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Pensions Reform and the Commission on Taxation Back  
Brian Daly urges the Commission on Taxation to reverse the trend of tax policy discrimination against the private sector when it considers how best the tax system can encourage long term savings to meet the needs of retirement.
The Minister for Finance announced the Terms of Reference and the composition of the new Commission on Taxation in February. It is welcome that one of the Commission’s priorities is to “consider how best the tax system can encourage long term savings to meet the needs of retirement”.

It is estimated that by 2050 there will be two working people to every pensioner in the EU compared to a current ratio of four to one. The aging population and declining culture of saving will put real pressure on State pension provision in the years ahead.
Incentivisation of private sector pension provision will therefore be key. As we have previously pointed out in Tax Monitor, there is plenty of room for improvement in relation to tax policy in this area.

The pensions tax myth
It is often asserted that there are very significant tax “breaks” associated with pensions provision in the private sector. Indeed, it was primarily the conclusion that these “breaks” had been abused in the past which lead to significant private sector pensions taxation changes in 2006.

All of this is unfortunate.The perception that the level of State support for pension saving is too high needs to be very strongly challenged. When referring to State support, people cite the level of tax relief for pension contributions by individuals and their employers as tax costs. Very little focus is put on the fact that when the pensions are paid out on retirement they are fully taxable.

It is totally inappropriate to suggest that employers’ tax savings for contributions to a pension scheme on behalf of their employees should be classified as State support for pension savings. Employers would be automatically entitled to tax relief if they chose instead to pay additional salary with no incentive for the employees to save it for their retirement. Pension contributions are as legitimate as any other employment expense and as such a tax deduction should be available under first principles and should not be regarded as a relief. The alternative is akin to counting companies’ tax deductions for salaries as the State’s cost of incentivising people to be employed!

It is possible to attempt to measure the extent to which the State subsidises individuals’ contributions to pension schemes over other investments via tax relief. When trying to estimate the net present value of the tax foregone by the State, several variables come into play. For example, the tax rate at which the saving is obtained, the tax rate at which the pension is ultimately taxed, the investment return over the period and the discount rate used.

However, when conservative assumptions are used in relation to fund growth and pensioner age, investment of pre-tax income, in a pension fund yields only somewhere in the region of 12-14% less tax to the Exchequer, in present value terms, than an equivalent after-tax investment in a gross roll-up fund, even when the pension tax free lump sum is taken into consideration.
Given the urgent need to ensure that we have an appropriate level of pension saving by the private sector, the current level of “subsidisation” of pension saving does not seem inappropriate. Indeed, I would argue it should even be higher.

Counter-productive measures
Pensions Cap
Measures were passed in 2006 to stop wealthy individuals from claiming tax relief on vast pension funds. As a result, the government is now penalising people who make good investment decisions leading to high performance of funds.

These measures impose a penalty tax on pension funds in excess of an amount based on an indexed value of €5million since 2006 (with higher cap exceptions for individuals whose funds were worth more than €5million in December 2005).

Where the provisions apply, the effective tax rate on the excess funds can be as high as 67% which is totally penal and disproportionate given the maximum rate at which tax relief will have been claimed upon contribution will be 41%. Given the limitations on the amount which self-employed individuals can contribute to pension funds with tax relief at the outset, it usually takes good investment management to get the value of funds over this €5million cap. A system which penalises astute investment is doing little to promote private pension provision which will accumulate wealth to be spent in retirement, sustaining economic activity and thus generating vital taxes to support public services and indeed, public pension provision.

In any case it is impossible for individuals or pension funds to ensure the cap is not breached unless they deliberately pledge to forego investment returns about a certain level, based on a guestimate of future indexation factors.

If a restriction is felt necessary it should only be made by reference to contributions, for example by limiting contributions to amounts which, actuarially, would put a medium performing scheme at the adjusted €5m limit. Such schemes could then take market risk and investment decisions without fearing penalties if they get it right.

ARFs distributions
Penal provisions in relation Approved Retirement Funds (“ARFs”) kicked in last year. ARF holders aged 60 and over were deemed to have drawn down 1% of the value of assets held in their ARF at 31 December 2007 and will be deemed to draw down a further 2% in the year ended 31 December 2008 and 3% in each subsequent year. The rules can apply even while the fund owner is still earning an income and getting tax relief on contributions to another pension scheme!

ARF holders are being forced to either drawdown part of their ARF fund or suffer tax twice, when they are deemed to draw down and again when they actually draw down the funds.

With current market conditions, in many cases losses will have been suffered and sensible investors would not normally choose to crystallise such losses. This is therefore another case of imposing double taxation on logical investment decisions.

The fact that these rules apply at age 60 when many people are economically active runs completely contrary to the economic necessity of extending worklife rather than reducing it.

Direction Needed
The reality for a Western economy like Ireland with a well established welfare state, is that people will continue to expect the State to provide retirement pension benefits to those who either don’t have the means or the motivation to adequately provide for themselves.

This is on top of the State’s obligation to provide generous pensions to public sector employees, linked to the current rate of pay for the job they were doing and not subject to the risk of market turmoil. It is worth noting that the pensions cap and adjustment factors are likely to exclude the majority of public servants. While there is nothing wrong with using pensions policy to incentivise good quality employees to join the public sector, the trend in recent years to disincentivise the private sector and penalise good pension investment decisions is both unfair to the private sector and shortsighted from a State point of view.

It is also sometimes asserted that tax reliefs should be structured so that incentives are shifted from the better off to those on lower incomes. This can lead to a conclusion that higher earners should have tax relief for their contributions tapered. This would certainly not be equitable if these taxpayers end up ultimately paying higher rate tax on pension payout. In addition, any move to reduce marginal tax relief to higher earners would unfairly increase the discrimination between the public and private sectors unless compensatory adjustments were made for higher rate taxpayers in the public sector.

The primary motivation of tax policy should therefore be to encourage as many people as possible in the private sector to fully provide for a comfortable retirement. In addition no worker should be penalised in their attempts to make such provision by their capability for making good investment decisions.

The positive results would be two-fold - a potentially decreased reliance on State pensions and a retired generation with more money to spend, generating more taxes to fund State pensions and other public services. Growth in the pension funds industry with its associated employment and corporate tax revenues would be a welcome side-effect.

The Commission’s Task?
The Commission will need to critically evaluate pensions and investments tax systems in other countries taking into account
how policy in other areas and other economic factors impact the position.

For example, like some countries, Ireland relies somewhat on the culture of home ownership for the funding of pensions, a culture fostered to some extent through tax policy (e.g., mortgage interest relief, principal private residence relief from capital gains tax etc). Current unprecedented levels of indebtedness may result in the necessity for many to fund mortgage obligations well into retirement, necessitating higher annual pension streams.

Such factors will need to be taken into account when comparing tax policy. One pension system worth examining is the Australian one. It has seen a huge increase in privately held pension coverage following a radical overhaul of its system in the 1990’s. Australia’s current regime provides for a low, though not zero rate tax environment for funds invested in pensions, limits fund size by reference to contributions only and does not tax pension payouts. It would seem to result in a greater overall level of State subsidy and certainly requires evaluation.

Other areas needing review include how to improve access to PRSAs, ARFs and other alternatives perhaps having recourse to the more flexible Self-Invested Personal Pensions (SIPPs) introduced in the UK.

Moves over the last few years have unfortunately been to restrict rather than enhance support from the State to encourage people in the private sector to save for retirement. Ireland is one of the leading examples of the positive effects tax incentives can have on stimulating positive and productive direction of private sector resources. The country will face a major challenge if its citizens have not saved sufficiently for their retirement. Anything the Commission can do to reverse the recent trend vis-?-vis the treatment by the State of private sector pensions would do us all a significant service in the long term.

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