Quarterly Economic Commentary, Summer 2018

Abstract

Tax treatments of pensions vary widely across countries. This paper examines the current tax treatment of pension contributions in Ireland and some widely discussed alternatives, including equalising the tax relief available to low and high earners. The analysis takes into account both explicit contributions in the private sector, and the implicit value of publicly funded pensions. INTRODUCTION Most OECD countries are facing the ‘twin challenge of ensuring both the adequacy and financial sustainability’ of their pension systems (OECD, 2014). Ageing populations, falling fertility rates and stagnating employment levels mean that funding the income of the elderly by using taxes paid by the working age population is becoming more and more difficult. Similar pressures affect Ireland although its relatively high fertility rate does afford some advantage compared to many European countries. Calls for reform of both public and private pension systems in Ireland have been frequent over the last decades and have come from many sources. The OECD, while acknowledging that Ireland is better positioned than many countries, recommends that Ireland ‘continue to adapt and fine-tune its pension system so that it can provide affordable and adequate benefits to Irish retirees in the long term’. Collins and Hughes (2017) also call for reform of the pension system, questioning the effectiveness of the current set of policy instruments focused on getting people to save for their retirement. Reform of State pension entitlement is already under way. The retirement age has increased from 65 to 66, and further increases – to 67 in 2021 and 68 in 2028 – have been announced and passed in legislation. 1 This paper represents a development of work initially conducted for the Pensions Council. We thank the Council for initiating this project, and Council members Helen McDonald and Shane Whelan for helpful comments. We thank Gerry Reilly and the SILC team at the CSO for access to SILC data on which the SWITCH tax-benefit model is based. * Karina Doorley is Research Officer at the Economic and Social Research Institute, Research Fellow at the Institute of Labor Economics and Adjunct Lecturer at Trinity College Dublin. Tim Callan is Research Professor at the Economic and Social Research Institute, Research Fellow at the Institute of Labor Economics and Adjunct Professor at Trinity College Dublin. Mark Regan is Research Assistant and John Walsh is Senior Research Analyst at the Economic and Social Research Institute. https://doi.org/10.26504/qec2018sum_sa_doorley 70 | Q uar t er ly Eco nomi c C omme nt ary – S um me r 2 01 8 State pensions in Ireland are not earnings related. As a result, the attainment of adequate replacement of employment income depends, for those on middle and higher incomes, on being supplemented by private pensions. Policy instruments which can encourage such private sector provision include both tax incentives and, potentially, legislative provisions regarding the availability of pension schemes to employees, and the manner of their operation. These can range from making membership of a pension scheme mandatory, to arrangements by which membership is automatic unless individuals opt out of the scheme. In this paper we focus on the tax treatment of pension contributions, which forms an important element of the overall tax treatment of pensions through pension contributions, investment income from pensions, and pensions in payment. This is a partial view of the overall territory, but offers some new insights. It does not lead directly to policy recommendations; several other factors would need to be taken into account in order to reach such conclusions. There is wide variation the tax treatment of pension contributions across countries. Whitehouse (1999 and 2000) sets out four distinct options, characterised by whether or not contributions, pension fund income, and payments of pensions are taxable (T) or exempt (E). The current tax treatment of pensions in Ireland can be characterised as broadly following the principle that contributions are exempt from income tax. Pension fund income, which is the investment income derived from them, is also exempt, while income received from a pension is taxable in the normal way. Such an approach is not uncommon internationally and is labelled EET as contributions are Exempt, investment income is Exempt, and pensions in payment are Taxed. In the Irish system, there is a deviation from the strict EET framework, as lump sum payments at retirement are also exempted from tax. Whitehouse characterises EET as an expenditure tax, which could also be achieved under a TEE regime, taxing contributions on entry, but leaving pension fund income and pensions in payment exempt from tax. About half of the countries surveyed by Whitehouse (2000) had tax regimes which approximated an expenditure tax, or were more favourable to pensions than that. However, the other half of the countries surveyed had tax treatments closer to the comprehensive income tax approach, either TTE or ETT. Given this wide variation in country practice, there is no single standard approach to the tax treatment of pensions which commands universal acceptance. Our analysis focuses solely on potential changes to the tax treatment of contributions. Thus, in the Irish context, we can contrast the impact of the current system – with Q uar te r l y Eco nomic Comm en ta ry – S umm er 20 18 | 7 1 pension contributions exempt from tax – with alternatives where pension contributions are fully subject to tax, or have more restricted relief (e.g., through standardisation or hybridisation of the relief). It is not within the scope of this paper to move further to a full consideration of a move from EET to TEE (the prepaid expenditure tax) or TTE (one version of the comprehensive income tax). Nevertheless, the insights from this partial analysis of changes to the tax treatment of pensions may be of assistance in the broader debate regarding the tax treatment of pensions and alternative means (such as auto-enrolment) for the encouragement of pension savings. The Irish system exempts private pension contributions from income tax through its EET approach. EET systems are generally considered to result in higher pension contributions than TEE (Taxed, Exempt, Exempt) systems (Armstrong, 2015).There is limited evidence that this kind of tax relief is cost effective in incentivising individuals or households to save for retirement. Rather, findings from international policy reforms indicate that when these incentives are introduced or removed, households divert private savings into pension contributions or vice versa (Attanasio and Rohwedder, 2003; Attanasio et al., 2004; Chetty et al., 2014). Benjamin (2003) estimates that one-quarter of the savings under the US scheme known as 401(k) represents new national savings. In addition to this, households who normally save the most were found to be largely contributing funds that they would have saved anyway. This suggests that tax incentives for pension contributions face a ‘deadweight’ problem, whereby they subsidise savings that would have taken place anyway and this seems to be particularly so for those at higher incomes. As the tax relief afforded in Ireland is at the individual’s marginal tax rate, this makes it more beneficial to those with higher earnings. Potential paths to restructuring tax incentives for pension contributions were discussed in the Green Paper on Pensions (Department of Social and Family Affairs, 2007). Among other reforms suggested, equalising the tax relief available to low and high earners was considered in order to increase the financial incentive for low earners to make pension contributions. Callan et al. (2009) and Collins and Hughes (2018) also discuss the distributional implications of the provision of tax relief at the individual’s marginal tax rate: the research reported here provides a more up-to-date picture, and examines the distributional implications of a move to alternative forms of tax relief such as standard rating of the relief. Pension funds are exempt from income and capital gains tax while pension income is subject to partial taxation on withdrawal from the fund. Estimates of the revenue foregone due to tax relief on pension contributions are available from The Revenue Commissioners but should be interpreted with some caution. 72 | Q uar t er ly Eco nomi c C omme nt ary – S um me r 2 01 8 These estimates quantify the revenue foregone from exempting pension contributions from taxation, without adjustment for the change in pension contribution and investment behaviour that such a switch would result in. Nevertheless, the TET system provides a useful benchmark system against which we measure some reform scenarios – but the TET system is not proposed here as a policy reform. According to the Revenue Commissioners (2013), comparing the current EET Irish system with a hypothetical TET system yields a revenue foregone figure of approximately €1.3 billion.