AUG 2009 Incentivising Retirement Saving – A Waste of Money?

Context Social security and retirement funding review by government Re-evaluation of equity of tax incentives ‘Gap’ solution needed for those for whom tax relief means little Competing national budget priorities

Context Courteousy Old Mutual

Retirement Saving: Typical Policy Levers 1. Increasing income 2. Improved returns (credits, contribution matching & tax incentives) 3. Financial education (informing rationality) 4. Financial regulation (essential for long-term time horizons) 5. Mechanical inducement to counter inertia, procrastination & myopia (auto-enrolment, compulsion, limits on liquidity & preservation)

‘Improved Returns’ via the Tax System 1. Tax allowance (fixed percentage from taxable income) 2. Tax deduction (deducted in proportion to income level) 3. Tax credit (fixed amount deducted from tax liability) 4. Tax exemption (part or source is exempted from tax) 5. Preferential tax rate (preferring certain income or sources)

Distributional Effects of Relief Mechanisms Antolin and Ponton (2007)

Relief Mechanisms for Retirement Saving TEE / ETE / EET General international practice 1. Most countries provide tax relief for mandated systems 2. In unfunded systems, contributions normally exempt, while benefits are fully taxed 3. For funded systems, same as (2) and the interest earned is not normally taxed (EET) 4. For retirement income: consumption-like tax is applied (exempts at accumulation stage, but taxes when drawn down at decummulation) Holtzmann and Hinz (2005)

Design in Retirement Systems Yoo & de Serres (2004)

Estimated Tax Cost for SA DeductionR 27.0 bn Fund income at 18% (no CGT)R 4.5 bn Lump-sum formula ? Total (at least)R 31.5 bn R31.5 bn = 1.9% of GDP vs 1.7% in Ireland & UK EU Social Protection Committee (2008) Tax Statistics: NT, SARS (2008)

Literature: Effect of Subsidies on Saving Ambiguous in theory. Difficult to estimate response – people might simply spend more in the present rather than save more. (Neuberger and McCarthy:2004) Literature divided on empirical results, but on balance favours positive response, especially with lower income cohorts. Besley & Meghir (1998) call it at best a marketing opportunity for governments and Antolin et el (2004) estimate range of new saving in contributions of between 25% to 40%. For funded retirement saving, offset against household saving quite high, greater redistributive component, less offset (Disney,2005).

Effectiveness of Incentives re New Saving Blundell, Emmerson & Wakefield (2006)

Funded Retirement Sav on Household Saving

A Few Further Pointers from the Literature Consumer as rational optimiser: 50% of working adults say they have ‘no idea’ of their likely retirement income; those with 15yrs to retirement, 50% say they do not know if they have sufficient to retire on (Mayhew:2003) Optimisation requires complex calcs, past experience limited (only retire once) and info from others limited. People are myopic and use ‘rules of thumb’ (Thaler: 1994) People tend to choose a lifetime savings pattern separately from distribution. Rise in pension or housing wealth offsets other saving, especially when close substitutes (Hawksworth: 2006) - e.g. provident funds vs annuitisation

Conclusions on Incentives ?

Political Economy 1. Low-income groups like large, highly distributive systems 2. Middle income groups favour earnings related systems 3. High-income earners prefer no system at all – have access to private systems 4. Acknowledgement at least of some form of altruism leads to solidarity between these groups 5. The tax system plays a vital role in re-distribution and cannot be viewed in isolation Conde-Ruiz and Profeta (2002)

Net Replacement Rates (Mandatory Schemes) Percentage Change between Gross and Net Replacement, Mandatory Schemes Calculated using Whitehouse (2007), World Bank

Regressive Bias in Incentives Regressive Nature of Tax Incentives (individual earnings, multiple of average) Calculated using Whitehouse (2007), World Bank

Introduction to CGE Modelling Based on previous modelling done by Go, Kearney, Korman, Robinson and Thierfelder (2008). Utilise a Computable General Equilibrium (CGE) model. Extended the modelling to include the informal sector as a recipient of the wage subsidy. Modelled a 5,10 and 15 percent wage subsidy to medium and low skilled workers in the formal and informal sector. Modelling is performed against different assumptions of labour market flexibility; medium and low market flexibility is investigated. Assume that the informal labour category is unemployed. The demand for more workers will therefore lead to an increase in employment, while real wages will remain constant.

Background to the CGE Model Used Follows modelling tradition set by Dervis and De Melo (1982). Solved using GAMS software program. Set of equations solved simultaneously. Imposes a structure of behaviour based on microeconomic theory. Neoclassical assumptions: Optimising behaviour Non-linear first order conditions Maximise profits and utility Demand equals supply in goods and factor market. Imposes a relationship between prices and taxes. Most important data source is a Social Accounting Matrix (SAM). For this analysis a 2005 SAM is used as compiled by Quantec. Labour is highly disaggregated in this SAM for the purpose of this analysis (9 labour categories).

21 Schematic View of the Model Activities Factor Costs Wages & Rents Intermediate Input Cost Sales Private Consumption Taxes Domestic Private Savings Government Consumption Gov. Savings Investment Demand ImportsExports Foreign Savings Transfers Foreign Transfers Commodity Markets Factor Markets HouseholdsGovernmentSav / Inv Rest of the World L Löfgren, et al (2001)

Results - Summary Medium elasticity case shown. Size of wage subsidy in 10% case is approximately 1,5 percent of GDP or R24,3 billion in 2005 terms. As a result of the additional economic activity generated the net cost is R14,3 billion. When the subsidy is extended to the informal sector the cost increases by R3,1 billion, and the net cost to R16,3 billion. The cost per job created falls to R as more jobs per rand spend is created when the subsidy is extended to the informal sector.

Results – Employment and GDP

Results - Employment Agriculture sees largest percentage gains in employment, however overall share in total employment relative low. Largest employment gains is in services sector.

Results – Equivalent Variation Gives an approximation of the welfare impact of the wage subsidy. Wage subsidy extended to the informal sector increases welfare in general; but also benefits the poor more relative to the high income groups.

Results – Low Elasticity Case Low elasticity case shown. Employment gains are much lower; 3.21% of 10% wage subsidy when extended to informal sector compared to 6.28% for medium elasticity case. Cost per job created is therefore significantly higher. How flexible is South Africa’s labour market?

Conclusions The cost per job created of a wage subsidy is high, but can be lowered if extended to the informal sector. The cost per job created is high because all the workers receive the wage subsidy and not only the new entrants. It is lower when extended to the informal sector because the average wage in the informal sector is lower. The labour market flexibility assumed has a significant impact on the results. Under a low market flexibility assumption, the employment gains under a wage subsidy are much lower. How flexible is SA’s labour market? Literature indicates that SA’s labour market flexibility is relatively low. The wage subsidy should therefore, ideally, be accompanied by policies to improve labour market flexibility in South Africa for it to be effective. The paper did not consider alternative designs for the wage subsidy.

Tax Wedge as % of GDP SA % GDP Taxes on individuals7.9 Skills Development Levy0.3 UIF0.1 Wage subsidy (gross)1.9 Total10.2

Individual’s Tax Disaggregation

Practical Policy A social security tax of 5% applied to earnings of R and more is estimated to yield about R16.5 bn, leaving a considerable shortfall This would need to be sacrificed elsewhere or be deficit financed Hardly the time to raise taxes on employers or individuals We need an alternative that does not have the potential dead- weight loss for the economy, yet is effective ‘at the margin’

An Alternative: State Sponsored Co-contribution Papke (1995) cited by Neuberger and McCarthy (2004)

An Alternative: State Sponsored Co-contribution Papke (1995) cited by Neuberger and McCarthy (2004) FindingAuthor Existence positively correlated with participation, level has little effect Poterba, Venti & Wise (1992) Corroborate above findingPapke, Petersen & Poterba (1993) Participation & contributions insensitive to match rate over time Kusko, Poterba & Wilcox (1993) Existence of match, not quantum that mattersScott (1994) Concur with above findingPapke (1995), Even & Macpherson (1996), Basset et el (1998), Kusko et el (1998) Increases in match rate raise savingClark and Schieber (1998), VanDerhei and Copeland (2001), Choi, Laibson et el (2002)

An Example: Direct Subsidy for Low Income Voluntary coverage rate by deciles of income EU Social Protection Committee: 2008 German Riester Pensions pay a basic subsidy of €154 per adult, and an additional child subsidy of €185.

Another Example: New Zealand In 2005 NZ announced auto-enrolled KiwiSaver, with eight weeks for opt out. Tax incentives were added on 1 July 2007 after 20 yrs of neutrality: New member sign-on incentive of $1000 tax free; Matching contribution of up to $20 per week ($1043 per year); Subsidy for the purchase of first home of up to $5000; Fee subsidy of $40 per year; Wage subsidy for employers (offset to compulsory employer contributions) of up to $20 per week; Employer contributions set to rise from 1% of gross pay to 4% by 2011; Investment income receives favourable tax treatment Nationwide survey showed auto-enrollees had made a relatively small contribution by Dec 2007 (33%, 32% opt-out) Incentives made the difference – ‘new saving’ range between 9-19 cents per dollar (Gibson and Le: 2008)

Conclusions On tax incentives: Adage: “an old (and well-understood) tax is a good tax” probably implies to existing retirement incentives too; 30 yr review of literature for Mirrlees Review: incentives do matter, but results differ based on education and demographics (Meghir and Phillips: 2008) People use ‘capping’ or ‘limits’ as guides to sufficiency optimisers (Thaler: 1994) and could interpret tax limits as guides to income replacement in retirement; Combine existing EET with direct incentives for low income individuals and employers to overcome initial inertia (sign-up incentive) with co- contribution of ratio which can be gradually phased in (test elasticity); Achieve ‘solidarity’ through tax mechanism (social security tax) rather than in the fund, which can increase labour force resistance, distort actuarial neutrality and ‘line of sight’ for member; Use mixture of compulsory annuitisation and commutation to reduce substitutability of retirement saving for discretionary saving Don’t forget the other policy levers (income growth, mechanical inducement, regulation, education)

Conclusion “…although common sense has been described as ‘that most blunt of intellectual instruments’, it remains the most useful tool in deciding the issue.” Leach AJA, 2009, WJ Fourie Beleggings CC v Commissioner for SARS, Supreme Court of Appeal. THANK YOU