Can a Pension Reform Be Conducted by Differentiating of The Tax Rates?

Following the discussion for the new taxes next year, a debate arose in Bulgaria for the tax treatment of the money deposited in the voluntary pension funds. According to the current legislative system in Bulgaria the payments in the voluntary pension security system are deducted from the taxable individual income, but if money are drawn preliminarily from personal accounts before the terms for receiving of pension annuity are met, earnings are liable to 12% income tax rate.

The idea for the tax exemption of money, once deposited in the private pension system, met the greatest opposition from the private pension funds. According to the Association of Complementary Voluntary Pension Insurance, this will lead to drawing out of around 100 million levs (50 million Euro) from the funds and will be a hardship for the stability of the system /the balance value of the assets of the voluntary pensions funds for the first three months of 2006 is 435 million levs (222.4 million Euro)/. Consent was reached with the minister of finance Mr. Oresharski that the tax would not be abolished.

However, the fear that speculations will be stimulated and people would rather use the pension funds as a tax shield in order to lessen the effective tax rates that are imposed on them is fully justified. People are rational and the taxation system, which is compulsory, coercive and the rates are comparatively high, is a big enough stimulus for utilization of all legal means for tax evasion.

The annual average yield accomplished by the pensions funds for the last two years is 8.4%, which is substantially above the average interest rates on deposits for the period (3.2%), which makes the pension funds an alternative to the banking system although it is not within their scope of activities and general purpose. The higher yield rate should be a premium for the lower liquidity of the savings.

The reasons given by the Ministry of Finance for justification of the proposal are as follows: stimulation of the development of the voluntary pension insurance from one hand and from another – easier administration of the tax system. According to representatives of the government administration defining the taxable part of the income from premature drawing of the money from the personal accounts in the pension funds is difficult to accomplish in practice. However, both of these reasons lack any sound grounds.

To the pension funds it is of utmost importance the time horizon of the savings as well as the inflows and outflows from the personal accounts to be able to be forecasted with a high probability so that the portfolio of assets to be managed most efficiently. One of the characteristics of the pension system model is that the time horizon of the savings is comparatively long which allows for investments in long-term projects or instruments and receiving capital gains in return from the accumulation of more economic value.

Although, most probably, the tax will not be abolished, the question for the dependence of whole business sectors on government decisions is still on the agenda. In the particular case, the tax has not a fiscal role rather than a regulatory one. That is so because the pension funds are restricted in their policy for the fees they collect. The fee for preliminary drawing of money from the personal accounts before the pension age is reached is limited to most 20 levs (10.22 Euro). According to term 259 of the Social Security Code the pension funds cannot collect other taxes and fees rather than the ones indicated in this chapter [chapter 28 from Social Security Code “Taxes and Fees”].

Conducting tax policy through differentiated tax rates is not only a hindrance for the tax collecting process and leads to higher costs for tax system administration but also changes the behavior of people and the environment in which they operate. If the individual income tax system is simplified, this would reduce “time” tax for taxpayers, which is the opportunity cost for people to calculate and pay taxes by taking into account all restrictions and possibilities for minimization of tax payments. If the tax rate is flat, without differentiated rates and complicated procedures for alleviation, preferences, stimuli and so on, the tax base will be wider which allows for reduction of the tax rates for all and the distortion of the market reality will be reduced to minimum size.

In order to stimulate savings in the voluntary pension funds, the government should withdraw from its activity to promise pensions through the PAYG system, which is characterized by inherent instability and inadequacy to the demographic changes. The dependency ratio in Bulgaria, measured as a percentage of the population in a retiree age (the population measured as the number of people between 15 and 64 according to the methodology by Eurostat) is 24.9% for 2005, and in 2050 this indicator will increase to 60.9% according to the forecast by Eurostat. At the same time the ratio of the number of retirees to the overall number of the occupied people in the private and non-subsidized government sector is an indicator that brings more economic sense and if we take it into account, even a more alarming situation will be observed.

This week was undertaken also another step concerning the pension system in the country. A special law project was passed by the parliament for the creation and management of a special Silver Fund, which will accumulate part of the financial resources from the privatization and the fiscal reserve of the country. The Silver Fund will assist the government pension system. Before we can evaluate the creation of this fund, it is important to take into account its purpose and what it will be used for. In this case, we do not talk about reformation in the pension system but about delay of its bankruptcy. In several years the ratio of occupied to retired will be greater than 1:1 (for the retired) and at the same time the promises for higher pensions and reducing of the social security taxes means that the deficit of the National Social Institute will widen and the implicit government debt will be higher which will challenge the stability of the whole system.

The feature in common between the appeals for higher pensions and conducting of “more social” policy and the creation of a Silver Fund is the promise, which a great part of the people recognize that the government will take care of them when they are old – simply because it is “obligated to do it”. These signals hinder the development of the capital pension system and all other forms of private voluntary insurance. In order the pension reform to be conducted, a political and social support should be achieved and a realized conviction by people for its necessity. Differentiating the tax rates and making the tax system more complicated do not help in changing the models of thinking, just the contrary – it hinders the rational utilization of the resources in the economy.