignores extreme cases where pensions are taxed at all three possible points or at none of them, and where either investment returns alone are taxed or alone are exempt. These more unusual régimes are discussed below. Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 The tax treatment of funded pensions 417 tax rate of return to saving equal to the pre-tax rate of return. They are neutral between consumption now and consumption in retirement. Faced with either régime, an individual earning 100 now can consume now, paying 25 in tax and buying goods worth 75, or they can save, allowing consumption of 120.79 in five years. But 120.79 is simply the amount available for consumption now, increased at a 10 per cent rate of compound interest, i.e. 75x(l.l)5. This also means these régimes are equitable in their treatment of different individuals: people who save for future consumption pay the same tax as those who consume now. Finally, the two systems also deliver the same net present value of revenues to the government. However, the timing is different: revenues are deferred until retirement under EET, but received immediately under TEE. Table 1 Alternative pensions taxation régimes EET TEE TTE ETT Contribution 100 100 100 100 Tax -25 25 - Fund 100 75 75 100 Net investment return 61.05 45.79 32.67 43.56 Fund at retirement 161.05 120.79 107.67 143.56 Tax on pension 40.26 - - 35.89 Net pension 120.79 120.79 107.67 107.67 Net present value of tax 25 33.14 25 33.14 Note: Assumes 10 per cent annual real return, 25 per cent tax rate and five-year investment term. In practice, the EET and TEE systems may not have the same effect because of the point at which the tax exemption occurs. If an individual pays a different marginal income tax rate while in work from the tax rate paid in retirement, then preand post-tax rates of return will no longer be equalised. The individual will benefit more from a régime granting tax relief when his or her marginal rate is higher. The last two systems involve taxation at two points. Under the third régime, savings are made out of taxed income, income earned by the fund is then taxed but benefits received are exempted (TTE). The tax exemption in the last system occurs at the point of contribution, while fund income and benefits are taxable (ETT). The effects of these two systems are the same in this simple model. However, the post-tax rate of return is now below the pre-tax rate (7.5 per cent rather than 10 per cent: 107.67 = 75x(1.075)5). These two systems result in a Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 418 Edward Whitehouse disincentive to saving, because consumption now is worth more than consumption in the future. The EET and TEE régimes are equivalent to the 'expenditure tax' of the public finance literature3, while the ETT and TTE systems correspond to a 'comprehensive income tax'. The origin of these names is clear. The first two régimes tax only consumption (or expenditure) and at the same rate whether consumption is undertaken now or in the future. In contrast, the last two systems tax all accruals to income, whether from earnings or investments, irrespective of whether they are saved or consumed. These two benchmark tax systems are different ways of interpreting 'fiscal neutrality' with respect to savings. Equalising preand post-tax rates of return is neutral between present and future consumption. A comprehensive income tax is neutral between consumption and saving, treating savings in exactly the same way as any other form of consumption. However, savings are not a commodity like any other good or service. They are a means to future consumption, and this is particularly obvious where saving for retirement is concerned. Neutrality between consumption now and consumption in retirement is the relevant concept for taxing pensions, and that is the form of neutrality achieved by the expenditure tax.4,5 2. An international comparison of the tax treatment of pensions Having examined the taxation of pensions in theory, this section compares pensions taxation in practice in a range of countries.6 Table 2 summarises the tax treatment of pensions in OECD countries at three stages identified in the previous section: when contributions are made, investment returns accrue and when the pension is paid out.7 3 The EET system is the classical example of an expenditure tax. The TEE system is often called the 'pre-paid expenditure tax'. 4 On these issues, see Kaldor (1955), Carter Commission (1966), Meade Committee (1978), Pechman (1980), United States Treasury (1977, 1984), Andrews (1974) and IFS Capital Taxes Group (1995). 5 Unfortunately, optimal tax theory gives little guidance on the appropriate tax treatment of savings. The theory shows that the cross-elasticity of labour supply with respect to the interest rate is a central variable in an intertemporal model, but there is no empirical agreement on the magnitude of this variable. The only firm conclusion is that neither a capital tax rate of zero (the expenditure tax) nor a capital tax rate equal to the tax on labour earnings (the comprehensive income tax) is optimal. 6 See also Dilnot (1992, 1996a), Johnson (1993) and Whitehouse (1996) for international comparisons of pensions tax incentives. 7 The Table refers to individual pension savings accounts. Employer-based plans are significant in a number of countries and their tax treatment is usually similar to personal pensions. Exceptions are Australia and Portugal -where employer contribuSchmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 The tax treatment of funded pensions 419 The first column relates to the personal income tax treàtment of contributions made out of earned income. In most countries - exceptions include Australia, Iceland and Japan - contributions to a pension are made out of pre-tax income or attract a tax rebate. The extent of this deductibility is limited in most countries. The next three columns relate to the treatment of investment returns. In most countries, income accruing in the pension fund accumulates tax-free, although Australia and Sweden apply a special tax rate (15 and 10 per cent respectively) to pension fund investment returns that is lower than marginal income tax rates. Denmark taxes only real investment returns, in line with the 'pure' comprehensive income tax. The final two columns of Table 2 cover taxation of the pension in payment. The tax treatment of withdrawals from the fund, either as an annuity or a lump sum, varies considerably. All countries bar New Zealand extract some tax at this point, although there are often tax concessions available. Australia, Ireland, Japan and the United Kingdom, for example, allow withdrawal of a tax-free lump sum to be from the fund. In most countries, withdrawals from the fund before retirement age are not permissible, although in some, such as Austria and the United States, this is possible subject to a tax penalty. Table 3 shows tax treatment in a range of countries, most of which have recently moved, or are proposing to move, towards a funded pension system. In the majority of Latin American countries, the tax treatment is of the traditional expenditure tax kind (EET). The only exception is Peru, which has a pre-paid expenditure tax (TEE). Hungary and Poland have both adopted the expenditure tax for their new mandatory pension funds. Poland operates a pre-paid expenditure tax régime for voluntary pension contributions. Hungary gives a much more generous treatment: exempting investment returns and pensions in payment as well as giving a tax credit on contributions which exceeds even the highest tax rate (see the box in the next section). The Czech Republic taxes its voluntary funds in a similar way, matching contributions up to a limit. tions are fully deductible, but employee contributions only partially deductible - and Germany and the United States - where employer contributions are deductible but employee contributions are taxed. Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 420 Edward Whitehouse o £ o c— co _ K « ed W P/§< , io o ti o ti o i-Tt5 O <u o < CSI E gl-3 0°D CD ^ ^ CU £ <v S 8 O o Om h ih o.a ed 0 T3 ed <D ,jO S £ a> a> ed ìh ^ ^ S r2 W So-S « ^ §ts ^ h o; 0) ed 0 Cd ! 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Domestic equities comprise 52 per cent of pension funds' portfolios, with overseas equities making up a further 23 per cent. Assuming that other countries' corporate income tax rate is also 31 per cent, then the effective tax rate on pension funds under this system would be 0.52x0.21 + 0.23x0.31, or 18.1 per cent. The tax credit for equities owned by companies and pension funds was abolished in the 1997 budget by the incoming New Labour government. The system is now classified as one of 'partial shareholder relief' (OECD, 1991). So although pensions funds remain exempt from tax on their dividends, there is no longer any allowance made for taxes paid at the company level. The net tax revenues in this simple example are now 24.8 (31 % of 80). This increases the effective tax rate on domestic equities from 21 to 31 per cent. The overall effective tax rate on pension funds, with a total of 76 per cent invested in equities, is therefore 0.76x0.31, or 23.6 per cent. As this is a little higher than the standard rate of income tax (23 per cent), the true tax régime for standard-rate taxpayers is ETT rather than EET. One likely impact of this reform is to encourage companies to switch from equity to debt finance, either from loans or bond issues. The effect of this is illustrated in the final column of Table 5, which shows what would happen if the company doubled their debt but kept their retained earnings constant. Debt interest payments increase from 20 to 40 and retained profits remain 27.6, leaving 13.9 for the dividend. However, net tax receipts fall to 18.6, and so the net return to pension fund investors (as bond and shareholders) increases. There is already evidence of companies organising their finances to reduce their tax payments in this way. 5. Distributional issues and restrictions on pension contributions Table 2 showed that most countries restrict the extent to which pension contributions can be deducted from the personal income tax. This is normally to circumscribe tax avoidance or because of distributional concerns. Higher-income individuals are better able to make pension contributions, and receive a larger tax advantage because of the deductibility of contributions against higher rates of income tax. Limits on deductibility can take a number of forms: • absolute limits on the amount of contributions (e.g. Australia, Germany) • limits on the proportion of contributions that can be deducted {e.g. Austria, Finland) Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 430 Edward Whitehouse • limits on the proportion of income on which contributions can be made {e.g. United Kingdom) • limits on the deductibility of contributions at higher rates of income tax Table 5 investigates the last of these further using the simple framework of Table 1. The first four columns look at an individual who pays a higher tax rate, assumed to be 40 per cent, during both their working life and retirement. The first column shows the standard expenditure-tax treatment. Since contributions are deductible at the higher rate, the result up to retirement is the same as for the standard rate taxpayer in Table 1. After retirement, however, 40 per cent tax is payable, so the net pension is just 96.63. Again, the tax is neutral over the timing of consumption: the individual can consume 60 now or 96.63 = 60x(l.l)5. Again, the classical expenditure tax has the same effect as the pre-paid expenditure tax, shown in the second column. The deductibility of pension contributions is restricted to the standard rate of tax - assumed to be 25 per cent - in the third column. Partial deductibility means the gross contribution of 100 is reduced by 15 (the difference between the higher and standard rates). The result is a lower pension - 82.14 or 15 per cent lower - than the unrestricted expenditure tax. However, although the pension is 14 lower, the net present value of tax receipts is only nine higher. The partial taxation of contributions means there is less to tax when the pension is paid. The fourth column shows a comprehensive income tax at a 40 per cent rate. This shows that restricting the deductibility of contributions is close to introducing a comprehensive income tax. Moreover, the arguments for and against this treatment can also be applied to the argument that contributions should not be deductible at higher rates of income tax. The final four columns show a similar analysis for a person who pays the higher rate of tax when contributions are paid and investment returns accrue, but pays the standard rate of tax during retirement. Column five shows that the classical expenditure-tax treatment delivers the same pension and tax receipts as for people who pay the standard rate of tax during their working life (compare Table 1). But the pre-paid expenditure tax raises more revenue than the classical tax from people who are higher-rate taxpayers when working and standard-rate taxpayers when they draw their pension. Again, restricting the deductibility of contributions to the basic rate (column seven) reduces the pension compared with unrestricted deductibility. It also raises the tax take, but the initial gain from restricted deductibility is offset by the loss from the lower revenues on the lower pension. The net effect is again close to the comprehensive income tax (column eight). Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 The tax treatment of funded pensions 431 o o o LO CO CO o o o o o o o m io co Oi O O O O CM ,-H T"H 1-4 y-À o O CO CO ^ N o o o H CO ^ N m co io co 10 10 cm co o o rt^ co H r-i r}i CO CO CO CO o> T5 X S cd p ti O 'w ti CD a a Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 432 Edward Whitehouse 6. Measuring the revenue cost of pensions taxation incentives The concept of a 'tax expenditure' was developed in recognition of the fact the tax system can be used to achieve similar goals to public spending programmes, but accounting for the costs and benefits of tax measures is often less rigorous and regular than for direct expenditure. A tax expenditure is said to exist when the tax system deviates from some benchmark tax system. In general, this norm includes the tax rate structure, accounting conventions, administrative provisions and provisions relating to international fiscal obligations. Defining a tax expenditure in practice can be difficult: some tax measures may not be readily classified as part of the benchmark or an exception to it.14 Tax expenditures are usually calculated using the socalled 'revenue forgone' method, which computes the tax that would have been payable ceteris paribus if the tax concession were removed, and economic behaviour remained unchanged. Fourteen OECD countries now produce tax-expenditure reports. With three occasions at which they might be taxed, pensions offer a broad range of possible benchmarks, a subset of which were presented in Table 1. Countries' methods of calculating tax expenditures for pensions differ, and a number of countries (including Belgium, Canada and the United Kingdom) have recently changed their methods of reporting tax expenditures for pensions. In Australia, Canada, Spain and the United States, the comprehensive income tax - with pension benefits tax-free and contributions and investment returns taxed - is used as the benchmark. Usually, however, there is no inflation adjustment, so nominal rather than real returns are taxed. In the United Kingdom, the actual tax treatment is compared with a so-called 'unapproved' scheme, where contributions and investment returns are taxed but the withdrawal of the pension as a lump sum is tax-free. This is equivalent to the comprehensive income tax treatment (i.e., TTE). Other countries (such as the Netherlands) do not report tax expenditures for pensions at all, or (for example, Germany) choose a benchmark very much closer to the actual system. The results are highly sensitive to the choice of benchmark. The difference in the results between measuring the cost against the comprehensive income tax and the expenditure tax can be seen from the relative positions of the two lines in Figures 1 and 2. The baseline against which the actual treatment is compared is between 25 and 50 per cent higher (depending on the country's tax system) in the comprehensive income tax case. Dilnot and Johnson (1993a,b) argue that, since an expenditure tax is the most appropriate tax treatment for pensions, tax expenditures should be calculated 14 See OECD (1984, 1995) and Surrey (1975) for a detailed discussion. Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 The tax treatment of funded pensions 433 O ^ ^ £ O £ I H & S 5 6 CS] CTS 00 CTS CTS 1-H i—1 rH O o o CSI CO CSI CO CO i-H i—I 1-H CTS 00 co 00 00 CTI CTI CTS CTS OS CTS CTS CTS CTS CTS CTS OS os OS CTS ai OS OS OS CTI CTS CTS CTS CTS CTS CTS CTS CTS CTS CTS CTS OS OS T—1 rH T—1 1-H i—1 rH 1—1 i—1 i—I ì-l i—l i-H i—I rH i-H i—I 1—1 1—1 IO Ol M IO N N in o ri o lOOCSji-Hr-HCOOOO OCSÌOOOi-HCOO d - M ^ g CCO r& PQ U O £ £ S s E Q a o CO — S CSI ^ a S e a ri-2 oo <o « W 5_1 & M W -M HH 00 CSI w PL, CO Crt c^ OS I © "tf 1-H CO © © CI c « £ ^ CO H ^ EH PL >v rD S Cfl "fa S tì —I CJ Ci rJ pf O «Sii 18 a 2 w) 'aJ PQ CO T3 cd tì ed U tì ed i—( E! E £ cd a; 0 T3 ^cd "a; ed tuo ^ _ i S T3 * s s O Dh > PL ai c/3 a o t>J0 PI ¡2 cu 0) cd in q; '3 £ Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 434 Edward Whitehouse against this norm. A second argument for using an expenditure tax as benchmark is that in response to the abolition of pension tax incentives, savings would flow to similarly fiscally privileged assets. Taking account of behavioural responses, the extra revenue raised from abolishing pensions tax incentives would be small. Dilnot and Johnson found that the United Kingdom tax expenditure on pensions was just £lbn when measured in this way, compared with around £7bn reported in official figures at the time of their study. Table 6 shows tax expenditures relating to pensions reported by OECD governments in national currencies and as a percentage of total tax receipts. Compared with a comprehensive income tax base, over 3 per cent of income tax revenues are forgone in Australia, Canada, the United Kingdom and the United States. In Canada and the United Kingdom, pensions are the largest item in tax expenditure accounts; in the United States, they are the second largest, after health insurance. These tax expenditures are also large when compared with direct public spending. In the United Kingdom, for example, the total reported in the tax expenditure accounts for 1996-97 was over £10bn compared with £30bn spent on state pensions. However, because of the use of different benchmarks in computing revenues forgone, many of these figures are not strictly comparable between countries. Nor, because of behavioural responses, are they an accurate indication of the revenues that the removal of tax reliefs for pensions would raise. 7. Objectives for the tax system The first section of the paper argued that the expenditure tax was the most appropriate treatment for pension savings because it is neutral in the allocation of consumption between the working life and retirement. There are further reasons, including ones of equity and simplicity, for thinking that an expenditure tax might offer the best way of taxing pensions. First, identifying investment returns, especially those in the form of unrealised capital gains, can be difficult. Taxing gains on realisation rather than as they are accrued causes different problems.15 15 Defined-benefit plans (where the value of the pension benefit is related to some measure of earnings and years of scheme membership) raise further administrative difficulties. At any point during scheme membership, the value of the pension depends on two future, uncertain variables - the total duration of membership and future earnings - and so the value of fund and investment returns cannot be allocated to individuals. When marginal income tax rates vary (as in any progressive tax system), it is not possible to find the appropriate tax rate to apply to the pension fund, unless some arbitrary rate is used. This also applies to contributions to the fund: in a defined benefit plan, these bear no relation to the pension benefit being accrued, and Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 The tax treatment of funded pensions 435 Secondly, as the marginal effective tax rates in Figure 3 showed, the comprehensive income tax has difficulty dealing with inflation. Taxing investment returns often means that nominal returns are taxed, meaning the posttax real return falls still further below the pre-tax real return. If, for example, the real interest rate were 2.5 per cent, and inflation 7.5 per cent, then the TTE and ETT systems without inflation adjustment would result in the net pension showing no real return. The 7.5 per cent post-tax nominal return is only just enough to compensate for inflation. A higher level of inflation would deliver negative real returns. Many OECD countries do tax certain assets this way, such as ordinary interest-bearing deposits (see OECD 1994, Table 4.1). By contrast, the expenditure tax, by avoiding taxing investment returns, maintains equal preand post-tax real returns whatever the mix of inflation and real returns in the nominal interest rate. However, a comprehensive income tax raises more revenue at a given tax rate: the discounted total tax take is 25 under the expenditure tax and 33 under the comprehensive income tax in the example given in Table 1. The broader tax base of comprehensive income allows a lower tax rate to collect the same revenues. A 20.5 per cent rate in the simple model would raise the same revenues as an expenditure tax with a 25 per cent rate. This could have important economic effects through labour-supply incentives and the incentive to work in the 'black' or 'shadow' economy.16 But it still means savings choices are distorted. An individual could choose to consume 79.5 now or save for retirement and consume 116.5 then. But that is equivalent to just 72.3 at working age (or, equivalently, the neutral consumption in retirement would be 128). An expenditure tax may also affect portfolio choice. Since pensions are taxed on withdrawal under the classical expenditure tax (EET), the government becomes a co-investor, sharing in any rents, but also participating in any losses. This may encourage a riskier choice of portfolio.17 A second concept of fiscal neutrality with respect to savings decisions is neutrality between different types of savings instruments.18 If one savings employer contributions are typically made as some percentage of the aggregate payroll (Disney and Whitehouse, 1994, 1996). 16 However, dynamic models of the economy suggest that wage earners benefit from the lower taxation of capital under an expenditure tax. The economy's capital stock is higher, increasing productivity and wages. 17 Of course, this may be corrective if investors suffer from myopic risk or loss aversion. 18 Hamilton and Whalley (1985) find that this type of neutrality is extremely important. They find that both a comprehensive income tax and expenditure tax which treat all savings equally dominate a hybrid system with an expenditure tax treatment for housing and a comprehensive income tax treatment for everything else. The reduced price distortion between assets dominates the effect of reduced distortion of intertemporal choice. See also Hamilton (1987). Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 436 Edward Whitehouse medium is taxed more lightly than others are, then it will tend to attract funds at their expense. Economic inefficiency results as decisions are distorted compared with those that would be made in a tax-free environment. In many countries, saving for retirement is treated favourably compared with other savings media. A number of arguments have been proposed to support this relatively generous treatment: • the state should ensure that people maintain a standard of living in retirement approaching the level when they were of working age; • by encouraging individual provision for retirement, the cost of social security benefits may be reduced, particularly when means-tested benefits are an important source of retirement income; and • the state should increase long-term savings to add to the level and / or stability of capital available for investment. The first argument is a paternalist one; the state gives incentives to save for retirement (relative both to current and to future, pre-retirement consumption) because in the absence of incentives, individuals will fail to make 'sufficient' provision.19 There are a number of reasons why, first this rationale may not be valid and, secondly, why the tax system is not a good way of achieving it. It is hard to define 'sufficiency' of retirement income beyond an adequate minimum. Offering tax incentives for retirement saving may not ensure that everyone achieves a minimum standard; some will still fail to provide whereas others may even over-provide.20 Other means of ensuring that retirement living standards approach the level during working life may be more effective and, perhaps, less distortionary: for example, the state can adjust the level of compulsory private pension contributions (the 'second pillar'). The second argument is one of 'moral hazard' - individuals will not provide for themselves if they know the state will give them an adequate income anyway. Pensions are partly - e.g. in the United Kingdom - or wholly - e.g. in Australia - means-tested in a number of countries. This means-testing produces a substantial disincentive to save for retirement, especially for people with low incomes. Again, however, it does not follow that attaching fiscal privileges to pensions is an effective way of minimising the cost to the state, compared, for example, with mandating a certain level of contributions. The reduction in current revenues that results from the tax incentive adds to this argument. 19 Diamond (1977) and Samuelson (1987). 20 Other individuals may be 'over-annuitised', i.e. hold more of their wealth in the form of annuities (which cannot be bequeathed) than they would wish in the absence of tax privileges. Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 The tax treatment of funded pensions 437 Tax incentives for pensions appear to increase pension savings. Examples include the 'success' of registered retirement savings plans, RRSPs, in Canada, personal pensions in the United Kingdom, and individual retirement accounts, IRAs, in the United States.21 Whether this results, however, from a substitution of pensions for other savings media or from an increase in overall savings is difficult to ascertain. If people have a fixed target for retirement savings, a new tax incentive for pensions could induce them to reduce current savings, since their level of retirement income would remain the same. Tax incentives cost the government by reducing revenues, cutting public sector saving. Even if household savings increase, the overall effect on national saving is uncertain. The empirical evidence on the effect of tax incentives on savings is inconclusive. Alan Blinder commented, .. there is zero evidence that tax incentives that enhance the rate of return on saving actually boost the national saving rate. None. No evidence. Economists now accept that as a consensus view'.22 Many empirical studies of household saving, particularly of IRAs in the United States, have found a positive effect23, although others are sceptical.24 The OECD (1994a) study of taxation and savings concludes its survey of evidence in a number of countries, 'There is no clear evidence that the level of taxation, along with other factors affecting the rate of return, does generally affect the level of saving'.25 Given the inconclusive nature of this literature, it does not seem wise to suggest that a desire to increase economy-wide saving either is or should be a major objective for the taxation of pensions. Changing the composition of saving towards long-term retirement savings might at times, however, be a useful policy tool. Having established the desirability of expenditure tax treatment for pensions and of a 'level playing field' for different types of saving, the final policy choice is between the classical expenditure tax (EET) and the pre-paid expenditure tax (TEE). The pre-paid expenditure tax has much to recommend it. First, by bringing the revenues from pension taxation forward compared with the deferred 21 See Carroll and Summers (1987) on RRSPs, Disney and Whitehouse (1992a,b) on personal pensions, and Venti and Wise (1986,1987) and Gravelle (1989,1991) on IRAs. 22 Interview in Challenge, September-October 1992 quoted by Gylfason (1993). 23 See, for example, Hubbard (1984), Venti and Wise (1987), Feenberg and Skinner (1989) and Poterba, Venti and Wise (1996). 24 For example, Gravelle (1989, 1991), Munnell (1986) and Engen, Gale and Scholz (1994). 25 OECD (1994a), p. 189. See also Robson (1995) and Boadway and Wilasdin (1994) for a discussion. Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51 438 Edward Whit ehouse taxation in the classical expenditure tax, it alleviates the transitional pension deficit when moving from a pay-as-you-go to a funded system. The outgoing Conservative government in the United Kingdom proposed such a scheme in 1997.26 Croatia has also adopted the pre-paid expenditure tax. Secondly, it limits tax avoidance and evasion by ensuring the government collects the money up-front. It also ensures revenues can be collected from foreign workers or people who intend to emigrate on retirement. Thirdly, it will raise more revenues from people who are higher-rate taxpayers during their working life but pay tax at the standard rate during retirement.27 However, the pre-paid expenditure tax has two major drawbacks. First, although the tax incentive may be equivalent to a classical expenditure tax, psychology suggests that the up-front tax relief is perceived as more valuable. Financial-services companies also find up-front reliefs a better selling point.28 Secondly, the pre-paid expenditure tax subjects funded pensions to 'policy risk'. A future government may not feel bound by commitments of previous governments not to tax pensions in payment or investment returns, and may view pension funds as an easy revenue target. This is likely to undermine the attractiveness of funded pensions to potential investors. 8. Conclusions The expenditure-tax system taxes pensions once: either when contributions are made or when benefits are withdrawn. It is the best way of taxing pensions, because it does not distort the decision whether to consume now or save and consume in the future, unlike the comprehensive income tax. Moreover, it is also easy to administer and the tax burden does not vary arbitrarily with inflation. A more generous treatment than the expenditure tax is not justified, neither by the impact on national saving nor the effect on public pension and social-assistance liabilities. Most countries tax pensions using a system close to the expenditure tax. The pre-paid version of the tax, which exempts benefits, collects more revenue up-front. However, it may not be credible if consumers suspect the government might eventually tax benefits when they are paid. Finally, in the context of the design and implementation of a pension reform, it is important to take the cost of tax reliefs, measured by tax expenditures, into account. 26 This is the so-called 'basic-pension-plus' scheme. See Whitehouse (1998), section VI, Department of Social Security (1997) and Whitehouse and Wolf (1997). 27 The effect can be seen by comparing the first and fourth columns in Table 6. The TEE treatment would still produce a net pension of 96.63 if the taxpayer were a higher-rate taxpayer while in work and standard-rate taxpayer in retirement. 28 See Thaler (1994). Schmollers Jahrbuch 120 (2000) 3 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.3.415 | Generated on 2023-04-04 12:27:51