Taxation of Saving for Retirement: Current Rules and Alternative Reform Approaches

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Forthcoming in Australian Business Tax Reform in Retrospect and Prospect, edited by Chris Evans and Richard Krever, published in 2009 by Thomson Reuters, Sydney. Reprinted by permission.

Abstract

Most advanced countries exempt returns to retirement saving from income tax, but private saving rates are falling and many people are saving too little for retirement. There is a trade-off between the goals of promoting wide participation in retirement saving plans and allowing more choice to employees. In the United States, purely employer funded plans have been replaced by plans that rely more on voluntary employee contributions, while private saving has declined. Two approaches that may promote more retirement saving are refundable tax credits for low-income workers and rules that encourage or require automatic enrollment in retirement saving plans.

Introduction

Saving rates in most advanced economies have been declining for the past quarter-century. Low saving rates reduce economic growth and make economies more dependent on capital imports to maintain investment. Resulting capital market imbalances may have contributed to the current worldwide economic crisis. With ageing populations, policymakers also worry if people are saving enough for retirement.

Public finance scholars and policymakers have long debated the relative merits of taxing income or consumption. While income taxation continues to be a major revenue source, most countries allow consumption tax treatment for most saving for retirement. With only a few exceptions, efforts in the 1980s to reform income taxes by broadening the tax base and lowering tax rates left preferences for retirement saving in place.

The mantra of tax reformers remains the same-lower tax rates and a broader tax base (whether income or consumption) to improve fairness, efficiency, and simplicity. But the laudable goals of tax reform run afoul of practices in many countries to use the tax system actively to promote social and economic goals. The widespread use of "tax expenditures" has been documented in a number of studies. In recognition of the fact that the tax system will continue to be used to promote social goals, some authors have addressed the issue of when it is best to use the tax system or spending to advance policy goals, while others have argued that social goals could be achieved more efficiently by converting tax expenditures to refundable credits. Concerning taxation of saving, the terms of the debate have shifted from how to make the tax system neutral to how to use the tax system most effectively to raise saving.

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