World Bank Pension Reform Primer

This note was written by Edward Whitehouse of Axia Economics, London. It Is part of a series produced by the Social Protection Advisory Service of the World Bank. These notes can be obtained from Social Protection, World Bank, 1818 H Street NW, Washington DC 20433, telephone +1 202 458 5267, fax +1 202 614 0471, e-mail socialprotection@worldbank.org. All of the notes are on the internet at www.pensionsprimer.com.

Taxation The tax treatment of funded pensions

he tax treatment of funded pensions is a critical policy choice in pension reform. In

countries with mature funded systems—the Netherlands, Switzerland, the United Kingdom and the United States—pension funds are worth 85 per cent of GDP on average. They are a major force in private savings flows, supplying capital to industry and providing retirement incomes. In a pension reform, a generous tax treatment will encourage switching to the new funded, defined-contribution pensions (if the scheme is voluntary) and political acceptability (whether it is voluntary or not). But balanced against that, the cost of tax reliefs can be very high. They may encourage tax evasion and avoidance and have undesirable distributional effects if higher rate taxpayers are better placed to take advantage of tax reliefs. Possible ways of taxing pensions There are three points at which saving in a funded pension can be taxed

?? when employers or employees contribute ?? when investment income and gains accrue ?? when benefits are paid out

Four of the eight basic possible tax combinations are shown in Figure 1. It looks at a contribution of 100 made five years before retirement, with a proportional tax of 25 per cent and annual returns of 10 per cent a year.

The first system exempts contributions and fund income but taxes the pension in payment. Hence the name exempt, exempt, taxed (EET). The second is TEE: contributions are made out of taxed incomes, but benefits can be withdrawn tax-free. In this simple framework, these have the same effect: a choice between consuming 75 now or saving and spending 121 in five years. The two also deliver the same present value of revenues for government. But under EET—the ‘classical expenditure tax’—revenues are deferred until retirement, while under TEE—called the ‘pre-paid expenditure tax’—they are received immediately. Possible pensions tax regimes 1

EET TEE TTE ETT Contribution 100 100 100 100 Tax — -25 -25 — Fund 100 75 75 100 Returns 61 46 33 44 Final fund 161 121 108 144 Tax -40 — — -36 Net pension 121 121 108 108

The other two systems tax pensions twice. Both tax investment returns, and the first taxes contributions and the second, withdrawals. Again, these two systems—called the ‘comprehensive income tax’—are equivalent in this simple case. The reward for saving is lower than the expenditure tax: 108 to spend in five years rather than 121. The post-tax rate of return is the same as the pre-tax rate of return (121=75x1.15), when

T

Taxation 2 expenditure is taxed, but is 7.5 rather than 10 per cent under the comprehensive income tax (108=75x1.0755). Which benchmark? The expenditure tax is the most appropriate benchmark for taxing pensions. The comprehensive income tax treats savings as if they are like any other good or service. But savings are a means to future consumption, and this is particularly obvious when earnings are deferred to provide retirement income. The expenditure tax is neutral between consuming now and consuming in the future. The expenditure tax is also easier to

administer., because taxing investment returns, especially unrealised capital gains, can be difficult. Finally, the comprehensive income tax has difficulty with inflation, because it taxes nominal returns. If in the example real returns were 2.5 per cent and inflation 7.5 per cent, then post-tax returns would be 7.5 per cent nominal and zero real. At higher inflation rates, real returns would be negative. The comprehensive income tax, however, raises more revenue due to its broader base (a total of 31 discounted, compared with 25 for the expenditure tax). So the tax rate can be lower.

Pensions taxation in practice 2

better than

expenditure tax expenditure tax between expenditure and

comprehensive income tax worse than compre-hensive income tax

Australia Austria

Czech Republic Hungary Ireland Korea

Portugal United Kingdom

Argentina Canada

Chile Colombia

Costa Rica Germany

Luxembourg

Netherlands Poland Spain

Switzerland United States

Uruguay

Denmark Finland France Norway Sweden

Belgium Iceland Japan

New Zealand

Pensions taxation in practice Expenditure tax treatment is the most common in practice, covering nearly half the countries shown in Figure 2. Some countries (the right of Figure 2) are close to or less generous than the comprehensive income tax. New Zealand is TTE. Belgium taxes the asset value of the fund each year. Iceland and Japan have a TET system (although Japan allows tax-free lump-sums to a limit). Finland’s regime is EET, but only 60 per cent of contributions are deductible. Denmark and Sweden are ETT. Others are more generous than the expenditure tax. In Ireland, Portugal and the United Kingdom, annuity payments are taxed, but a tax-free lump sum can be taken. Australia has a complicated system. Contributions are only partly exempt. Investment earnings and benefits are taxed at a

special, lower rates. Only a quarter of annuity payments is taxed in Austria. In Hungary (see box), contributions attract a tax credit, and in the Czech Republic, contributions are matched by the government. up to a limit. Cost of pensions tax incentives Fourteen OECD countries now produce ‘tax expenditure accounts’ showing revenues foregone from tax concessions relative to a benchmark. In Australia, Canada, Spain, the United Kingdom and the United States, actual pensions taxation is compared with the comprehensive income tax (TTE), assuming behaviour would not change if tax incentives changed. But Germany uses a benchmark closer to the actual system, so the cost of pension reliefs appears much smaller.

3 Taxation

Australia, Canada, the UK and the US report that pensions concessions cost over 3 per cent of total tax revenues. In Canada and the UK, they are the largest tax expenditure; in the US, the second largest after health insurance. However, these figures are misleading. If the expenditure tax is appropriate, then the cost should be measured against that benchmark rather than a comprehensive income tax. Revenues foregone measured in this way would be around £1bn in the UK and zero in Canada and the US. Cost of pensions tax incentives 3

$5.3bn

BFr 8.9bn

C$10.9bnFMk 3.1bn

DM 17.bn

IR£275m

Esc 2.8bn

Pta 16bn

Skr 9.7bn

£10.2bn

$57bn

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

Australia 92-93

Belgium 89

Canada 89

Finland 91

Germany 91

Ireland 90

Portugal 92

Spain 93

Sweden 92

UK 96-97

US 91

per cent of total taxes

How generous a tax treatment? There are three arguments for taxing pensions more generously than other kinds of saving ?? to ensure people have a standard of living in

retirement close to when they were working ?? to cut the cost of social-security benefits for

pensioners ?? to increase long-term savings

The first argument is paternalism. Without an incentive, people will be myopic and fail to make sufficient provision. This might well be true, but the tax system is not the way to put it right. Even with the incentive, people may not save enough. It is hard to define what is a ‘sufficient’ retirement income, beyond a reasonable minimum. The best way of being paternalist is mandating minimum retirement savings, either through state provision (the ‘first pillar’) or compulsory contributions to private funds (the ‘second pillar’).

Taxing pensions in Hungary

The table runs through the tax treatment of pensions in Hungary in the same way as the theoretical framework of Figure 1. It looks at two taxpayers, one paying the lowest rate of 20 per cent and the other, the highest rate of 48 per cent. The 50 per cent credit means the fund gets more than 100 even for a higher-rate taxpayer. After five years of 10 per cent returns, the final fund is over 200 for the lower-rate taxpayer, much more than the 121 of the expenditure-tax benchmark. The net (post-tax) rate of return is over 20 per cent, double the pre-tax return of 10 per cent. If we also take account of reduced social-security contributions the effect is still more pronounced.

20% tax 48% tax Earnings 100 100 Tax -20 -48 Tax credit 50 50 Fund 130 102 Returns 79 62 Final fund 209 164 Return (%) 21.2 25.9 The second argument is ‘moral hazard’: if the state ensures an adequate income anyway, there is no reason for people to provide for themselves. Again, the tax system is not the best way of avoiding the fiscal impact of moral hazard. Also, the tax incentive cuts revenues. Increasing savings, the final factor, has been the subject of a major academic dispute. Whether the ‘success’ of new kinds of pensions—registered retirement savings plans, RRSPs in Canada, personal pensions in the United Kingdom and individual retirement accounts, IRAs in the United States—is a result of substituting these new plans for other kinds of savings is difficult to ascertain. And the budgetary cost of incentives can mean national savings fall, even if household savings increase. The OECD concludes: ‘There is no clear evidence that the level of taxation, along with

Taxation 4 other factors affecting the rate of return, does generally affect the level of saving’. With no clear answer, increasing savings should not be an objective for pensions tax policy. Which kind of expenditure tax? We have argued that the expenditure tax is the most desirable tax treatment for savings. The final policy choice is between the classical expenditure tax (EET) and the pre-paid expenditure tax (TEE). The latter has many attractions. First, it brings immediate revenues, which are deferred until retirement under the classical tax. This alleviates the transition deficit when moving from a pay-as-you-go to a funded pension system.. Such a scheme was proposed by the outgoing Conservative government in the United Kingdom in 1997 and has been adopted in Croatia. Secondly, it limits tax avoidance and evasion because the government collects the money up-front. Revenue is also collected from foreign workers and people who emigrate in retirement. However, the pre-paid expenditure tax has two major drawbacks. The up-front tax relief of the classical tax is perceived as more valuable and is less vulnerable to ‘policy risk’. A future government may not feel bound by its predecessor’s commitment not to tax pensions in payment or investment returns under the pre-paid tax. Pension funds in mature systems are large and could prove an attractive revenue target.

Conclusions and recommendations

?? the ‘expenditure tax’ taxes pension savings once, either when contributions are made or benefits withdrawn

?? it is the best way of taxing pensions, because it is neutral between consuming now and consuming in the future

?? most countries treat pensions close to the expenditure tax

?? the pre-paid tax, which exempts benefits, collects more revenue now, but may not be credible

Further reading Whitehouse, E.R. (1998), ‘Tax treatment of funded

pensions’, Social Protection Discussion Paper no. 9812, World Bank.

Dilnot, A.W. (1992), ‘Taxation of private pensions: costs and consequences’, in OECD, Private Pensions and Public Policy.

On the taxation of savings generally:

OECD (1994), Taxation and Household Saving. Boadway, R and Wilasdin, D. (1994), ‘Taxation

and saving: a survey’, Fiscal Studies, vol. 15, no. 3, pp. 19-63.

Robson, M.H. (1996), ‘Taxation and household saving: reflections on the OECD report’, Fiscal Studies, vol. 16, no. 1, pp. 38-57.

On measuring the cost of tax concessions:

OECD (1995), Tax Expenditures: Recent Experiences.