Private Pension Savings and the Taxability of High Income Earners

1. Private Pension Savings and the Taxability of High Income Earners Christopher Heady School of Economics University of Kent International Conference on Taxation Analysis and Research London, 1st – 2nd December 2011

2. Introduction • The share of top income recipients in gross incomes has increased strongly. • Should governments respond by increasing top rates of personal income tax? • Problem of incentive effects, represented by the elasticity of taxable income. • This elasticity is affected by tax planning, including use of tax-preferred pensions. • How important is this effect?

3. Top income shares: the big picture

4. How should tax policy respond? • Optimal tax theory says that tax rates should be higher with more inequality • But we might not have started at the optimum • Need to worry about incentive effects, as summarised by the elasticity of taxable income, capturing: • Incentives to earn more money • Incentives to avoid and evade taxes

5. Increase top income tax rates? • Raising these taxes is clearly redistributive • But the marginal tax elasticities of taxable income suggest that raising the rates will have limited revenue-raising effect. • However, this may be over-stated: • The estimates do not take account of increases in other tax bases or in the future • Elasticity can be reduced by limiting opportunities for tax planning and evasion

6. Private pensions as an example of tax avoidance • The use of tax-preferred savings reduces tax liabilities during working life but increases them during retirement. • This is a pattern that is common to many other tax avoidance strategies (e.g. keeping income in corporations) • The elasticity of taxable income only captures the reduction in taxes. • How important are these effects?

7. Modelling private pension behaviour • Need to model choice between pension and non-pension savings • Empirically important • To have more than inter-temporal substitution • This requires pensions to have a disadvantage, to set against tax gains: • Lock-in of savings, so the funds cannot be used to meet short-term contingencies • Modelled by a random adverse shock

8. A very simple model • Taxpayer lives for two periods: • Work and retirement • Taxpayer has fixed income in period 1 but chooses pension and non-pension savings • Sequence of events: • Taxpayer chooses pension savings • Random shock is either realised or not • Taxpayer chooses non-pension savings • Choices result in consumption in periods 1 and 2

9. Some more very simple detail • There is no return on savings and no pure time preference • Utility is sum of expected value of concave functions of consumption in each period • The shock is a fixed amount, ε, which occurs with probability (1-π) • There are no bequests • Tax is levied on earnings minus pension savings, and (at a lower rate) on pension income

10. Analytical results • If the shock does not occur, consumption is the same in each period because marginal savings are not tax-preferred • If the shock does occur, consumption is different in the two periods because: • Marginal savings are tax-preferred (there is no non-pension savings in this case) • It is not rational to save enough to fully compensate for the (uncertain) adverse shock

11. Numerical examples • The analytical results do not show how important these effects are • Parameter values: • Income in period 1 = 150 • Shock (ε) = 50 • Top marginal tax rate, t1 = 40% or 50% • Income at which top marginal rate starts = 90 • Tax paid on income below top tax bracket = 30 • Flat rate tax on pension income = 20% • Utility function is constant elasticity of marginal utility, α = 1 or 2

12. Pension savings results • Pension savings increase with tax rate • This could account for a large part of observed difference between elasticities of broad and taxable income • Effect is larger for smaller αbecause of implied larger elasticity of substitution

13. Tax revenue results • Tax revenues increase with tax rate in both periods although rate only increased in period 1 • Increase relatively more in period 2 with higher elasticity of substitution (low α)

14. Implications for optimal rates • Based on US data, the revenue-maximising top marginal tax rate is: • 53.4% using standard (Gruber and Saez, 2002) estimate of elasticity of taxable income • Adjusting elasticity to account for extra tax revenue during retirement (assuming α = 1) increases rate to 55.2% • Preventing additional tax-preferred pension contributions of top tax rate payers increases rate to 66.0%

15. Conclusions • Tax-preferred pensions can be a major form of tax avoidance • Effects on optimal tax rates of recognising future revenue increase is small. • But effect of limiting tax–preferred pension contributions could be substantial • Need for more detailed modelling • More time periods could increase tax avoidance • But, closing down one method of tax avoidance might increase others