February 1, 1998

The tax treatment of pension savings in discussion

Pension saving is tax favored for two reasons. First, the return on pension saving is not subject to income tax. Second, the tax rate at which pension premiums can be deducted typically exceeds the tax rate at which pension benefits are taxed.

This paper explores the implications of alternative ways to eliminate the tax-favored status of pension saving for pension rights to be accumulated after the year 2000. One way to abolish the tax subsidy is to tax pension saving in the same way as other (non-pension) private saving. This would imply that individuals would no longer be allowed to deduct pension premiums from their taxable income. Moreover, the return on pension saving would be subject to income tax. Finally, pension benefits would no longer be subject to tax. This reform would not only eliminate the tax subsidy to pension saving but would also imply that households would pay taxes at an earlier stage in their life cycle.

The paper investigates how the government should recycle the additional revenues from the elimination of the tax subsidy so as to compensate the private sector at each point in time for the lower subsidies to pension saving. It turns out that the government can reduce taxes by about 3% of wages (i.e. about f 12 billion in 2000). This implies that during the first three decades of the next century part of the additional revenues from the elimination of the tax subsidy are used to reduce public debt. The associated lower interest payments on public debt would finance part of public spending in the middle of the next century when older people account for a large part of the population. At that time, the reform would narrow the tax base because pension benefits would no longer be taxed.

Contacts

Paul Besseling Read more
Lans Bovenberg Read more