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

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

< R12k R12 - R75k R75k - R150k R150k - R1m > R1m

Annual Income

Peo

ple

in

Mil

lio

ns

Formally Employed Existing Provision

Formally employed excludes agricultural workers

Formally Employed = 9.3mExisting Provision = 5.8m

Courteousy Old Mutual

Retirement Saving: Typical Policy Levers

1. Increasing income2. 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

• Deduction R 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

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 systems2. Middle income groups favour earnings related systems3. High-income earners prefer no system at all – have

access to private systems4. 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

FactorCosts

Wages& Rents

IntermediateInput Cost

Sales

PrivateConsumption

Taxes

Domestic Private Savings

GovernmentConsumption

Gov. Savings

Investment Demand

ImportsExports

Foreign Savings

Transfers

Foreign Transfers

Commodity Markets

Factor Markets

Households Government Sav / Inv

Rest of the World

LLöfgren, 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 R37 993 as more jobs per rand

spend is created when the subsidy is extended to the informal sector.

5% 10% 15% 5% 10% 15%Employment (% change) 2.09 4.34 6.80 3.01 6.28 9.87GDP (% change) 0.86 1.75 2.67 0.97 1.97 3.01Initial wage subsidy shock (R billion) 12.18 24.37 36.55 13.75 27.51 41.26Wage subsidy cost (R billion) 12.65 26.33 41.16 14.30 29.79 46.64Net cost (R billion) -6.77 -14.33 -22.79 -7.72 -16.35 -26.04Cost per job created (R million) 48585.23 48570.02 48543.99 38087.33 37993.16 37887.16

Wage Subsidy to Formal Semi- and Unskilled Labour

Wage Subsidy to Formal Semi- and Unskilled Labour as well as Informal

Results – Employment and GDP

Results - Employment

5% 10% 15% 5% 10% 15%High-Skilled Formal Employed Agriculture 0.447 0.908 1.384 0.529 1.075 1.640

Industry 0.247 0.497 0.753 0.306 0.618 0.935Services -0.035 -0.071 -0.108 -0.043 -0.088 -0.133

Skilled Formal Employed Agriculture 4.330 9.060 14.250 4.504 9.428 14.836Industry 2.688 5.589 8.732 2.815 5.853 9.146Services 3.115 6.505 10.211 3.214 6.712 10.537

Semi- and Unskilled Formal Employed Agriculture 4.330 9.060 14.250 4.504 9.428 14.836Industry 2.088 4.341 6.782 2.193 4.558 7.121Services 3.418 7.139 11.208 3.493 7.295 11.453

Informal Employed Agriculture 1.168 2.379 3.636 4.504 9.428 14.836Industry 0.804 1.630 2.481 3.265 6.792 10.619Services 0.770 1.561 2.377 3.981 8.318 13.066

Self Employed Agriculture 0.166 0.339 0.522 0.221 0.453 0.697Industry 0.072 0.146 0.224 0.121 0.247 0.379Services -0.029 -0.058 -0.090 -0.042 -0.085 -0.131

Wage Subsidy to Formal Semi- and Unskilled Labour

Wage Subsidy to Formal Semi- and Unskilled Labour as well as Informal

Labour

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?

5% 10% 15% 5% 10% 15%Employment (% change) 1.10 2.25 3.48 1.56 3.21 4.97GDP (% change) 0.45 0.91 1.37 0.51 1.02 1.54Initial wage subsidy shock (R billion) 12.18 24.37 36.55 13.75 27.51 41.26Wage subsidy cost (R billion) 12.43 25.38 38.90 14.04 28.68 43.99Net cost (R billion) -8.23 -16.90 -26.07 -9.34 -19.20 -29.63Cost per job created (R million) 90832.26 90220.66 89556.92 72266.70 71613.93 70915.63

Wage Subsidy to Formal Semi- and Unskilled Labour

Wage Subsidy to Formal Semi- and Unskilled Labour as well as Informal

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 individuals 7.9Skills Development Levy 0.3UIF 0.1Wage subsidy (gross) 1.9Total 10.2

Individual’s Tax Disaggregation

Practical Policy

A social security tax of 5% applied to earnings of R120 000 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)

Finding AuthorExistence positively correlated with participation, level has little effect

Poterba, Venti & Wise (1992)

Corroborate above finding Papke, Petersen & Poterba (1993)

Participation & contributions insensitive to match rate over time

Kusko, Poterba & Wilcox (1993)

Existence of match, not quantum that matters Scott (1994)

Concur with above finding Papke (1995), Even & Macpherson (1996), Basset et el (1998), Kusko et el (1998)

Increases in match rate raise saving Clark 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.

2008 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.

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