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News : Irish Last Updated: Nov 27, 2009 - 7:28:20 AM

ESRI supports single rate of tax relief on Irish pension contributions; Estimates savings in range €500 million to €1 billion
By Finfacts Team
Nov 26, 2009 - 6:13:52 AM

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The Economic and Social Research Institute (ESRI) says that a single rate of tax relief on Irish pension contributions would save public money and would be fairer. A report published by the institute on Wednesday, estimates that between €500 million and €1 billion could be saved by changing the system of pensions tax relief.

ESRI researchers Tim Callan, Claire Keane and John Walsh say that tax relief at a standardised rate could help to achieve the overall objectives of public pension policy in a more efficient and equitable way. Currently, over €8 out of every €10 of tax relief goes to taxpayers in the top one-fifth of the income distribution. This is because high income earners are more likely to participate in pension schemes, more likely to make higher contributions, and the value of tax relief at the top rate of income tax is about double that for the standard rate taxpayer. There is a strong incentive for high earners to contribute to pension schemes, but a weaker incentive for those with low and middle incomes.

The report says evidence from the UK and the US suggests that much of the saving by high income households would take place even without the incentive (what economists call “deadweight loss”). There is also growing evidence that decisions on pensions can be strongly influenced by non-economic factors, at lower cash cost to the Exchequer. For example, pension schemes in which the default option is to enrol in the scheme, but with an option for individuals to withdraw (sometimes called “soft mandatory”), and a system of partial matching of contributions at a single rate, rather than tax relief, have been found to be effective in other countries.

The researchers looked at whether the single rate of tax relief be the standard rate or some hybrid rate between the standard and top rates of tax? Both options were examined in the ESRI report, which found:

  • Standardisation of relief on all pension contributions (employee, employer and implicit government contributions) could raise revenue of over €1 billion per annum. This would imply a reduction in income tax relief for top rate taxpayers, but no change for those paying the standard rate. Revenue raised could be applied to sustaining State pension levels as demographic pressures on the financing of public pensions intensify

  • An increase in the relief from the standardised level to allow relief at a hybrid, 30% rate - - an option similar to that recommended by the Commission on Taxation and included in the Programme for Government - - would involve gains for standard rate taxpayers and losses for top rate taxpayers, and a gain to the Exchequer in the region of €500 million per year.

The Minister for Social and Family Affairs Mary Hanafin said: "The recent commitment in the new Agreed Programme for Government to introduce a 33% rate of tax relief for all those who contribute to pension schemes is aimed at delivering such equity. I am very pleased that the ESRI research shows that such an approach favours those on lower and middle incomes, who are a core group that we wish to see providing for their own retirement.”

However, UCD economist Moore McDowell has criticised the proposal to introduce a single rate of tax relief for pensions and radically reduce the tax-free lump sum which is the only real encouragement to pension saving in the current system.

McDowell produced a paper on the issue for Irish Life - - the country’s largest pensions company.

There are increasing signs that the Government is moving to the introduction of a single rate of tax relief of 30% on pension contributions and to further limit the tax-free lump sum which is currently available on retirement.

McDowell’s arguments include:

  • Contrary to common belief, the current tax reliefs encourage middle income earners to save for their pension much more than higher income earners

  • Proposed reforms will run counter to EU policy on tax relief for pensions

  • Critics of current system using a flawed argument

  • Changes will discourage saving for pensions

McDowell defends the current system and argues that criticisms of it stem from a fundamental misunderstanding of the way in which the tax treatment of pensions works in practice; “A myth has grown which suggests that tax reliefs on pensions are net benefits to the taxpayer. They conveniently ignore the fact that pension funds are taxed at the point of drawdown not at the point of contribution but the net effect for the exchequer and for the tax payer are broadly neutral under the current system. However under the reforms proposed, middle income earners will be disadvantaged by paying the marginal rate of tax on drawdown but enjoying less relief at the point of contribution.”

McDowell points out that contrary to popular belief, the main beneficiaries in most cases [ie: where the use of pensions is not simply a tax avoidance device by the very wealthy] from the present structure are not the very rich but those with middle incomes [€45,000 - €75,000].

The proposed change to a flat 30% rate of relief would in effect mean charging 11% income tax on contributions in the case of contributors paying the higher rate of tax [who will then be taxed at the higher rate when taking their pension out] while reducing the tax bill of those on the lower rate by 150% of their contributions. McDowell argues that such a change will mean that anyone earning over €35,000 will face a reduced incentive to make pension contributions;

McDowell also warns that the proposed move to a single rate of tax relief on pension contributions [of 30%] will ensure Ireland’s pension is less attractive than that which applies in most of the EU15 countries and which has been explicitly endorsed by the EU Commission as the correct approach to taxing pensions.

McDowell warns that the move to a single rate of tax relief on pensions [30%] will result in a tax structure which discourages saving for pensions and which will ultimately work against the stated policy goals of the State to increase the level of provision people make for themselves.

Finally McDowell cautioned the Government against using the present budget crisis to introduce a “reform” that is simply a device to improve the Exchequer’s cash flow position rather than to address the problem of inadequate pension provision - - and in fact exacerbate it.

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