Life-Cycle Saving Taxation - Essay Example

Savings-Neutral Taxation Current Taxation System of Household Savings Currently, the UK government encourages citizens to save by offering tax reprieve on pension contributions (HMRC.com, 2014). Tax reprieve or relief on saved earnings by households implies that household savings are not taxed at the point of saving. The tax relief one enjoys causes the pension fund or tax bill to reduce on the taxable income accumulated. Tax reprieve enjoyed by individuals depends on whether one has subscribed to occupational, public or personal pension schemes. Persons contributing through public service or occupational option enjoy full relief since the employers take the pension contribution before calculating for tax. In addition, an employee is able to claim tax relief through the tax return if the pension contribution is not catered in the deduction of tax by the employer. Similarly, individuals under the personal scheme forfeit income tax before the pension contribution is catered. However, the tax is reclaimed by the pension provider at a basic rate of 20 per cent (HMRC.com, 2014). In addition, an individual is able to claim back the excess tax remitted through the tax return. However, the maximum amount of income saving that enjoys tax relief under the current taxation system is £50,000. Furthermore, an individual taking early withdrawal from the pension pot before the retirement age is liable for paying tax bill that is equal to 55 per cent of the pension savings withdrawn. However, if an individual withdraws the pension after reaching the set out age, he/she will pay tax depending on the taxable income after the tax-free allowances (HMRC.com, 2014). The tax that individuals pay on their pension is a lump-sum tax that is a fixed tax regardless of the asset owned or income. Consequently, household income savings are not taxed in UK but they are taxed when the savings is withdrawn. This strategy encourages savings in the country from household income earned during their working days to consume it in their retirement at a fair taxation scheme. Neutral Taxation System The proposed taxation system by the author is one that observes the neutrality principle in taxing the income savings. Neutrality principle in taxation is the condition where the individual’s efficacy in the economic well being is not hindered by taxation mechanism employed by the policy makers (Anderson, 2012). This implies that the taxation of the households’ savings should be done in a way that does not distort their choice on the time they should consume income. In addition, the taxation system should avoid distorting the choices households make on the asset under which they save through. This means a savings-neutral taxation system proposed aims at ensuring households are not deterred from making savings for future consumption or engaging in non-cash income asset investment. The rationale behind neutral taxation system is to eliminate inefficiency and distortion of the households’ choices (Schanz, 2011). The system proposed understands that individuals make income savings currently with the intention of consuming the savings at another date in future. Thus, a taxation mechanism that is capable of deterring households from making savings currently for future consumption is discouraged under the proposed savings-neutral system since it distorts their time choice of consumption. This implies a taxation system should not be the one that taxes consumption undertaken on a later date heavily compared to the current date consumption. Taxing tomorrow consumption heavily compared to the current consumption has the capacity of distorting the choice of consumption by households according to the neutral taxation system concept (Mirrlees, et al., 2011). This is because taxing tomorrow consumption heavily has the potential of discouraging households from saving today since they will face higher tax than if they consume the amount today. Thus, the neutral taxation proposed by the author argues that the taxation system adopted by the country towards the household savings should not target normal returns of the savings. This is because the return accumulated from the savings is the premium that compensates for the consumption that has been delayed. Thus, taxing the normal returns that is accrued from savings is a disincentive since it takes away the risk-taking compensation for delaying consumption. Similarly, the neutral taxation system contends that individuals should not be taxed differently on their savings due to the vehicle of saving utilized (Mirrlees, et al., 2011). This is because taxing individuals due to the way they save their earnings for tomorrow consumption interferes in their future plan since it forces them to enter pension plans they do not wish. Individuals should be allowed to decide whether to make their savings through savings account, gilts or shares without discrimination. This is because taxing different saving mechanisms differently has the capacity of distorting asset investments by households due to the incentives that is created (Mirrlees, et al., 2011). Thus, individuals will not efficiently be able to choose the future consumption of the current income saved. Purpose of the Neutral-Tax Treatment of Life-Cycle Savings The purpose life cycle savings plan under a neutral taxation system is to achieve an optimal taxation system that eliminates distortion and inefficiency on the decision of the households on their income savings and asset investment (Mirrlees, et al., 2011). Generally, the system targets the utility of the households through an optimal design of reducing the distortions that are created by taxation. Thus, the system targets on the potential threats in the taxation system that is likely to distort the choices of the households in consuming their savings and assets of undertaking the saving. This is to be achieved by coming up with a taxation system that is able to achieve neutrality on time consumption and asset. The comprehensive taxation system has been discouraged in the new system been proposed since it discourages savings by making consumption in future more expensive to present consumption (Anderson, 2012). This is because earnings and savings returns are both taxed when received under comprehensive taxation. Thus, the present value of the current income consumed exceeds the future income consumed. In addition, inflation fluctuation is not catered in coming up with the effective rate to tax the real rate of interest bearing assets that makes it to increase as the inflation fluctuates. This has the potential of reducing the wealth accumulated compared to the time it takes to generate (Schanz, 2011). Consequently, the savings-neutral taxation system proposes three types of alternatives that are capable of minimizing savings and asset choice distortions on householders. One of the alternatives of achieving a savings-neutral taxation system is cash flow expenditure taxation. Under this system, incomes are only taxed when they are consumed by the household (Mirrlees, et al., 2011). Thus, savings enjoy tax deferral until the day the consumer will make consumption in future. This implies that the income that is not consumed currently is not subjected to accrual normal returns taxation. Consequently, a household will not be discouraged from making savings for future consumption through taxation. The second savings-neutral tax system that is available is labor earning tax. Labor earning taxation eliminates taxation on income savings even on the first saving undertaken by the householder (Mirrlees, et al., 2011). Similarly, this taxation system is optimal in ensuring households are not faced with consumption choice distorts. This is because households are not faced with consumption choice distortion in future from their current income savings. The risk-taking compensation of holding their current income in savings is not taken away through taxation that will discourage them from making savings. Thirdly, income tax bearing rate-of-return on allowance is considered is another route of savings-neutral. The system taxes supernormal savings return and labor earnings (Mirrlees, et al., 2011). This rationale ensures that households do not face taxation on their savings return unless they are above the expected return. The expected return on income savings is the premium they take for taking the risk of consuming their current income in future. Thus, households decision to make saving for future consumptions will not be distorted through taxation. Employing any of the three savings-neutral tax systems ensures the risk-free return is not taxed that makes the household’s current or future consumption choice undistorted. Consequently, the savings-neutral system is purposely meant at ensuring households future consumptions through the savings they make currently from their income is not distorted through taxation. In addition, the systems aims at ensuring households’ asset holding are do not inefficiencies in generating future wealth due to taxation. Strengths and Weakness of the Proposals The savings-neutral mechanisms proposed bears strengths and weaknesses due to the impact they cause. One of the strength of the proposals is the ability to protect the normal return of income savings from taxation (Mirrlees, et al., 2011). The normal return of the income savings is the risk-free rate of return that should be avoided to ensure households choice on future consumption or current consumption is not distorted by taxation. In addition, the proposed savings-neutral have the strength of working as an effective in encouraging households to make savings from their current incomes. This is because the proposals ensure that the future value of the income saved is not less to the current income they would have consumed. Consequently, individuals are enticed to work to earn income that will support their future consumptions without distorting their savings that could encourage households to undertake leisure. Furthermore, the expenditure tax, rate-of-return on allowance (RRA) and labor earning ensures cash income and capital gains have equal treatment. This means inflation indexation is not required to in taxing interest bearing assets. Thus, distortions on timing and form of saving are eliminated through the proposed saving-neutral mechanisms (Chand, 2009). Furthermore, the rate-of-return on allowance ensures the government is able to receive up front revenue and a proportion of excess return accumulated. However, the proposals of the savings-neutral tax system pose a number of weaknesses in their implementation. One of the weaknesses of the proposed alternatives of the savings-neutral system is excess return that is left untaxed under the earnings tax proposal (Mirrlees, et al., 2011). This has the potential of denying the government revenue that reduces the tax base of the economy. Thus, it can allow investors to accrue indefinite income that is untaxed if it applied widely. Similarly, adoption of the RRA has the potential creating complexities on determining the risk-free return due to the fluctuation of interest. In addition, adopting RRA has the potential of causing the loss treatments and record-keeping requirement. This is a tedious exercise that is likely to cause tax leakages in the tax system. Potential Winners and Losers of the Proposed System Adoption of the savings-neutral system proposed has the potential of creating winners and losers in the economy. One of the winners the system is likely to create is the young employees and entrepreneurs. Income levels have the tendency of rising as households are growing and slow down as they approach retirement. Thus, young individuals will be able to experience an increasing income saving returns in their accounts compared to the middle aged and old aged population if the move is adopted currently. This will promote their future savings due to the high return it would have accumulated and enjoy a lump-sum fixed tax. In addition, high income earners in the economy will win under this arrangement. This is because high income earners will be able to save huge amount of their income without facing taxation. The tax relief will allow them to accumulate huge wealth in their saving accounts from savings normal return compared to the low-income earners. However, the government will be the biggest loser if the savings-neutral system is adopted. This is because the government will not be able to collect the revenue from normal savings income returns to support it fiscal expenditure. Similarly, the low income earners will lose under the proposed system. The low income earners will consume the biggest proportion of their income that will be taxed under the proposed taxation system compared to the untaxed proportion of their savings. This will create an unequal distribution of taxation regime in the economy since it will tax the poor heavily on the income earnings. References Anderson, J. E. (2012). Public finance: Principles and policy. Mason, Ohio: South-Western. Chand, S. N. (2009). Public finance. New Delhi: Altantic Publishers & Distributors. HMRC.com. (2014). Pension schemes and tax - the basics. Retrieved March 2014, from http://www.hmrc.gov.uk/pensionschemes/tax-basics.htm Mirrlees, J., Adam, S., Besley, T., Blundell, R., Bond, S., Chote, R., et al. (2011, September). Tax by Design: the Mirrlees Review. Retrieved 2014, from http://www.ifs.org.uk/mirrleesReview Schanz, D. (2011). Business taxation and financial decisions. Heidelberg: Springer. Read More