TARGETING RISK LOVERS? TAXATION OF PRIVATE PENSION SAVINGS, RISK PREFERENCES, AND GENDER.

• Author: Larsson, Bo

1. INTRODUCTION 657 II. THE DESIGN OF THE TAX POLICY 661 III. THEORY 663 A. A Comparison of the Designated Pension Savings Tax with the General Savings Tax Based on Expected Returns 664 B. Including Heterogeneous Risk Preferences and Stochastic Returns 665 IV. DATA 670 V. EMPIRICAL MODEL 672 VI. EMPIRICAL RESULTS 674 VII. CONCLUSIONS 677 APPENDIX 678 I. INTRODUCTION

   In the design of tax policies, regulators often focus on simplicity and tax neutrality across comparable objects for a given expected tax revenue. However, both the neutrality and the simplicity aspect only consider the expected outcome and not the full alteration of the incentive scheme when risk is incorporated. Ignoring risk in the design of taxes, however, is likely to have adverse and unintended effects.

   By studying a special case of taxation in Sweden, we can analyse and quantify the "costs" of ignoring risk when forming tax policies. Following a large tax reform in 1991, the government introduced a specific tax-incentive system to stimulate voluntary private pension saving. The basic idea was to allow deductions from taxable earnings for contributions to tax-deferred retirement savings accounts, i.e., designated pension savings accounts. More important, a unique feature of the tax policy was a decision to tax the returns at a presumptive rate and not on the actual rate. (1) Consequently, contributions are taxed yearly regardless of the actual outcome of the savings. As of January 2012, presumptive taxation was introduced as an option for all new savings in "Investment Savings Accounts" (ISK) that were a new form of designated pension savings introduced to stimulate pension savings. (2) The tax-incentive scheme with tax deductibility of savings for the designated pension savings accounts was lowered in 2015, and abolished in 2016, (3) but the presumptive taxation of ISK accounts and pension savings still applies.

   In this Article, we show theoretically that presumptive taxation creates a wider outcome (in rate of return to savings) distribution, which causes more weight in the tails of the distribution. This makes the investments under a presumptive tax scheme unattractive for individuals with high levels of risk aversion, causing less risk tolerant individuals to refrain from adopting investment schemes taxed with presumptive returns. Previous studies have found that low-wage workers and women tend to adopt more conservative investment strategies; (4) this result suggests that applying a presumptive tax scheme may discourage those who may need tax-induced, voluntary pension savings the most.

   We also test empirically if the tax incentive for designated pension savings is equally adopted along the distribution of risk preferences using Swedish register data. The data contains deposits to designated pension savings accounts along with vital, register-based data on important economic background variables. In addition, to elicit a measure for risk preferences, we use unique data on portfolio choices in individual pension accounts nationally introduced in 2000, following a Swedish pension reform. (5) Since the reform of the pension system covered the entire work force of approximately 4.4 million individuals, the study does not suffer from selection bias, sometimes plaguing other research on, e.g., self-directing in occupational pension schemes.

   The empirical analysis first confirms that women and individuals, believed to have lower familiarity with or to have low levels of assets, also are more conservative investors. To find our measure of risk preferences, we use a two-step estimation to derive a measure of risk-taking that is not explained by typical socio-economic factors. This measure of risk-taking is then used to estimate the association between risk-taking and the use of designated pension saving with presumptive taxation. Following this, we then find that the tendency to use designated pension savings is clustered in groups that are more risk tolerant, even when controlling for economic background and other risk exposure.

   In sum, this Article shows, theoretically and empirically, that a presumptive tax system deteriorates the situation of exactly those individuals who may already be in danger of obtaining insufficient savings and pension incomes. The adverse effect can be divided in two components. First, the possibility of self-directing pension contributions creates a lower pension wealth, with lower expected returns for those who are not willing to take on large risk exposure. Second, an unintended effect of the tax incentive is that those groups with a low level of risk tolerance also lack incentives for voluntary designated pension savings, along with having lower expected returns on their individual accounts. These two proposed effects create a worsened situation for those who may be in the largest need of providing for their future pensions. In particular, we show an adverse gendered effect on future pension incomes. Women in Sweden had 68% of men's pension income in 2018. While this gender gap is expected to diminish in the future, it is predicted to remain at around 80% for women and men born in the 1980s. (6)

   Finally, few countries, except Sweden, tax pension savings this way. However, taxation through presumptive returns is used in the Netherlands to tax capital income, i.e., the Dutch "Box-III"-tax. (7) Presumptive taxation has also received a lot of attention as an interesting solution among regulators, (8) but then with no account given to the effects of heterogeneous risk preferences. Thus, our results from analysing the taxation of designated pension savings in Sweden can be directly used to draw conclusions about systems like the Dutch Box-III tax system and highlights how it potentially can lead to larger income differences, as Roine and Waldenstrom show that capital income constitutes a large share of total income differences. (9)

   The Article is organized as follows. In Part II we describe the tax policy for pension savings. Part III outlines the model. In Part IV we give a summary of the data. In Part V we present the empirical analysis and results are given in Part VI. Finally, Part VII concludes.

2. THE DESIGN OF THE TAX POLICY

   This Article exploits a reform from 2000 to elicit measures of individual risk-taking for a large majority of the Swedish population and relates this to the use of designated pension savings under presumptive taxation. Consequently, as the study analyses choices made in 2000-2001, we describe only the tax system relevant for those years below.

   In 1991, Sweden underwent a major tax reform in order to reduce distortions created by the old tax system and a desire to create neutrality between different sources of income. The system strived to create an equal tax treatment for similar types of investments. As a consequence of an ageing population, the government also created a tax set to promote designated pension savings.

   Sweden has a dual income structure where labour and capital income are taxed under separate schemes. Savings are taxed under essentially three different forms: as "general"-savings, as designated pension savings, or as "endowment insurance"-savings. Table 1 presents the tax rules for the different types of savings that were relevant in 2000-2001.

   The first form of savings is general savings, like a bank account or shares in mutual funds. This type of savings is taxed at a level of 30% on their actual rate of return. While deposits are not tax deductible, losses on general savings can be used to lower current labour income tax. For losses made on stocks, 70% of the losses are deductible, while 100% of the losses on interest-bearing instruments are deductible against other labour income.

   Designated pension savings can be invested under two types of investment options. The first is a traditional insurance, and the second is a pure investment portfolio that can consist of either a portfolio of mutual funds or a fixed portfolio consisting of any type of security. Both types can be annualized at the earliest when the investor reaches 55 years of age.

   In contrast to general savings, deposits into designated pension savings can be used to lower current labour income tax. The tax rule that applied in 2000-2001 allowed a deposit into designated pension savings of SEK 18,200 ($1,950) to be deducted from the labour-income base for taxation for labour incomes in the interval of 0 to SEK 364,000 ($39,140). (10) For labour income above SEK 364,000 but below SEK 728,000 ($78,280), a deduction equal to 5% of income above SEK 364,000 could be made for designated pension savings, along with the SEK 18,200. For labour income exceeding SEK 728,000, the maximum deduction is 5% of SEK 728,000, which is equal to SEK 36,400. The annuities from the designated pension savings are taxed as income when annualized. (11)

   Of importance for this Article, designated pension savings are taxed under a special capital gains tax based on a presumptive return. Instead of taxing realized gains, a tax based on the average market interest rate on Swedish government bonds (with a remaining maturity of at least five years), Statslanerantan, is used. Therefore, regardless of the investment resulting in a gain or loss, the value of the savings is assumed to have grown at the same rate as the interest on government debt. The presumptive return is then taxed yearly at a rate of 15%.

   The third type of savings is "endowment insurance" savings, kapitalforsakring, and is taxed according to the same principle as designated pension savings. This is an investment that has to be locked for a minimum of five years and exists in two forms. First, a traditional insurance with a fixed minimum return that cannot exceed 3%, a limit set by the Finance Inspection Board, Finansinspektionen. The second is a unit link savings, which is invested in mutual funds. The presumptive return on these investment types is taxed at a rate of...