33389
World Bank Pension Reform Primer
Taxation
The tax treatment of funded pensions
T he tax treatment of funded pensions is a The first system exempts contributions and fund
critical policy choice in pension reform. In income but taxes the pension in payment. Hence
countries with mature funded systems--the the name exempt, exempt, taxed (EET). The
Netherlands, Switzerland, the United Kingdom second is TEE: contributions are made out of
and the United States--pension funds are worth taxed incomes, but benefits can be withdrawn tax-
85 per cent of GDP on average. They are a major free. In this simple framework, these have the
force in private savings flows, supplying capital to same effect: a choice between consuming 75 now
industry and providing retirement incomes. or saving and spending 121 in five years. The two
also deliver the same present value of revenues for
In a pension reform, a generous tax treatment will government. But under EET--the `classical
encourage switching to the new funded, defined- expenditure tax'--revenues are deferred until
contribution pensions (if the scheme is voluntary) retirement, while under TEE--called the `pre-paid
and political acceptability (whether it is voluntary expenditure tax'--they are received immediately.
or not). But balanced against that, the cost of tax
reliefs can be very high. They may encourage tax Possible pensions tax regimes 1
evasion and avoidance and have undesirable
distributional effects if higher rate taxpayers are EET TEE TTE ETT
better placed to take advantage of tax reliefs. Contribution 100 100 100 100
Tax -- -25 -25 --
Possible ways of taxing pensions Fund 100 75 75 100
Returns 61 46 33 44
There are three points at which saving in a funded Final fund 161 121 108 144
pension can be taxed Tax -40 -- -- -36
Net pension 121 121 108 108
?? when employers or employees contribute
?? when investment income and gains accrue The other two systems tax pensions twice. Both
?? when benefits are paid out tax investment returns, and the first taxes
Four of the eight basic possible tax combinations contributions and the second, withdrawals. Again,
are shown in Figure 1. It looks at a contribution these two systems--called the `comprehensive
of 100 made five years before retirement, with a income tax'--are equivalent in this simple case.
proportional tax of 25 per cent and annual returns The reward for saving is lower than the
of 10 per cent a year. 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
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 2
expenditure is taxed, but is 7.5 rather than 10 per administer., because taxing investment returns,
cent under the comprehensive income tax especially unrealised capital gains, can be difficult.
(108=75x1.0755). Finally, the comprehensive income tax has
difficulty with inflation, because it taxes nominal
Which benchmark? returns. If in the example real returns were 2.5 per
cent and inflation 7.5 per cent, then post-tax
The expenditure tax is the most appropriate returns would be 7.5 per cent nominal and zero
benchmark for taxing pensions. The real. At higher inflation rates, real returns would
comprehensive income tax treats savings as if they be negative.
are like any other good or service. But savings are
a means to future consumption, and this is The comprehensive income tax, however, raises
particularly obvious when earnings are deferred to more revenue due to its broader base (a total of 31
provide retirement income. The expenditure tax is discounted, compared with 25 for the expenditure
neutral between consuming now and consuming in tax). So the tax rate can be lower.
the future. The expenditure tax is also easier to
Pensions taxation in practice 2
better than expenditure tax betweenexpenditureand worse than compre-
expenditure tax comprehensiveincometax hensive income tax
Australia Argentina Netherlands Denmark Belgium
Austria Canada Poland Finland Iceland
Czech Republic Chile Spain France Japan
Hungary Colombia Switzerland Norway New Zealand
Ireland Costa Rica United States Sweden
Korea Germany Uruguay
Portugal Luxembourg
United Kingdom
Pensions taxation in practice special, lower rates. Only a quarter of annuity
payments is taxed in Austria. In Hungary (see
Expenditure tax treatment is the most common in box), contributions attract a tax credit, and in the
practice, covering nearly half the countries shown Czech Republic, contributions are matched by the
in Figure 2. government. up to a limit.
Some countries (the right of Figure 2) are close to
or less generous than the comprehensive income Cost of pensions tax incentives
tax. New Zealand is TTE. Belgium taxes the asset Fourteen OECD countries now produce `tax
value of the fund each year. Iceland and Japan expenditure accounts' showing revenues foregone
have a TET system (although Japan allows tax-free from tax concessions relative to a benchmark. In
lump-sums to a limit). Finland's regime is EET, Australia, Canada, Spain, the United Kingdom and
but only 60 per cent of contributions are the United States, actual pensions taxation is
deductible. Denmark and Sweden are ETT. compared with the comprehensive income tax
Others are more generous than the expenditure (TTE), assuming behaviour would not change if
tax. In Ireland, Portugal and the United Kingdom, tax incentives changed. But Germany uses a
annuity payments are taxed, but a tax-free lump benchmark closer to the actual system, so the cost
sum can be taken. Australia has a complicated of pension reliefs appears much smaller.
system. Contributions are only partly exempt.
Investment earnings and benefits are taxed at a
3 Taxation
Australia, Canada, the UK and the US report that Taxing pensions in Hungary
pensions concessions cost over 3 per cent of total
tax revenues. In Canada and the UK, they are the The table runs through the tax treatment of
largest tax expenditure; in the US, the second pensions in Hungary in the same way as the
largest after health insurance. However, these theoretical framework of Figure 1. It looks at
figures are misleading. If the expenditure tax is two taxpayers, one paying the lowest rate of
appropriate, then the cost should be measured 20 per cent and the other, the highest rate of
against that benchmark rather than a 48 per cent. The 50 per cent credit means
comprehensive income tax. Revenues foregone the fund gets more than 100 even for a
measured in this way would be around �1bn in the higher-rate taxpayer. After five years of 10
UK and zero in Canada and the US. per cent returns, the final fund is over 200
for the lower-rate taxpayer, much more than
Cost of pensions tax incentives 3 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
Australia 92-93 $5.3bn cent. If we also take account of reduced
Belgium 89 BFr 8.9bn
Canada 89 social-security contributions the effect is still
Finland 91 C$10.9bn
FMk 3.1bn more pronounced.
Germany 91 DM 17.bn
20% tax 48% tax
Ireland 90 IR�275m
Portugal 92 Esc 2.8bn Earnings 100 100
Spain 93 Pta 16bn Tax -20 -48
Sweden 92 Skr 9.7bn Tax credit 50 50
UK 96-97 �10.2bn Fund 130 102
US 91 $57bn
Returns 79 62
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
per cent of total taxes Final fund 209 164
Return (%) 21.2 25.9
How generous a tax treatment?
There are three arguments for taxing pensions
more generously than other kinds of saving The second argument is `moral hazard': if the state
?? to ensure people have a standard of living in ensures an adequate income anyway, there is no
retirement close to when they were working reason for people to provide for themselves.
?? to cut the cost of social-security benefits for Again, the tax system is not the best way of
pensioners avoiding the fiscal impact of moral hazard. Also,
?? to increase long-term savings the tax incentive cuts revenues.
The first argument is paternalism. Without an
incentive, people will be myopic and fail to make Increasing savings, the final factor, has been the
sufficient provision. This might well be true, but subject of a major academic dispute. Whether the
the tax system is not the way to put it right. Even `success' of new kinds of pensions--registered
with the incentive, people may not save enough. It retirement savings plans, RRSPs in Canada,
is hard to define what is a `sufficient' retirement personal pensions in the United Kingdom and
income, beyond a reasonable minimum. The best individual retirement accounts, IRAs in the United
way of being paternalist is mandating minimum States--is a result of substituting these new plans
retirement savings, either through state provision for other kinds of savings is difficult to ascertain.
(the `first pillar') or compulsory contributions to And the budgetary cost of incentives can mean
private funds (the `second pillar'). 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 Further reading
generally affect the level of saving'. With no clear
answer, increasing savings should not be an Whitehouse, E.R. (1998), `Tax treatment of funded
objective for pensions tax policy. pensions', Social Protection Discussion Paper
no. 9812, World Bank.
Which kind of expenditure tax? Dilnot, A.W. (1992), `Taxation of private pensions:
costs and consequences', in OECD, Private
We have argued that the expenditure tax is the Pensions and Public Policy.
most desirable tax treatment for savings. The final
policy choice is between the classical expenditure On the taxation of savings generally:
tax (EET) and the pre-paid expenditure tax (TEE).
The latter has many attractions. First, it brings OECD (1994), Taxation and Household Saving.
immediate revenues, which are deferred until Boadway, R and Wilasdin, D. (1994), `Taxation
retirement under the classical tax. This alleviates and saving: a survey', Fiscal Studies, vol. 15, no.
the transition deficit when moving from a pay-as- 3, pp. 19-63.
you-go to a funded pension system.. Such a Robson, M.H. (1996), `Taxation and household
scheme was proposed by the outgoing saving: reflections on the OECD report', Fiscal
Conservative government in the United Kingdom Studies, vol. 16, no. 1, pp. 38-57.
in 1997 and has been adopted in Croatia.
Secondly, it limits tax avoidance and evasion On measuring the cost of tax concessions:
because the government collects the money up- OECD (1995), Tax Expenditures: Recent Experiences.
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