Pension Policy: New Evidence on Key Issues

Abstract

We explore the direct impact of changes in the tax treatment of pensions using the SWITCH tax-benefit model. The model simulates the tax liabilities and benefit entitlements of a nationally representative sample of households -the data are drawn from the CSO's Survey on Income and Living Conditions (EU SILC) for 2005. A weighting scheme is used to adjust the data to represent the demographic situation in 2030 and 2050. All of the model results are based on the technical assumption of no change in behaviour. The fact that social welfare entitlements are incorporated in the model means that it is possible to analyse the direct impact of restrictions on income tax relief, coupled with an increase in social welfare pensions. These results could equally be interpreted in terms of changes in taxes helping to sustain existing levels of payment. Before analysing potential policy changes, we examine the potential impact of trends towards increasing coverage in occupational and private pensions, and in qualification rates for the contributory State Pension. Occupational/private pension coverage among current pensioners is about 30 per cent, but stands at about 60 per cent for the over 30s. This difference reflects the fact that the rate of pension coverage has been rising over time. If this higher rate of coverage is sustained then future pensioner populations will be more likely to have an entitlement to a private or occupational pension than the current cohort of pensioners. What implications would this have for the "at risk of poverty" measure for future pensioners? We estimate that this factor could reduce the "at risk of poverty" measure by about one-third -both in terms of the familiar head count ratio, but also in terms of broader measures taking account of the depth of poverty. In a similar fashion, we analyse the impact of increased rates of qualification for the contributory State Pension. This factor could lead to a reduction in the head count of poverty of about one-fifth, and would also help to reduce the depth of poverty. Debate about the appropriate tax base has, in the past, often been characterised as a contest between an income base and an expenditure base. More recent reviews of this area conclude that the optimal tax system contains some form of taxation of capital income, and a more productive question is how to tax capital income, given that earnings are subject to tax. Perhaps the strongest rationale for the pension-related deduction is that it serves as a mechanism for reducing net public sector spending, while avoiding the political economy difficulties of reducing wage rates explicitly. However, there are serious disadvantages associated with achieving the cost reduction in this fashion, which involves concentrating the burden of adjustment on those currently in employment, while they are in employment. An explicit wage rate reduction would also reduce the incomes of current and future pensioners. The pension-related deduction does not do this. In this way, it increases the replacement rates for public sector workers facing retirement decisions -tending to reduce labour supply, in a similar way to an income tax increase. Moreover, the progressive structure of the levy may damage labour market efficiency in the public sector. Broader tax/welfare measures to achieve distributional and anti-poverty goals may be more appropriate. Our review of the international scene is necessarily selective -our aim is to highlight findings of particular relevance to the scope of this study. We begin, in Section 2.2, by looking at the UK Pensions Commission's appraisal of the UK system and options for its reform (UK Pensions 2005). Section 2.3 then reviews some key papers on the nature and strength of the responses to financial incentives for retirement savings in the UK and in the US, where extensive research on these issues has been conducted. Of course, many factors other than financial incentives influence retirement savings decisions. There has been a growing literature on how behavioural factors influence retirement savings, and how changes in the way savings and pension plans are structured can influence the degree to which they are taken up by different groups. Such studies are reviewed in Section 2.4. The main implications for Ireland are drawn together in the final section. In this chapter we examine how the trade-offs facing policy are influenced by: 4.1