An economic analysis of the existing taxation of pensions (EET) versus an alternative regime (TEE)

The Government has recently issued a consultation document which raises the possibility of a substantial change in the taxation of pensions. In this paper we assess the economic consequences of changing from the existing EET system (where pension savings and returns are exempt from income tax, but pension income is taxed) to a TEE system (pension savings would be from taxed income but with no further taxation thereafter), making use of two complementary approaches. First, we review the economic and empirical literature, and second we construct a general equilibrium overlapping generations (OLG) model parameterised to UK data and the progressive UK tax system. Both approaches lead to the same outcome: that changing from EET to TEE would lead to a fall in personal savings. Our OLG model also finds that this reduction in savings would have broader macroeconomic consequences including lower aggregate investment, a smaller steady state capital stock, lower productivity and output, lower real wages, lower aggregate consumption, and a higher real interest rate. We compare steady state outcomes for EET to TEE while allowing for pension subsidy rates (i.e. a top-ups on pension savings out of taxed income) of between 10% and 50%. In order for the macroeconomic outcomes under TEE to approach those under EET, a pension subsidy of at least 50% would be required. However, this high rate of TEE subsidy on pension savings would crowd out other forms of government spending as aggregate tax revenues would decline by 3.2%.