Private Pension Saving: The Effect of Tax Incentives on the Rate of Return

Abstract

A factor often cited [3; 8; 10; 12] as a major incentive to pension demand is the specialized treatment afforded contributions to qualified private pension plans.' Contributions to pension plans can be made by either employers or employees. Employer contributions plus the interest they earn are sheltered from personal income until the money is received as benefits. This deferral is consistent with the realization doctrine which revails over most of the income tax [10, 77]. Pension contributions are not considered as part of current income because pensions are generally not immediately vested in the workers.2 Employee contributions, which generally enjoy immediate vesting, are considered a part of current income and taxed as such, but the interest earned on such contributions once in te t trust fund is treated like employer contributions. The effect of the deferral on either type of contribution is to increase the after rate of return on pension contributions and ceteris paribus make pensions a relatively more attractive means of saving. The purpose of this paper is to evaluate the extent to which sheltering increases the after rate or return of private pensions and to draw some implications as to the effect of this increase on pension demand. Although deriving a pension demand function is not within the scope of this paper, one element of such a function should certainly be the rate of return on a pension relative to the rates of return on alternative forms of saving. If deferral provides a significant advantage, pensions would be actively sought by workers and formed at their insistence. The importance of this analysis is that it will reveal the underlying factors that influence the relative rates of return. Pension coverage and contributions should vary across the population as the size of the benefit varies. The remainder of this paper is organized into five sections. In the first section some