Chapter 6. Assessing alternative approaches to designing financial incentives to promote savings for retirement

This chapter first describes the main features of the most common approach currently used by countries to promote savings for retirement, which taxes only pension benefits and exempts contributions and returns on investment. The chapter then assesses alternative approaches to designing financial incentives using a theoretical framework to see whether they would improve on the current main approach. The analysis measures improvement through the tax advantage that people may get over their lifetime when saving for retirement, and through the fiscal cost for the treasury.

    

The landscape of financial incentives to promote savings for retirement is changing. Historically, tax incentives were the most common type of financial incentive to promote savings for retirement, in particular the one deferring taxation to the retirement phase, taxing individuals only on their pension benefits (“EET”). This is still the main approach currently implemented, but recent developments are changing the landscape of financial incentives to promote savings for retirement. These include matching contributions, fixed nominal subsidies, or providing tax credits rather than tax deductions. These alternative approaches to designing financial incentives may alter the tax advantages that individuals get when saving in funded pension arrangements instead of in traditional savings vehicles, the relationship between tax advantage and income, and the fiscal cost for the treasury.

This chapter provide a theoretical assessment of alternative approaches to designing financial incentives to promote savings for retirement to see whether they would be an improvement on the current main “EET” approach. The analysis measures improvement through the tax advantage that people may get over their lifetime when saving for retirement, and through the fiscal cost for the treasury, relative to the tax advantage and fiscal cost of the current main approach based on taxing only pension benefits and exempting contributions and returns on investment. It uses a theoretical framework and illustrative cases to conduct the comparison, abstracting from country-specific parameters. This chapter does not cover other potential ways of assessing improvements on the current main approach to providing incentives, such as measuring whether alternative approaches achieve better participation rates, higher contribution levels, or higher national savings.

The best approach to designing financial incentives to promote savings for retirement depends on the intended policy objective. When the policy objective is to provide a similar tax advantage across income groups, policy makers can consider using tax credits, tax deductions at a fixed rate or matching contributions combined with tax incentives. These approaches increase the attractiveness of saving for retirement for middle to low-income groups, while reducing it for high-income earners, compared to the current main approach of taxing only withdrawals. When willing to target the tax advantage specifically at low-income earners, non-tax financial incentives (fixed nominal subsidies and matching contributions) and tax credits expressed as a fixed nominal amount are appropriate approaches. The assessment of the impact of difference approaches to designing financial incentives on the fiscal cost needs to differentiate between the short term and the long term impacts. Some approaches may indeed temporarily reduce the fiscal cost but end up costing more in the long term than the current main approach of only taxing withdrawals. Tax incentives designed in such a way that pension benefits are taxed tend to achieve comparatively lower fiscal costs than other approaches in the long term. Finally, no alternative approaches to designing financial incentives can improve on the current main approach of taxing only withdrawals by simultaneously providing higher tax advantages to individuals at a lower long-term fiscal cost.

The chapter proceeds as follows. Section 6.1 describes the main characteristics of the most common approach used currently by countries to promote savings for retirement, based on the tax advantages it provides to individuals and the cost it represents for the treasury. Section 6.2 lists alternative approaches to designing financial incentives and builds illustrative cases representing the most relevant approaches on which the comparative analysis in subsequent sections is based. Section 6.3 compares the tax advantage provided by alternative approaches, while Section 6.4 examines their fiscal cost. Section 6.5 includes a summary discussion and concludes.

6.1. Main characteristics of the most common approach to designing financial incentives

This section describes the most common approach used currently by countries to promote savings for retirement based on the tax advantages it provides to individuals and the cost it represents to governments.

Tax incentives tend to be the main type of incentive provided by governments to promote savings in funded pension arrangements. Tax incentives come from a differential tax treatment applied to funded pension arrangements as compared to other savings vehicles. In most countries, the “Taxed-Taxed-Exempt” (“TTE”) tax regime applies to traditional forms of savings, with contributions paid from after-tax earnings, the investment income generated by those savings taxed and withdrawals exempted from taxation. When the tax regime applied to funded pension arrangements deviates from the “TTE” tax regime, this could lead to a reduction in taxes paid over the individual’s lifetime.

As shown in Chapter 2, the most common tax treatment of retirement savings exempts contributions (i.e. they are deductible from taxable income) and returns on investment from taxation, while it taxes pension benefits and withdrawals as income. Half of the OECD countries apply a variant of this “Exempt-Exempt-Taxed” (“EET”) tax regime to retirement savings.

The overall tax advantage provided by the “EET” tax regime, as compared to a “TTE” benchmark, is essentially equivalent to exempting returns on investment from tax. Figure 6.1 shows the overall tax advantage provided by the “EET” tax regime (crosses) broken down by components (tax advantage on contributions, tax advantage on returns and tax advantage on withdrawals) for different levels of income. The overall tax advantage represents the present value of taxes saved by an individual over his/her working and retirement years when contributing the same amount (before tax) to a pension plan instead of to a benchmark savings vehicle. It is expressed as a percentage of the present value of pre-tax contributions.1 When tax rates are the same at the time of contribution and withdrawal (left panel of Figure 6.1), the initial tax relief on contributions is exactly compensated by the tax paid on withdrawals, regardless of the income of the individual saver. The overall tax advantage therefore comes solely from the exemption from taxation of returns on investment. Moreover, the after-tax rate of return is equal to the before-tax rate of return and the tax regime provides neutrality between saving and consuming to all individuals (cf. Chapter 3).

The link between the overall tax advantage provided by an “EET” tax regime and the income level of the individual depends on the structure of the personal income tax system. In countries where all individuals have their entire income taxed at a fixed rate, the overall tax advantage provided by the “EET” tax regime (and any other tax regime) is the same across the income scale. When personal income tax rates increase with taxable income, the overall tax advantage increases with income through higher marginal tax rates. Indeed, individuals with higher marginal tax rates benefit more on every unit of investment income to which a zero rate of tax applies. However, the amount of investment income that would have been generated by an after-tax contribution in a benchmark “TTE” savings account is lower for individuals with higher marginal tax rates. The result is that the overall tax advantage increases with marginal tax rates, but the rate of increase slows as the marginal tax rate increases (Brady, 2012[1]). This is illustrated in the left panel of Figure 6.1.

Figure 6.1. Overall tax advantage for an “EET” tax regime, by income level and components
Present value of taxes saved over a lifetime, as a percentage of the present value of contributions
picture

Note: The calculations assume an individual contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity. Personal income falls into five tax brackets with tax rates of 0%, 14%, 30%, 41% and 45% respectively. On the left panel, each individual remains in the same tax bracket over working and retirement years. On the right panel, the tax rate during retirement is defined according to the level of taxable pension income (including public pensions).

 StatLink http://dx.doi.org/10.1787/888933850963

The relative level of retirement income compared to income from work also affects the link between the overall tax advantage provided by the “EET” tax regime, and the level of income. Retirement income is usually lower than income from work hence the former is likely to be taxed at a lower average rate than the latter. In that case, the tax paid on withdrawals may not compensate fully for the initial tax relief on contributions and the overall tax advantage is larger. This also means that the tax regime may favour saving over consuming in particular for middle to upper-middle income earners (the after-tax rate of return is greater than the before-tax rate of return). In addition, depending on the distance between the tax rates in the different tax brackets, and the size of the tax brackets, the reduction in taxes paid on withdrawals may increase the distance in the overall tax advantage across income groups. The right panel of Figure 6.1 shows that the overall tax advantage increases significantly for individuals earning between 80% and 2 times the average earnings when they face lower tax rates during retirement than while working. For high-income earners, there is a convergence towards tax neutrality because the higher is the income, the less likely is the individual to experience a fall in tax rate at retirement.

Finally, “EET” tax incentives generate a long-term fiscal cost to the government. Figure 6.2 presents projections of the net tax expenditure level of a funded pension arrangement with an “EET” tax regime since its introduction. The net tax expenditure incurred by an “EET” arrangement, with respect to a “TTE” benchmark, is the sum of tax revenues forgone on contributions, tax revenues forgone on returns and taxes collected on withdrawals. The lag in the growth of benefits behind that of assets and investment returns is what creates the temporary increase in the net tax expenditure level. As the density of contributions progresses, asset and investment return levels grow and so, with a lag, do benefit levels.

Figure 6.2. Net tax expenditure for a maturing “EET” pension system, by components
As a percentage of GDP
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Note: The calculations assume that individuals save from the age of 20 to 64 and draw pension benefits from age 65 to 84; contributions represent 3% of GDP; the number of people in each single-year age cohort is equal; the same average tax rate (30%) applies to all sources of income; a nominal rate of return of 5.06% (3% real return plus 2% inflation); and GDP growth at 3.28% (1.25% real growth plus 2% inflation).

 StatLink http://dx.doi.org/10.1787/888933850982

Once the pension system is mature however, taxes collected on withdrawals are large. When all retirees draw their pension based on a full career and constant contribution rules, the net tax expenditure stabilises at its steady-state level. This level is characterised by the fact that the size of withdrawals in a given year exceeds the size of contributions, as withdrawals are the result of several years of contributions accumulating with compound interests. Taxes collected on withdrawals each year therefore more than compensate for tax revenues forgone on contributions.2 For countries already using the “EET” tax regime that are entering into a demographic transition in which the population is ageing, the higher tax revenues will come at a time when pressure on public services may increase.

6.2. What are the alternative approaches to designing financial incentives?

This section identifies alternative approaches to designing financial incentives to promote savings for retirement and builds illustrative cases that will help compare different approaches in the subsequent sections.

There are other tax regimes than the one taxing only withdrawals (“EET”) in OECD countries to promote savings for retirement. Chapter 2 shows that a broad range of tax regimes apply to retirement savings, from the “Exempt-Exempt-Exempt” (“EEE”) tax regime where contributions, returns on investment and pension income are all tax-exempt, to regimes where two of three flows of income are taxed.

The tax treatment of the different flows (contributions, returns on investment and withdrawals) can be somewhere in between the two opposite cases of full taxation and full exemption. Three examples taken from Canada, Australia and France illustrate this for each of the respective flows. In Canada, pension contributions are deductible from income, but only up to a nominal ceiling, which means that contributions above the ceiling are not tax deductible. In Australia, returns on investment are taxed at the fixed rate of 15% in the accumulation phase, but for many taxpayers this rate is lower than their marginal rate of personal income tax. This means that, for many people, the tax rate applied to returns in superannuation funds is lower than the one applying to returns generated in other savings vehicles. Finally, in France, pension benefits paid as annuities are treated as taxable income after a 10% deduction. The examples illustrate how partial tax relief and partial taxation are possible for the three types of flow.

Partial tax relief on contributions is widespread and can take several forms:

  • Ceiling on tax deductibility: Contributions are tax deductible up to a nominal ceiling. Contributions above the ceiling are not tax deductible and are therefore taxed at the individual’s marginal income tax rate. Most countries have ceilings on tax-deductible contributions.

  • Partial tax deductibility: Only a portion of the contributions is tax deductible. For example, in Portugal, 20% of an individual’s contributions to private pension plans are tax deductible. Like with the “EET” tax treatment, the partial tax deductibility reduces an individual’s taxable income. The reduction therefore applies at the individual’s marginal income tax rate.

  • Deduction at fixed rate: Contributions are tax deductible at the same fixed rate for everyone, independently of the individual’s marginal income tax rate. This approach is discussed as an alternative to tax deduction at the individual’s marginal income tax rate in some countries, like the United Kingdom, but is not implemented in any country yet.

  • Deduction at capped rate: Contributions are tax deductible at the individual’s marginal income tax rate, as long as that marginal rate is below a cap rate. For individuals with a marginal rate above the cap, contributions are deductible only at the capped rate. This approach is not implemented in any country yet.

  • Non-refundable tax credit: Contributions are not tax deductible but the individual receives a tax credit that reduces the amount of personal income tax due. The value of the tax credit can be calculated as a percentage of contributions (e.g. Belgium, Estonia, Finland, Israel and Korea) or as a fixed nominal amount (this approach is common for mortgages but it is not implemented in any country yet for retirement savings). The fact that the tax credit is non-refundable means that the value of the tax credit cannot exceed the personal income tax liability.

  • Fixed tax rate: Contributions are taxed at the same fixed rate for everyone. For example, in Australia, pension contributions are taxed at the fixed rate of 15%.3 As this rate is usually lower than the marginal income tax rate, most individuals benefit from a tax rate relief on their contributions.

Non-tax financial incentives in the form of matching contributions and fixed nominal subsidies are increasingly popular. Non-tax financial incentives are payments made by the government directly in the pension account of eligible individuals, thus increasing the assets accumulated to finance retirement. Research shows that understanding around tax relief is low among low-income individuals, who also tend to consider tax incentives as a secondary determinant in their decision to save (Sandler, 2002[2]; Clery, Humphrey and Bourne, 2010[3]; Kempson, McKay and Collard, 2003[4]). Policy makers in some countries therefore offer non-tax financial incentives to encourage low-to-middle income individuals to save for retirement.

Matching contributions are usually conditional on the individual contributing and correspond to a certain proportion of the individual’s own contributions, up to a nominal ceiling. The match rate paid by the government varies greatly across countries, from 4.25% in Austria to 325% in Mexico (programme for civil servants).4 A match rate of 50% can be found in Australia, where the matching contribution is targeted at low-income individuals, and in New Zealand, where it applies to all plan members.

Fixed nominal subsidies are designed to attract low-income individuals as the fixed amount paid into the pension account by the government represents a higher share of their income. They can be found in Chile, Germany, Lithuania, Mexico and Turkey.

Non-tax incentives may be used as a substitute or as a complement to tax incentives. For example, in Australia, the super co-contribution is a government matching contribution for low-income individuals making a voluntary contribution to their superannuation fund. This voluntary contribution is made from after-tax income, i.e. from money on which the individual has already been taxed at his/her marginal rate. In that case, the matching contribution comes as a substitute for any tax relief on contributions. By contrast, in the case of Riester pension plans in Germany, high-income individuals can cumulate the fixed nominal subsidy with tax deductions of contributions (although the amount that can be deducted is reduced by the value of the subsidy). There, both types of incentive complement each other.

The analysis in the next sections uses illustrative cases of the different alternative approaches to designing incentives to promote retirement savings discussed above. The selected illustrative cases are presented in Box 6.1. They can be split into three groups: alternative tax incentives to the “EET” tax regime, non-tax incentives and approaches to providing partial tax relief on contributions. Regarding non-tax incentives, the analysis assesses matching contributions and fixed nominal subsidies as a substitute for tax incentives, not as a complement. Therefore, the underlying tax regime applying to retirement savings under non-tax incentives approaches is the same one as for traditional savings vehicles (i.e. “TTE”). This allows examining the specificities of non-tax incentives as compared to tax incentives. Fixed nominal subsidies and matching contributions are treated as refundable tax credits paid into the pension account.

6.3. How does the tax advantages provided by alternative approaches to designing financial incentives compare with the one provided by the current main approach?

This section compares the tax advantage provided by alternative approaches to designing financial incentives to the one provided by the current main “EET” approach. The section starts by comparing different alternative tax and non-tax incentives and then compares different approaches to providing partial tax relief on contributions.

All the comparisons are done in a theoretical framework and using the illustrative cases presented in Box 6.1 to abstract from country-specific parameters and understand the specific characteristics of each alternative approach. The analysis assumes five personal income tax brackets with tax rates of 0%, 14%, 30%, 41% and 45% respectively. During retirement, the tax due is determined according to the level of total taxable pension income (including public pension).

Box 6.1. Selected illustrative cases of alternative approaches to designing financial incentives to promote savings for retirement

Alternative tax incentives

  • “EEE”: contributions, returns and withdrawals are tax free

  • “EtE”: contributions are tax deductible, returns are taxed at 15% and withdrawals are tax free

  • “EtT”: contributions are tax deductible, returns are taxed at 15% and withdrawals are taxed at the individual’s marginal tax rate

  • “TEE”: contributions are taxed at the individual’s marginal tax rate, returns and withdrawals are tax free

  • “tEt”: 50% of contributions are tax deductible, returns are tax free and 50% of withdrawals are tax exempt

  • “ttE”: contributions and returns are taxed at 15% and withdrawals are tax free

Non-tax incentives

  • Matching contribution: 50% match rate

  • Fixed nominal subsidy: 1% of the average earnings in the economy

Approaches to provide partial tax relief on contributions

  • Ceiling on tax deductibility

  • Partial tax deductibility

  • Deduction at fixed rate

  • Deduction at capped rate

  • Non-refundable tax credit (expressed as a percentage of contributions)

  • Non-refundable tax credit (expressed as a fixed nominal amount)

  • Fixed tax rate

Memo item: Tax treatment of traditional savings vehicles

  • “TTE”: contributions and returns are taxed at the individual’s marginal tax rate and withdrawals are tax free

Alternative tax and non-tax incentives

Changing the design of financial incentives modifies the overall tax advantage provided to individuals when saving for retirement. Figure 6.3 compares the overall tax advantage provided by the current main approach of taxing only withdrawals (“EET”) to that of alternative tax and non-tax incentives. The overall tax advantage results from comparing each tax and non-tax incentive separately to the tax treatment of a benchmark traditional savings vehicle where contributions and returns on investment are taxed at the individual’s marginal tax rate and withdrawals are tax exempt (“TTE”). Approaches that exempt or tax contributions and returns on investment favourably while taxing withdrawals (“EET”, “tEt” and “EtT” tax regimes) provide an overall tax advantage that nets outs a positive tax advantage on contributions, a positive tax advantage on returns and a negative tax advantage on withdrawals. Approaches that exempt or tax favourably contributions and returns on investment while exempting withdrawals provide an overall tax advantage that results from a positive tax advantage on contributions and a positive tax advantage on returns (“EEE”, “EtE” and “ttE” tax regimes).5 The tax advantage when retirement savings are taxed upfront (i.e. only contributions are taxed, “TEE”) comes from the tax exemption of returns on investment. Finally, non-tax incentives provide an overall tax advantage that result from a positive tax advantage on contributions and a negative tax advantage on returns. This negative tax advantage on returns is due to the fact that non-tax incentives increase the amount contributed to the pension plan, thereby increasing investment income and the tax due on it, as compared to the benchmark traditional savings vehicle.

Figure 6.3. Overall tax advantage for the “EET” tax regime and alternative tax and non-tax incentives, by components, average earner
Present value of taxes saved over a lifetime, as a percentage of the present value of contributions
picture

Note: “E” stands for exempt, “T” for taxed and “t” for partial tax relief. The calculations assume an average earner contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity. See Box 6.1 for the detailed design of each incentive.

 StatLink http://dx.doi.org/10.1787/888933851001

The ranking of the different types of tax and non-tax incentive on the overall tax advantage for the average earner vary according to the assumptions used. For example, when assuming a 50% match rate, the matching contribution approach is less advantageous to the average earner than the “EET” tax regime, but both approaches would be equivalent with a 75% match rate. Assuming a 10% contribution rate instead of 5% would make the “EET” and “EtE” tax regimes equivalent in terms of overall tax advantage as higher contributions translate into higher pension income, which is taxed at a higher rate in the case of the “EET” tax regime. It is also worth noting that, independently of the assumptions chosen, and compared to the “EET” approach, removing the taxation of withdrawals (“EEE” tax regime) will always increase the tax advantage, while taxing returns on investment (“EtT” tax regime) will always reduce the tax advantage.

An individual whose income is subject to a lower marginal tax rate during retirement than while working is better-off when retirement savings are taxed upon withdrawal (“EET”) rather than taxed upfront (“TEE”). Figure 6.3 shows that “TEE” tax incentives provide a smaller overall tax advantage to the average earner than “EET” tax incentives. The tax advantage on returns is the same for both tax regimes (grey bars). However, with the “EET” tax regime, the tax advantage on contributions is not compensated fully by the tax due on withdrawals when the individual’s marginal income tax rate falls at retirement. The overall tax advantage is therefore larger than just the tax advantage on returns. Only individuals, whose income remains subject to the same marginal tax rate during retirement as while working, are neutral between the two approaches that tax retirement savings upfront versus upon withdrawal.6

Tax incentives provide an overall tax advantage that increases with income in systems where tax rates increase with taxable income. Figure 6.4 illustrates how the overall tax advantage changes with the level of the income for the current main approach to designing financial incentives (“EET”) and alternative tax and non-tax incentives. All of the tax incentives provide a larger overall tax advantage to individuals with higher earnings. This is because of the underlying tax system, in which tax rates increase with income. This type of tax system implies that any tax relief is given at a higher rate for individuals whose income reaches higher tax brackets.

By contrast, in tax systems where a fixed tax rate applies to the entire income of the individual, all tax incentives become income neutral, because any tax relief is given at the same rate for everyone.

Figure 6.4. Overall tax advantage for the “EET” tax regime and alternative tax and non-tax incentives, by income level
Present value of taxes saved over a lifetime, as a percentage of the present value of contributions
picture

Note: “E” stands for exempt, “T” for taxed and “t” for partial tax relief. The calculations assume an average earner contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity. See Box 6.1 for the detailed design of each incentive.

 StatLink http://dx.doi.org/10.1787/888933851020

Non-tax incentives alone, when not associated with other tax incentives, provide a higher overall tax advantage to low-income earners in systems where tax rates increase with taxable income. This is not surprising for fixed nominal subsidies, but less intuitive in the case of matching contributions, as the match rate is equal for everyone. When the matching contribution is associated with the “TTE” tax regime, the match rate applies to after-tax contributions, implying that individuals with higher marginal tax rates receive a lower tax advantage on their contributions. In addition, the tax due on returns increases with income because matching contributions increase the level of total contributions and generate additional investment income, compared to a traditional savings vehicle. Therefore the overall tax advantage provided by matching contributions declines with income.

In tax systems where a fixed tax rate applies to the entire income of the individual, matching contributions become income neutral, but fixed nominal subsidies remain more advantageous to low-income earners. Matching contributions provide the same advantage to all income groups in such tax systems because the match rate is the same for all, while contributions and returns on investment are taxed at the same rate for everybody. Fixed nominal subsidies provide a tax advantage that declines with the income level because the value of the subsidy is fixed.

Adding non-tax incentives to tax incentives increases the overall tax advantage provided to individuals, while achieving a smoother overall tax advantage across income groups. Figure 6.5 illustrates the impact on the overall tax advantage of adding non-tax incentives on top of existing tax incentives. For example, introducing a 50% matching contributions for a pension plan that is already subject to the “EET” tax regime would increase the tax advantage on contributions for all earners in the same proportion (equivalent to the match rate). At the same time, it would also increase assets accumulated, pension benefits and the amount of tax due on the latter. That increase in tax due on withdrawals would hit higher-income earners harder, as they are the ones subject to the highest marginal tax rates. All in all, the introduction of a matching contribution would increase the overall tax advantage for all individuals, but more so for low-income earners. The combination of the “EET” tax regime with a matching contribution therefore achieves a smoother the tax advantage across income groups than “EET” alone or matching contributions alone.

Figure 6.5. Overall tax advantage for tax and non-tax incentives alone or in combination, by income level
Taxes saved over a lifetime, as a percentage of the present value of contributions
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Note: “E” stands for exempt and “T” for taxed. The calculations assume an individual contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity. The tax system is such that tax rates increase with taxable income. A 50% match rate is assumed.

 StatLink http://dx.doi.org/10.1787/888933851039

Approaches to providing partial tax relief on contributions

Different approaches can be used to provide partial tax relief on contributions. To understand the mechanisms through which the different approaches operate, Table 6.1 presents the formulas that determine the after-tax contribution for each of them. For example, in the case of a deduction at fixed rate, the after-tax contribution is equal to the before-tax contribution minus the tax liability on the contribution. In turn, the tax liability is the amount that would have to be paid without tax relief (the before-tax contribution multiplied by the marginal tax rate) minus the tax deduction (the after-tax contribution multiplied by the fixed rate of deduction). Interestingly, the after-tax contribution is equal to the before-tax contribution when the rate of deduction is equal to the individual’s marginal tax rate.

It is possible to design the different approaches in such a way that they will provide the same overall tax advantage to an individual. For example, an individual whose income is subject to a marginal tax rate of 30% will get the same overall tax advantage when deducting 50% of contributions; deducting contributions at a fixed rate of 15%; receiving a tax credit of 15%; or having contributions taxed at a fixed rate of 17.6%.

Table 6.1. Determination of the after-tax contribution for different approaches to providing partial tax relief on contributions

Formula to determine the after-tax contribution

Ceiling on tax deductibility

A T C = B T C - ( B T C × M T R - m i n { A T C , C e i l i n g } × M T R )

If ATC ≤ Ceiling:

ATC = BTC

If ATC > Ceiling:

A T C = B T C × 1 - M T R + C e i l i n g × M T R

Where “Ceiling” is the maximum contribution that is deductible

Partial tax deductibility

A T C = B T C - ( B T C × M T R - D P × A T C × M T R )

A T C = B T C × 1 - M T R 1 - D P × M T R

Where “DP” is the part of contributions that is deductible

Deduction at fixed rate

A T C = B T C - ( B T C × M T R - A T C × F R D )

A T C = B T C × 1 - M T R 1 - F R D

Where “FRD” is the fixed rate of deduction

Deduction at capped rate

A T C = B T C - ( B T C × M T R - A T C × m i n { M T R , C R D } )

If MTR ≤ CRD:

A T C = B T C

If MTR > CRD:

A T C = B T C × 1 - M T R 1 - C R D

Where “CRD” is the capped rate of deduction

Tax credit (%)

A T C = B T C - ( B T C × M T R - A T C × T C R )

A T C = B T C × 1 - M T R 1 - T C R

Where “TCR” is the tax credit rate

Tax credit (fixed amount)

A T C = B T C - ( B T C × M T R - T C A )

A T C = B T C × 1 - M T R + T C A

Where “TCA” is the tax credit amount

Fixed tax rate

A T C = B T C × ( 1 - F T R )

Where “FTR” is the fixed tax rate

Note: “ATC”= after-tax contribution; “BTC”=before-tax contribution; “MTR”=marginal income tax rate.

When changing the tax relief on contributions from full tax deductibility to partial tax relief, the decrease in the tax advantage on contributions is partially compensated by a lower taxation of withdrawals.7 Figure 6.6 shows the decomposition of the overall tax advantage for the “EET” tax regime and the partial tax deductibility approach. Only one alternative approach is shown in the graph, as all the other approaches to providing partial tax relief on contributions operate through the same mechanism. A change in the tax treatment of contributions (without changing the tax treatment of returns on investment and of withdrawals) obviously has an impact on the tax advantage on contributions, but also on the tax advantage on withdrawals. For example, when only 50% of contributions are tax deductible, the tax advantage on contributions decreases from 30% of the present value of contributions for the “EET” tax regime to 12% for the partial deductibility approach. Meanwhile, the tax advantage on returns remains the same (21%) and the tax advantage on withdrawals increases (from -14% to -12%). Indeed, a reduction in the tax relief on contributions lowers the level of after-tax contributions paid in the pension plan, and as a consequence it also lowers the level of assets accumulated, the future level of pension benefits, and the amount of tax due on the latter.

Figure 6.6. Overall tax advantage for the “EET” tax regime and the partial tax deductibility
Present value of taxes saved over a lifetime, as a percentage of the present value of contributions
picture

Note: “E” stands for exempt and “T” for taxed. The calculations assume an individual contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity.

 StatLink http://dx.doi.org/10.1787/888933851058

Among approaches to providing partial tax relief on contributions, a fixed tax rate on contributions favours high-income earners, while a tax credit expressed as a fixed nominal amount and a tax deduction at fixed rate favour low-income earners in systems where tax rates increase with taxable income. Figure 6.7 illustrates how the overall tax advantage changes with the level of income for the “EET” tax regime and different approaches to providing partial tax relief on contributions. The different approaches are defined so that the average earner gets the same overall tax advantage, which corresponds to deducting 50% of contributions. None of the approaches are income neutral.

Reducing tax relief on contributions through partial tax deductibility lowers the overall tax advantage for all income groups, but hits middle- and high-income earners harder than low-income earners. As shown in Figure 6.7, the gap in the overall tax advantage between full tax deductibility (“EET”) and partial tax deductibility of contributions increases with income. Indeed, low-income earners are the ones who benefit the least from the “EET” tax regime in the first place, because they already pay little or no income tax before the deduction of contributions. Reducing the portion of contributions that can be deducted from taxable income therefore has a lower impact for low-income earners.

Tax deductions at a fixed rate increase the overall tax advantage for low-income earners and reduce it for high-income earners, thereby achieving a smoother relationship across income groups, compared to tax deductions at the marginal rate. Low-income earners are better-off with a deduction at fixed rate than with a deduction at their marginal rate when the fixed deduction rate is higher than their marginal income tax rate.

Tax credits expressed as a proportion of contributions are equivalent to tax deductions at fixed rate except for very low-income earners. Indeed, very low-income earners who pay little or no income tax benefit less from the tax credit because of its non-refundable nature. By contrast, they get an extra relief when their income is taxed at a rate below the fixed rate of deduction.

Figure 6.7. Overall tax advantage for the “EET” tax regime and different approaches to providing partial tax relief on contributions, by income level
Present value of taxes saved over a lifetime, as a percentage of the present value of contributions
picture

Note: “E” stands for exempt and “T” for taxed. The calculations assume an individual contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity. The tax system is such that tax rates increase with taxable income. All the strategies are equivalent in terms of overall tax advantage for the average earner and correspond to the case where 50% of contributions are tax deductible.

 StatLink http://dx.doi.org/10.1787/888933851077

Tax credits expressed as a fixed nominal amount target tax advantages at low-income earners. As the value of the tax credit is fixed across the income scale, its value in relative terms declines with the income level. Unfortunately, individuals paying little or no income tax do not benefit as much when the credit is non-refundable.

By contrast, high-income earners are better-off when contributions are taxed at a fixed rate. Indeed, as the income level increases, the gap between the individual’s marginal income tax rate and the fixed tax rate increases, leading to a larger tax advantage on contributions and thereby a larger overall tax advantage. However, this approach could act as a disincentive for very low-income earners if the fixed tax rate exceeds their marginal income tax rate (c.f. negative overall tax advantage for individuals earning 20% of average earnings, Figure 6.7).

The impact of introducing a ceiling on tax-deductible contributions depends on whether individuals make excess contributions. Figure 6.8 compares the overall tax advantage across different income groups, when there is no ceiling on the tax-deductibility of contributions (“EET”) and when a ceiling is introduced, with and without the possibility of making excess contributions. When excess contributions are allowed, introducing a ceiling reduces the amount of taxes saved only for individuals who contribute beyond the ceiling. The ceiling has no impact on the overall tax advantage as long as contributions remain below it. When the analysis assumes that all individuals contribute the same proportion of their earnings (5%), the likelihood of exceeding the ceiling increases with income. In addition, as the ceiling is set as a fixed nominal amount, the part of taxable contributions increases with the income level, thereby reducing the tax advantage on contributions and the overall tax advantage as income increases.

Figure 6.8. Overall tax advantage for the “EET” tax regime, with and without a ceiling on tax deductibility, by income level
Present value of taxes saved over a lifetime, as a percentage of the present value of contributions
picture

Note: “E” stands for exempt and “T” for taxed. The calculations assume an individual contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity. The tax system is such that tax rates increase with taxable income. The ceiling corresponds to 20% of the average earnings in the economy.

 StatLink http://dx.doi.org/10.1787/888933851096

However, when excess contributions are not allowed, or when individuals do not want to contribute above the ceiling, high-income individuals actually get a larger overall tax advantage. When individuals refrain from making excess contributions because those contributions do not get tax relief, the introduction of the ceiling modifies the amount contributed into the plan. High-income earners are more likely to reach the ceiling and therefore to reduce their contributions as a proportion of their earnings. This would lead high-income earners to accumulate fewer assets, have lower pension benefits, and therefore pay less tax (as compared to a situation without the ceiling). Lower pension benefits translate into a higher overall tax advantage for high-income earners because the proportion of their total pension income in the last tax bracket will be lower compared to a situation without the ceiling (c.f. individuals earning 8 or 16 times the average earnings in Figure 6.8, black dashed line).

Finally, most of the approaches to providing partial tax relief on contributions are income neutral in tax systems where individuals have their entire income taxed at a fixed rate. A tax credit calculated as a fixed nominal amount would still offer the largest overall tax advantage to low-income earners. In addition, in personal income tax systems where all individuals pay tax on their first unit of income, even very low-income earners can benefit from tax credits.

6.4. Evolution of the fiscal cost when changing the approach to designing financial incentives to promote savings for retirement

This section looks at the evolution of the fiscal cost when changing the approach to designing financial incentives to promote savings for retirement.

The analysis focuses on the transition from the current main approach to designing financial incentives (exempting contributions and returns on investment while taxing withdrawals, “EET”) to different alternative approaches. The fiscal cost is assessed through the calculation of the net tax expenditure related to the preferential tax treatment of retirement savings and of direct spending related to non-tax incentives.8 The analysis calculates the yearly net tax expenditure associated with the tax treatment of private pension plans, today and into the future, based on the revenue forgone method and using the cash-flow approach. The revenue forgone method measures the amount by which tax revenues are reduced by a particular tax concession, under the assumption of unchanged behaviour from the taxpayer. The cash-flow approach estimates the effect on government cash-flows in a given year. The net tax expenditure in a given year is calculated as the net amount of tax revenues forgone on contributions, tax revenues forgone on accrued income and tax revenues collected on withdrawals. The section first assesses the impact of a transition from the “EET” tax regime to another tax or non-tax incentive and then looks at the impact of reducing tax relief on contributions following different approaches.

Transition to alternative tax and non-tax incentives

This sub-section looks at the evolution of the fiscal cost over time when there is a transition from the “EET” tax regime to an alternative tax or non-tax incentive. Figure 6.9 shows projections of the fiscal cost and its components (revenues forgone on contributions, revenues forgone on returns, revenues collected on withdrawals and direct spending) for a pension plan with “EET” tax incentives. The pension plan is mature in year t and replaced five years later, at t+5, by an alternative tax or non-tax incentive for new entrants to the labour market.9 The left panel of Figure 6.9 shows the total fiscal cost, as well as the fiscal cost resulting from the “EET” tax regime and the alternative incentive. The right panel shows tax revenues forgone on contributions, tax revenues forgone on returns, taxes collected on withdrawals and direct spending resulting from the transition between the two approaches.

Figure 6.9. Fiscal cost and its components in case of a transition from an “EET” tax regime to an alternative incentive
As a percentage of GDP
picture

Note: “E” stands for exempt, “T” for taxed and “t” for partial tax relief. The calculations assume that individuals save from age 20 to 64 and draw pension benefits from age 65 to 84; contributions represent 3% of GDP; the number of people in each single-year age cohort is equal; the same average tax rate (30%) applies to all sources of income; a nominal rate of return of 5.06% (3% real return plus 2% inflation); GDP growth at 3.28% (1.25% real growth plus 2% inflation). See Box 6.1 for the detailed design of each incentive.

 StatLink http://dx.doi.org/10.1787/888933851115

The fiscal cost follows a regular trend when there is a transition from the “EET” tax regime to an alternative tax incentive that either exempts withdrawals or taxes returns, everything else being equal. When exempting withdrawals (transition to the “EEE” tax regime), the net tax expenditure increases as the proportion of taxable pension income decreases over time. When taxing returns on investment (transition to the “EtT” tax regime) the net tax expenditure declines as the tax relief on returns is reduced. This is, however, slightly compensated by a decrease in taxes collected on withdrawals. This stems from the fact that assets grow at a lower post-tax rate of return (as compared to the “EET” tax regime), translating into lower assets accumulated at retirement and lower pension benefits for future retirees.

For the transitions to the other alternative tax incentives it is necessary to distinguish between the short term and the long term to understand the evolution of the fiscal cost. In the short term, the transition from the “EET” tax regime to either of the “EtE”, “tEt”, “ttE” or “TEE” tax regimes translates into a lower net tax expenditure. This is despite the fact that these approaches provide a similar or larger tax advantage to individuals than the “EET” tax regime. That result is due to the phasing out of the “EET” tax regime. Indeed, for the four alternative tax incentives, some of the fiscal costs are reduced overnight when the new system is introduced at t+5, as contributions stop being paid in the “EET” plan and start building assets in the new plan. There is a reduction in tax revenues forgone on returns on investment for the “EtE” and “ttE” tax regimes, while there is a reduction in tax revenues forgone on contributions for the “tEt”, “ttE” and “TEE” tax regimes. At the same time, revenues collected on withdrawals are still high at t+5, as all retirees have contributed to the “EET” system and therefore pay taxes on their pension benefits. Over time, tax revenues collected on withdrawals decline slowly (to zero for the “EtE”, “ttE” and “TEE” tax regimes), resulting in an increase in the net tax expenditure. Therefore, the net tax expenditure follows a U-shape following the transition, first declining and then increasing.

Taxing retirement savings upfront (“TEE”) rather than upon withdrawal (“EET”) costs more to the treasury in the long term, despite the fact that both tax regimes provide the same overall tax advantage to individuals (when tax rates during working years remain at the same level during retirement, which is what is assumed in Figure 6.9). Indeed, the net tax expenditure related to the “TEE” tax regime is just equal to tax revenues forgone on returns because as compared to the tax treatment of traditional savings vehicles (where only withdrawals are exempt from taxation) only the tax treatment of returns is different. The net tax expenditure related to the “EET” tax regime is lower for a mature pension system, as taxes collected on withdrawals more than compensate for tax revenues forgone on contributions (because withdrawals are the result of the accumulation of contributions and the compound interest on those accumulations). Consequently, the net tax expenditure resulting from the “EET” tax regime is lower than just tax revenues forgone on returns on investment. In the short term however, the transition from taxation upon withdrawal to upfront taxation would lead to a sharp decline in the net tax expenditure, as explained above.

The transition from the “EET” tax regime to a non-tax incentive also involves two phases for the evolution of the fiscal cost. The last panel of Figure 6.9 shows the transition to a matching contribution approach, but the mechanism is the same for a fixed nominal subsidy, the only difference being the level of direct spending. In the short term, the transition to a matching contribution would reduce the fiscal cost. When the new system is introduced at t+5, direct spending on the matching contribution substitutes the tax expenditure related to tax revenues forgone on contributions.10 In addition, returns start to be taxed (the matching contribution is not associated with any preferential tax treatment), so that revenues forgone on returns decline (and turn into a net collection of taxes over time) and so do the total fiscal cost. At the same time, revenues collected on withdrawals are still high at t+5, as all retirees have contributed to the “EET” system and therefore pay taxes on their pension benefits. Over time, revenues collected on withdrawals decline to zero, explaining the final rise of the total fiscal cost.

The fiscal cost also increases when introducing a non-tax incentive on top of a tax incentive, for example a matching contribution with an “EET” tax regime. However, in the long run, that increase is smaller than the direct spending on the non-tax incentive, as it is partially compensated by an increase in tax revenues collected on the higher withdrawals.

There is no alternative approach that improves on the current main approach of taxing only withdrawals by simultaneously providing a higher tax advantage to individuals at a lower long-term fiscal cost. Figure 6.10 compares the overall tax advantage provided to the average earner by different approaches to designing financial incentives to their long-term fiscal cost. All the approaches that provide a higher tax advantage to the individual than the “EET” tax regime are also more costly to the treasury (“EEE”, “EtE” and matching). In addition, some approaches that provide a comparable tax advantage to the individual achieve higher fiscal costs (“TEE”, “tEt” and “ttE”). This is because they do not tax retirement benefits, or only at a reduced rate, generating less tax revenues once the system is mature.11

Figure 6.10. Overall tax advantage and long-term fiscal cost for alternative approaches to designing financial incentives
picture

Notes: “E” stands for exempt, “T” for taxed and “t” for partial tax relief. See Box 6.1 for the detailed design of each incentive.

For the fiscal cost: The calculations assume that individuals save from age 20 to 64 and draw pension benefits from age 65 to 84; contributions represent 3% of GDP; the number of people in each single-year age cohort is equal; the same average tax rate (30%) applies to all sources of income; a nominal rate of return of 5.06% (3% real return plus 2% inflation); GDP growth at 3.28% (1.25% real growth plus 2% inflation).

For the overall tax advantage: The calculations assume an average earner contributing 5% of wages from age 20 to 64 and withdrawing benefits from age 65 to 84 as a fixed-payment annuity. A single tax rate of 30% applies to all sources of income.

 StatLink http://dx.doi.org/10.1787/888933851134

Transition to partial tax relief on contributions

This sub-section compares the effect of providing partial tax relief on contributions on the net tax expenditure. Similarly to the previous sub-section, the analysis assumes that a mature pension plan with an “EET” tax regime in year t is replaced with a new pension plan with reduced tax relief on contributions five years later, at t+5, for new entrants to the labour market. Figure 6.11 only shows the case of partial tax deductibility (50% of contributions), as the mechanism is the same for all the other approaches to providing partial tax relief on contributions.

Figure 6.11. Net tax expenditure and its components in case of a transition from an “EET” tax regime to a partial tax deductibility of contributions
As a percentage of GDP
picture

Note: “E” stands for exempt and “T” for taxed. The calculations assume that individuals save from age 20 to 64 and draw pension benefits from age 65 to 84; contributions represent 3% of GDP; the number of people in each single-year age cohort is equal; the same average tax rate (30%) applies to all sources of income; a nominal rate of return of 5.06% (3% real return plus 2% inflation); GDP growth at 3.28% (1.25% real growth plus 2% inflation); 50% of contributions are tax deductible for the alternative approach.

 StatLink http://dx.doi.org/10.1787/888933851153

Reducing the tax relief on contributions lowers the net tax expenditure, especially in the short term. Indeed, the reduction in tax revenues forgone on contributions happens overnight when the new system is introduced at t+5, as contributions stop being paid in the “EET” plan and start building assets in the plan with reduced tax relief on contributions. At the same time, revenues collected on withdrawals are still high at t+5, as all retirees have contributed to the “EET” system and therefore pay taxes on their pension benefits. Over time, tax revenues forgone on returns remain constant, while tax revenues collected on withdrawals decline slowly, resulting in an increase in the net tax expenditure from the previous lower level. The decline in tax revenues collected on withdrawals stems from the fact that after-tax contributions are lower when paid in the plan with reduced tax relief on contributions. This translates into lower assets accumulated at retirement and lower pension benefits for future retirees. The new steady-state net tax expenditure is lower than the one for the “EET” system, but higher than at the time of the transition between the two systems.

6.5. Summary discussion and conclusion

This section brings together the analysis presented in the previous sections and discusses some implications of using different alternative approaches to designing tax and non-tax financial incentives to promote savings for retirement.

Providing higher tax advantages for certain income groups

Matching contributions, fixed nominal subsidies and tax credits can provide a higher tax advantage than even exempting from taxation all income flows for certain income groups. The tax regime where none of the flows are taxed (“EEE” tax regime) is the tax incentive leading to the highest tax advantage for the average earner, everything else being equal.12 However, matching contributions and fixed nominal subsidies may provide larger incentives for certain income groups. For example, matching more than 75% of an individual’s contributions provides a larger tax advantage to an average earner than the “EEE” tax regime. For a low-income earner (with an income lower than 60% of average earnings), matching 50% of contributions is already enough to provide a more favourable tax advantage than the “EEE” tax regime. Similarly, tax credits can potentially lead to a higher tax advantage if the credit rate is large enough.

Taxing retirement savings upfront or upon withdrawal

Taxing retirement savings upfront (i.e. taxing only contributions, “TEE”) is often seen as an equivalent approach to taxing retirement savings upon withdrawal (“EET”). In particular, upfront taxation also achieves tax neutrality between saving and consuming, as long as returns are not above the normal return to saving (Mirrlees et al., 2011[5]). However, there are a number of different implications for the individual and the government between the two designs that are worth analysing.

Upfront taxation (“TEE”) and taxation upon withdrawal (“EET”) provide the same overall tax advantage only when the income of the individual is subject to the same marginal tax rate throughout their working and retirement years. This is obviously the case in countries where the entire income is taxed at a fixed rate. However, in countries where tax rates increase with taxable income, not all individuals will be subjected to the same tax rate over their entire lifetime. In that case, the optimal tax treatment in terms of tax advantage depends on individuals’ circumstances.

Individuals would be better-off having their retirement savings taxed upfront or upon withdrawal depending on whether their income tax rate will be higher or lower during their working or retirement years. Individuals would be better-off paying taxes upfront (respectively upon withdrawal) when they expect tax rates during retirement to be greater (respectively lower) than they are when contributions are made. As discussed earlier, individuals usually face a lower tax rate during retirement than while working. When this is the case, taxation upon withdrawal will provide a higher overall tax advantage than upfront taxation. By contrast, individuals would be better-off paying taxes upfront when they expect tax rates during retirement to be greater than when they are working. For example, when both public and private pension incomes are taxable, the individual may be subject to a higher tax rate during retirement than the one at which tax relief was granted on contributions.13

Low levels of financial knowledge may, however, affect individuals’ behaviour and retirement plan choices when they are provided with the opportunity to choose between upfront taxation and taxation upon withdrawal. For example, Beshears et al. (2017[6]) show that employees in the United States who are offered choice between a Roth 401(k) plan (upfront taxation, “TEE”) and a traditional 401(k) plan (taxation upon withdrawal, “EET”) do not contribute less to their occupational pension plan than employees who could only contribute to a traditional 401(k) plan.14 The authors find that the insensitivity of contributions to the introduction of the Roth option is partially driven by ignorance and/or neglect of the different tax rules.

In addition, behavioural biases may lead to a different perception of the two tax treatments. Contributions to plans with taxation upon withdrawal immediately reduce the participant’s income tax due. Plans with upfront taxation do not provide tax relief today, they exempt future pension income from taxation. Because of present bias, individuals may want to secure the tax advantage earlier rather than later and therefore prefer taxation upon withdrawal.

By contrast, other behavioural factors could lead individuals to prefer upfront taxation. For example, Cuccia, Doxey and Stinson (2017[7]) show that uncertainty may lead to anxiety and influence plan choice. Plans with taxation upon withdrawal may be perceived as more uncertain than plans with upfront taxation because the amount of taxes that will be due on withdrawals is unknown, as tax rates may change due to tax reforms or to a change in the individual’s economic status. Low levels of financial literacy and behavioural biases may therefore lead some individuals to choose the plan with the tax treatment that would not provide them with the largest overall tax advantage.

Taxation upon withdrawal may also discourage early withdrawals and lump sum payments. With taxation upon withdrawal, pension benefits are added to the individuals’ earnings and taxed at their marginal rate. Early withdrawals when the individual is still working and earning work income may therefore push taxable income into a higher tax bracket. In the same way, lump sum benefits may represent large amounts that move an individual into a higher tax bracket than would apply to a lower annual level of pension benefits (annuities or programmed withdrawals) if the same tax treatment applies to all types of post-retirement product. By contrast, upfront taxation with no tax on withdrawals creates no financial disincentive for early withdrawals and lump sum payments.

Although upfront taxation may be appealing to the treasury because it does not defer tax collection, in the long run this tax regime may translate into a higher fiscal cost than taxation upon withdrawal. If we compare the yearly fiscal effects of the two tax regimes, we see that in the short term, upfront taxation leads to a lower fiscal cost than taxation upon withdrawal. This is because, when taxing only withdrawals, tax collection is deferred, while the cost related to tax revenues forgone on contributions is fully incurred as they are made. With upfront taxation, the net tax expenditure is simply equal to tax revenues forgone on returns. In the long term, once the two systems reach maturity, the fiscal impact is reversed: taxation upon withdrawal leads to a lower annual fiscal cost than upfront taxation. This is because, with taxation of withdrawals, tax revenues collected more than compensate for tax revenues forgone on contributions, as the size of withdrawals in a given year exceeds the size of contributions in a mature pension system.15 16

Upfront taxation may be preferable when considering mobility across countries. If individuals initially contribute to a plan with taxation upon withdrawal and then move to another country later in their working life or after retirement, the original country faces a tax revenue loss if those individuals pay income tax in their new country of residence, unless there are perfectly offsetting movements in the opposite direction. With upfront taxation, mobility across countries does not impact tax revenues across countries. Retirement savings are taxed in the country where contributions are made and whether the individual later moves does not affect tax revenues.

Using tax credits or tax deductions

Non-refundable tax credits and tax deductions are economically equivalent when the credit rate is equal to the deduction rate. For example, for an individual facing a 30% marginal tax rate, it is equivalent to deduct contributions from taxable income or to get a tax credit of 30%.17

Tax credits achieve a smoother overall tax advantage across income groups than tax deductions at the marginal rate. Tax credits provide the same tax relief on after-tax contributions to all individuals with sufficient tax liability, independent of their income level and marginal income tax rate. They are equivalent to tax deductions at fixed rate, except for very low income-earners who benefit less from the tax credit because of its non-refundable nature.

Tax credits and tax deductions are, however, not very valuable for individuals with low or no income tax liability, unless tax credits are refundable. Individuals whose tax liability is lower than the value of a non-refundable tax credit will not receive the full credit. For individuals not paying income tax, deducting contributions paid into a pension plan does not reduce the income tax due. Making tax credits refundable (i.e. when the tax credit is higher than income tax due, the treasury pays the difference to the individual) restores their attractiveness for low-income earners as long as claiming the credit is not too cumbersome. Additionally, tax credits may also be expressed as a fixed nominal amount and be used to target the tax advantage at low-income earners, as the nominal amount represents a higher share of their income.

The structure of tax declaration and tax collection may influence individuals’ perception of the two approaches and lead to different outcomes. For example, when pension contributions are deducted from pay before calculating and paying personal income tax, the tax relief is automatically provided and saved in the pension account. This may not be the case when tax deductions and tax credits need to be claimed through the income tax declaration. When contributions are first taxed at the individual’s marginal rate, the tax refund may be provided later in the year or even the following year to the individual. If individuals anticipate that they will eventually get a tax refund, they can increase their after-tax contribution to save the whole tax relief in the pension account. However, if they do not anticipate it, the after-tax contribution may not be as high as with an automatic direct tax deduction.18

Using tax incentives or non-tax incentives

Non-tax incentives are not linked to the individual’s tax status, making them attractive to all individuals. Matching contributions are calculated as a proportion of after-tax contributions. With fixed nominal subsidies, all eligible individuals receive the same amount in their pension account. As non-tax incentives are not linked to the individual’s tax status, the value of the incentive is not limited by the tax liability.19 Therefore all individuals can fully benefit from them as long as they fulfil the entitlement requirements (e.g. having an income below a certain level, contributing a certain proportion of income).

Moreover, non-tax incentives are paid directly into the pension account, which may not always be the case with tax incentives. Non-tax incentives are automatically paid into the pension plan, therefore increasing the assets accumulated by retirement and future pension benefits. By contrast, individuals eligible for a tax credit or a tax deduction (when it needs to be claimed) may not save the value of the incentive in the pension account if they do not increase their after-tax contributions in anticipation of the lower tax withholding or the receipt of a tax refund.

In addition, matching contributions may have a larger impact on retirement savings than economically equivalent tax credits.20 A study by Saez (2009[8]) shows that individuals receiving a 50% matching contribution participate more in retirement savings plans and contribute more than individuals receiving an equivalent incentive framed as a 33% tax credit.21 This result suggests that taxpayers do not perceive the match and the tax credit to be economically identical. Some individuals may have perceived the 33% credit rate as equivalent to a 33% match rate, thereby reducing the incentive. Another factor could be that individuals had to wait for two weeks to receive the credit rebate. Due to loss aversion, contributing for example USD 450 and then receiving USD 150 back may feel more painful than contributing just USD 300 and obtaining a match of USD 150 to reach the same USD 450 total contribution.

Matching contributions alone, when not associated with other tax incentives, provide a higher overall tax advantage to low-income earners when tax rates increase with taxable income. This is despite the fact that the match rate is equal for everyone. When the matching contribution is associated with a “TTE” tax regime, the match rate applies to after-tax contributions, implying that individuals with higher marginal tax rates receive a lower tax advantage on their contributions. Moreover, returns on investment are taxable. Taxes paid on returns are higher compared to a traditional savings vehicle because matching contributions increase the level of total contributions and generate additional investment income. Therefore, the overall tax advantage provided by matching contributions declines with the individual’s income level. This is an important difference with tax incentives, which tend to offer larger overall tax advantages to higher-income earners in tax systems where tax rates increase with taxable income.

Substituting deductible contributions for government matching contributions may increase participation in retirement savings plans. For example, in Turkey, participation in pension plans was initially encouraged through tax-deductible contributions. In order to make the system more inclusive and boost savings, tax relief on contributions was replaced by government matching contributions in January 2013.22 Between 2012 and 2013, the number of new participants increased by 65%, suggesting that government matching contributions were more effective in increasing the attractiveness of saving for retirement for some people.

From the point of view of the government, the difference between tax and non-tax incentives stems from the salience of the cost of promoting savings for retirement. The budgetary cost of a financial incentive would ordinarily be the same whether incurred in the form of a direct spending (non-tax incentive) or an equal amount of tax expenditure (tax incentive). Tax expenditures however involve a cost less salient or obvious than the cost of a government spending programme.

Adding non-tax incentives to tax incentives

Most OECD countries already have tax incentives in place. Removing them may be politically and in practice cumbersome. Adding non-tax incentives to tax incentives could be envisaged. For example, introducing matching contributions for a pension plan that is already subject to the “EET” tax regime increases the overall tax advantage provided to individuals and the fiscal cost to the treasury, but achieves a smoother overall tax advantage across income groups. Moreover, the additional fiscal cost is limited in the long term by the extra tax collected on larger withdrawals. It could also be contained by capping matching contributions and/or the amount of contributions that can be deducted, although these approaches would modify the relationship between the overall tax advantage and the income level.

Conclusion

This chapter has assessed alternative approaches to designing financial incentives to promote savings for retirement. The assessment has been done relative to the most common approach used currently to provide financial incentives, taxing only withdrawals and exempting the other income flows, contributions and returns on investment (“EET” tax regime). The alternative approaches examined include different ways of taxing retirement savings, like taxing only contributions (“TEE”), as well as non-tax incentives like matching contributions and fixed nominal subsidies. The chapter has compared the different approaches based on the overall tax advantage they provide to individuals saving for retirement and the fiscal cost for the treasury.

The results lead to a few general conclusions:

  • The best approach to designing incentives to promote savings for retirement depends on the policy objective. Compared to the current main approach of taxing only withdrawals, there is no alternative approach to designing financial incentives that provides a higher overall tax advantage to the individual at a lower fiscal cost to the treasury simultaneously.

  • Tax incentives, including the current main approach of taxing only withdrawals, tend to provide the largest tax advantages to high-income earners.

  • When the policy objective is to provide a similar tax advantage across income groups, tax credits expressed as a proportion of contributions, tax deductions at fixed rate and matching contributions added to existing tax incentives can be used. These approaches increase the attractiveness of saving for retirement for middle to low-income groups, while reducing it for high-income earners, compared to the “EET” tax regime.

  • When the policy objective is to encourage low-income earners specifically to save for retirement, tax credits expressed as a fixed nominal amount as well as non-tax incentives, such as matching contributions and fixed nominal subsidies, are appropriate approaches.

  • When the policy objective is to reduce the fiscal cost, it is possible to reduce tax relief on contributions through partial, fixed or capped tax deductions, as well as tax rate reliefs. Taxing returns on investment is another alternative.

  • Tax incentives that provide the same overall tax advantage to the individual can have different cost implications for the treasury. For example, when comparing upfront taxation with taxation upon withdrawal (i.e. “TEE” and “EET”), in the short term, because taxation is deferred, taxation upon withdrawal leads to a higher fiscal cost than upfront taxation. In the long term however, when the system is mature, taxation upon withdrawal will imply a lower fiscal cost than upfront taxation because the tax collected on withdrawals in the “EET” regime is higher than the tax collected on contributions in the “TEE” regime.

  • Tax incentives designed in such a way that pension benefits are taxed tend to achieve comparatively lower fiscal costs than other approaches in the long term.

References

[6] Beshears, J. et al. (2017), “Does Front-Loading Taxation Increase Savings? Evidence From Roth 401(K) Introductions”, Journal of Public Economics 151, pp. 84-95.

[1] Brady, P. (2012), The Tax Benefits and Revenue Costs of Tax Deferral (September).

[3] Clery, E., A. Humphrey and T. Bourne (2010), “Attitudes to pensions: The 2009 survey”, Research Report, No. 701, Department for Work and Pensions.

[7] Cuccia, A., M. Doxey and S. Stinson (2017), “The relative effects of economic and non-economic factors on taxpayers' preferences between front-loaded and back-loaded retirement savings plans”, Working Papers, No. 2017-7, Center for Retirement Research at Boston College.

[4] Kempson, E., S. McKay and S. Collard (2003), Evaluation of the CFLI and Saving Gateway pilot projects, Personal Finance Research Centre, University of Bristol.

[5] Mirrlees, J. et al. (2011), Tax by design, Oxford University Press.

[8] Saez, E. (2009), “Details Matter: The Impact of Presentation and Information on the Take-up of Financial Incentives for Retirement Saving”, American Economic Journal: Economic Policy, Vol. 1/1, pp. 204-228, http://dx.doi.org/10.1257/pol.1.1.204.

[2] Sandler, R. (2002), Medium and long-term retail savings in the UK: A review.

Notes

← 1. The methodology used to calculate the overall tax advantage is described in Chapter 3.

← 2. As opposed to the overall tax advantage which is calculated over the lifetime of an individual, the fiscal cost is calculated over the total population at different points in time. On the one hand, at the level of the individual, the present value of the sum of all taxes collected on withdrawals during retirement is equal to the present value of the sum of all taxes saved on contributions while working, as long as the same tax rate applies during working and retirement years. On the other hand, the calculation of the net tax expenditure sums up revenues forgone on contributions and on returns from working individuals with revenues collected on withdrawals from retirees. When the system is mature, the size of withdrawals in a given year is more important than the size of contributions, as withdrawals are the result of several years of contributions accumulating with compound interests.

← 3. A higher tax rate applies for very-high earners, at 30%.

← 4. The Mexican government matches each peso contributed voluntarily by civil servants with 3.25 pesos. Individuals can contribute up to 2% of their income to this plan.

← 5. For the approach that taxes only returns on investment at a fixed rate of 15% (“EtE” tax regime), the analysis shows that the tax advantage on returns is positive. This however depends on the assumption for the fixed tax rate. If the fixed tax rate increases, the tax advantage on returns diminishes and even turns negative for a tax rate above 20%. This stems from the fact that the amount contributed in the pension plan is higher than in the benchmark traditional savings vehicle (because of the tax deductibility of contributions), thereby increasing investment income and the tax due on it.

← 6. The neutrality between the two tax regimes also requires that the discount rate is equal to the rate of return.

← 7. For all the approaches, the analysis assumes that returns on investment are tax exempt and that withdrawals are considered as taxable income. Therefore, only the tax treatment of contributions differs between the different approaches.

← 8. The methodology used to calculate the net tax expenditure is described in Chapter 5.

← 9. The parameters are the same as those presented in Box 6.1.

← 10. The cost related to the direct spending may be larger, smaller or equal to the cost related to tax revenues forgone on contributions depending on the parameters used to define the matching contribution (match rate and ceiling).

← 11. The ranking of the different approaches according to the tax advantage they provide to the average earner is different from the one presented in Figure 6.3. In order to compare the different approaches to designing financial incentives on their fiscal cost and the overall tax advantage they provide to the average earner, it is necessary to assume that the average earner is subjected to the same fixed tax rate on contributions, returns and withdrawals (30%). This is because, for the calculation of the net tax expenditure, the analysis assumes that the same average tax rate of 30% applies to all sources of income and for all the individuals in the economy. In Figure 6.3, the calculations of the overall tax advantage assume that the tax rate varies with the average earner’s level of taxable income along his/her life (i.e. labour income while working and public and private pension income while retired).

← 12. This result is valid when all tax incentives are compared within the framework of the same personal income tax system.

← 13. Another example is when means-tested public pension benefits treat “EET” and “TEE” withdrawals differently, including the former for the means test but not the latter.

← 14. With upfront taxation, lower after-tax contributions are needed to achieve the same after-tax benefit in retirement as with taxation upon withdrawal (assuming that tax rates remain the same over the lifetime). The authors therefore expected that contributions would go down after the introduction of the Roth option in the occupational pension plan.

← 15. The size of withdrawals would, however, be lower if retirees pay taxes on their pension benefits at a lower rate than the one at which they got tax relief on their contributions while working.

← 16. If the government invests the taxes collected on contributions with the upfront taxation regime instead of spending them, it could obtain the same gains when the system reaches maturity as with the tax regime that taxes retirement savings upon withdrawal.

← 17. With tax credits, contributions are included in taxable income. This implies that tax is paid on them and the tax credit is calculated based on the level of after-tax contributions.

← 18. Approaches that lead to lower after-tax contributions than direct tax deductions entail a larger fiscal cost because fewer assets are accumulated by retirement, leading to lower pension benefits and less tax collected on withdrawals.

← 19. Refundable tax credits could replicate the economic effects of non-tax incentives, as long as they are refunded directly into a pension account.

← 20. A credit rate of t is economically equivalent to a match rate on the contribution of t/(1-t). For example, a 25% refundable tax credit is economically equivalent to a matching contribution of one-third. This is because the tax credit rate is expressed as an inclusive rate (i.e. including the value of the credit), while the match rate is expressed as an exclusive rate (i.e. excluding the value of the matching contribution).

← 21. The study compares participation in and contributions to IRAs in the United States. An “EET” tax treatment applies to IRAs. The matching contribution and tax credit in the experiment supplement the already existing tax incentive.

← 22. The tax treatment of returns on investment and withdrawals has remained the same over time, with returns taxed upon withdrawals and withdrawals tax exempt.

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