Amended Taxation of Pension Savings

Transcription

1 65 Amended Taxation of Pension Savings by Leif Lybecker Eskesen, Suzanne Hyldahl and Birgitte Søgaard Jensen, Financial Markets Department Background As a measure to stimulate savings, in June the Whitsun package of economic measures was adopted by the Folketing (Parliament). This package includes a number of amendments of legislation concerning taxes and duties. In particular: Green taxes are raised The tax deductibility of interest payments is reduced to approximately 32 per cent The rules for the deductibility of contributions to capital pension schemes are amended Taxation of pension assets is amended The package of legislative measures entails considerable changes in the taxation of pension savings. The Real Interest Tax Act is replaced by a new Act on Taxation of Yields on Pension Savings with significantly changed taxation principles for institutional investors. An important element is considerable simplification of the rules on taxation of pension savings. In the future market prices (the stockpiling principle) will be applied to the valuation of the taxation basis, rather than the previous realization principle. At the same time, the variable real-interesttax rate will be replaced by a fixed capital-yield tax. The transition to market values entails that in the future bonds and derivatives will be taxed according to the same principle. This eliminates the tax obstacle to using derivatives as an element of portfolio management. Another important aspect is that the taxation base will be widened since returns on equity are no longer exempt from taxation. Apart from the new taxation principles the legislative package includes new terms for the investment opportunities of institutional investors. The ceiling for equity investments is raised, which will give immediate access to increased investment in shares. However, many factors will determine whether investors choose to use this wider access to equity investments. Under the Whitsun package index-linked bonds are still exempt from tax, but subsequent to the package a bill has been proposed to introduce taxation of newly-issued index-linked bonds. Danmarks Nationalbank's Monetary Review, 1st Quarter 1999 is expected to include an article on index-linked bonds.

2 66 In overall terms it is evaluated that the amended principles will lead to smoother functioning of the capital market, particularly the bond market. The simplified taxation principles mean that taxation factors will no longer have any particular significance for institutional investors' investment considerations. This will make price-setting on the Danish bond market more effective. Application of market prices to the valuation of the taxation base implies that central-government revenue from year to year will to a greater extent match fluctuations in bond yields and share prices. As a result price fluctuations during the year will be reflected directly in revenue, rather than being distributed over a number of years as before. At the same time, on average the new rules must be expected to yield higher revenue to the central government than would have been the case with continued real-interest tax. This is partly because the current development in interest rates and prices indicates a falling real-interest-tax rate, and partly due to addition of returns on equity to the taxation base. Effects on the bond market The complex real-interest-tax rules affect the investment decisions of institutional investors. The Whitsun package entails that with effect from the year 2000 the Real Interest Tax Act is rescinded and replaced by the new Act on Taxation of Yields on Pension Savings. The taxation of bond yields will influence the behaviour of tax-liable investors and thereby also the Danish bond market. A changed behaviour pattern is expected because the principle for valuing the taxation base is based on realization rather than stockpiling, and because the tax rate is variable rather than fixed, cf. Box 1. The real-interest tax has led to a lock-in effect. This means that taxliable investors' decisions on whether to realize any capital gains or to alter their bond portfolios are distorted by the real-interest tax. As a consequence the volume of bonds traded has been moderate for long periods and price-setting has therefore been less effective. If the current interest-rate level is lower than when the bond was purchased the market rate will typically exceed the mathematical revaluation rate. On sale of the bond, under the Real Interest Tax Act the difference is taxed over five years. This is an accrual problem in the sense that the tax payment is brought forward, but since the present value of the In this article the terms institutional investors and investors liable to real-interest tax are used as synonyms. These are life insurance companies, pension funds, the Social Pension Fund, ATP, LD, aid and charity funds, capital pension funds, etc., as well as certain bank savings schemes.

3 67 Box 1 Taxation of bond yields The Real Interest Tax Act The Real Interest Tax Act, which entered into force in 1984, is very complex. The following is a brief summary. The real-interest tax is a variable tax. It is based on the philosophy of taxaing the element of the taxable yield on pension savings which exceeds 3.5 per cent per annum after adjustment for inflation. The tax rate is thus fixed each year so that on average the real yield on taxable pension savings is 3.5 per cent after tax. The real-interest-tax rate will therefore vary from year to year as a consequence of fluctuations in e.g. inflation and interestrate levels. The real-interest-tax rate has been falling in recent years. It will be 35.8 per cent in 1998 and 33.8 per cent in Under the Real Interest Tax Act capital gains and losses on Danish bonds are valued on the basis of a realization principle, including mathematical revaluation. This entails that capital gains/losses on sale are included in the taxation base, while bonds which are retained in portfolios are subject to taxation of the yield calculated via the mathematical revaluation. In other words, changes in market values as a consequence of changes in interest rates are only liable to taxation on their realization. Furthermore, the Real Interest Tax Act contains a provision that capital gains/losses on sale - but not drawing - of the bonds are carried to a special balance (the realization balance or 20-per-cent balance) which is subject to addition or subtraction of 20 per cent each year on the compilation of the taxation base. The tax payment is thereby distributed over five years. The Act on Taxation of Yields on Pension Savings With effect from the year 2000 the real-interest tax will be replaced by a fixed nominal tax of 26 per cent. The valuation method will be amended to a stockpiling principle under which both realized and unrealized capital gains/losses will be included in the taxation base on any change in market value. The realization balance will lapse as a natural consequence of the new valuation principle. The introduction of the stockpiling principle and the discontinuation of the realization balance will achieve symmetry in the taxation of realized and unrealized capital gains/losses. Mathematical value adjustment (also called reduction of remaining maturity) is described in Michael Olsen and Morten Linnemann Bech, "The Banks' Earnings", Danmarks Nationalbank, Monetary Review, 2nd Quarter 1998.

4 68 tax increases when the payment is brought forward the investor's incentive to sell the security will be reduced. The lock-in effect has been further reinforced by expectations that in view of the falling level of real interest rates the future real-interest-tax rate will decrease. Capital gains will thus be taxed at a future time and at a lower rate than on immediate realization of the assets. The transition to the stockpiling principle will introduce symmetrical taxation of unrealized and realized capital gains, cf. Box 1. In taxation terms the tax-liable investors will therefore be indifferent to whether the bond is sold or not. In other words, investment decisions will be (almost) unaffected by the tax situation of institutional investors. This will contribute to the smoother functioning of the bond market. The lock-in effect has been strongest for the turnover of bonds with long remaining maturities since prices for such bonds are more sensitive to changes in interest rates than prices for bonds with short remaining maturities. Due to their long-term commitments insurance companies and pension funds take a natural interest in bonds with long duration. This is reflected in the distribution of their holdings of mortgage-credit bonds, cf. Table 1. Insurance companies and pension funds have disproportionately large holdings of mortgage-credit bonds with a remaining maturity of more than 10 years. The last factor of relevance to the bond market is "bond laundering". In periods of falling interest rates it has been profitable just before the major bond drawing dates to launder (sell and repurchase) the share of the bond portfolio which is above par and at the same time has low book values. When the bond is drawn the gain is included directly in the taxation base, while the capital gain on sale is distributed on the taxation base over five Table 1 Fixed-yield mortgage-credit bonds by owner, end of 3rd quarter 1998 Holdings, kr. billion Distribution by remaining maturity Less than 10 years More than 10 years Total Per cent Insurance companies and pension funds Financial institutions Abroad Other Total , Source: Bond Statistics, Statistics Denmark.

5 69 years via the 20 per-cent balance, cf. Box 1. When the new taxation rules are introduced this artificially generated turnover will disappear. As a consequence of the amended taxation method the investment decisions of institutional investors will be less influenced by their tax situation. In view of the relatively large presence of these investors in the Danish bond market this will lead to generally more efficient price-setting and increased liquidity. Use of derivatives Derivatives such as swaps, whereby one payment flow is swapped for another, can be put to profitable use in portfolio management. After building up a portfolio with particularly attractive characteristics an investor can change the portfolio's interest exposure without realizing elements of the portfolio. Under the new taxation rules bonds and derivatives will be taxed according to the same principle (stockpiling). The current taxation method has a mismatch between the taxation of derivatives based on market value and the taxation of the underlying bond based on the mathematical revaluation principle. This mismatch has made it less advantageous to use derivatives in the management of risk since the hedging of the bond after tax has been poor. The uncertainty concerning future real-interest-tax rates has probably contributed further to the limited use of derivatives. The adjustment of the valuation principle and the introduction of a fixed tax rate will make the use of derivatives in portfolio management more attractive to these investors. Effects on portfolio composition History shows that in the long term shares have yielded higher returns than bonds, but have also shown greater volatility. This applied to Danish securities in the period , cf. Table 2. Today's institutional investors prefer bonds to shares, even though typically they have a long-term investment horizon. 2) However, their investment considerations are influenced by other factors besides the investment horizon. They include tax conditions, quantitative restrictions, capital considerations, etc. These factors are affected by the Whitsun package. In particular, with effect from June 2, 1998 returns on equity, which were previously exempt from real-interest tax, will be subject to a 5-per-cent tax; 2) The interest-rate risk or duration is e.g. reduced by swapping from fixed to floating interest rates. The investment horizon depends on the "maturity" of the institution and thus on the size of the requirement of the liquid yield on the assets.

6 70 Table 2 Average yield in Denmark, Mean (per cent) Spread (percentage points) Bonds Shares Source: Michael Pedersen "The Equity Premium Puzzle - a Theoretical and Empirical Analysis", thesis at the Institute of Economics, University of Copenhagen, November Note: Share yields include dividend. with effect from the current fiscal year the ceiling for equity investments has been harmonized at 50 per cent; and booking at market value has been made mandatory. The introduction of a 5-per-cent share tax is an outright tightening of share taxation. However, the effect of the share tax on the proportion of shares in a portfolio is by no means unequivocal, since it also depends on the taxation of the bonds. The new capital-yield tax of 26 per cent must be compared with the expected future real-interest-tax rate in the present system. Moreover, the volume of institutional investors' equity investments is subject to a ceiling which imposes a limit on the proportion of their assets/provisions that may be placed in shares. This ceiling was previously 35 per cent for ATP (the Labour-Market Supplementary Pension Fund)/LD (the Employees' Capital Pension Fund) and 40 per cent for life insurance companies and pension funds. With effect from the 1998 fiscal year it will be harmonized at 50 per cent. The effect of this relaxation depends on whether the previous ceiling was actually binding. In recent years institutional investors have increasingly preferred placement in shares. However, for professional pension funds and especially life insurance companies the proportion for shares has generally been far below the previous ceiling of 40 per cent, cf. Chart 1. At the end of 1997, only 21 per cent of the pension funds and life insurance companies had share placements exceeding 34 per cent, while 66 per cent had less than 30 per cent placed in shares. ATP and LD on the other hand were to a greater degree bound by their equity investment ceiling since their share placements at end-1997 were respectively 33.5 and 33.3 per cent. Both have stated that they are unable to purchase new shares without first selling off from their existing portfolios. For life insurance companies and pension funds the equity investment ceiling is negatively delineated in the sense that under the new rules they are required to place at least 50 per cent of their provisions in gilt-edged securities. The remaining 50 per cent may be placed in e.g. shares.

7 71 Chart 1 Proportional shareholdings of pension funds Between 30 and 34 per cent 13 per cent More than 34 per cent 21 per cent Less than 30 per cent 66 per cent Source: Statistics reported to the Financial Supervisory Authority at end-1997 by life insurance companies and pension funds. The raising of the ceiling is therefore in the first instance assessed to be of significance mainly to ATP and LD, but to some extent also to the professional pension funds. The less than full utilization of the equity investment ceiling among the life insurance companies and the professional pension funds can to some extent be attributed to the fact that they offer a guaranteed minimum yield which under certain circumstances could result in low risk investment strategies. In view of the tendency in recent years of a narrowing of the differential between guaranteed and market interest rates it is in the pension funds and life insurance companies' interest, all other things being equal, to make less risk-oriented investments. Against the background of the higher short-term risk on equity investments the institutions might therefore wish to limit the proportion of shares in their portfolios. The transition to mandatory booking at market value is expected to reduce the incentive to invest in shares since price fluctuations will affect the book value of equity to a greater extent. Particularly in the short term shares show greater price volatility than bonds, so the risk of eroding the underlying capital will increase with the proportion of shares in the portfolio. The transition can therefore lead to a more prudent investment strategy on the part of ATP, LD and to some extent also the professional pension funds. In contrast to life insurance companies they have so far normally based book values on a cost method. The impact on the investment strategy is expected to be most pronounced for the less wellconsolidated institutions.

8 72 Overall the effect of the Whitsun package on the proportion of shares in the portfolios of institutional investors cannot be clearly determined. This is partly because the consequences of the share tax depend on investors' expectations of the future level of interest rates and inflation, and partly due to the offsetting effects of the higher equity investment ceiling and the now mandatory booking at market values. Effects on central-government revenue Had the real-interest tax been retained, there would be prospect of a falling tax rate in the coming years as a consequence of the low real interest rate. The tendency of a falling tax rate, and thereby declining revenue, already began in 1994, cf. Chart 2. The transition to a fixed nominal tax rate of 26 per cent will eliminate this uncertainty. Moreover, the introduction of the share tax is on average expected to make a positive contribution to revenue. At the same time, however, the transition from valuation of the taxation base according to a realization principle to valuation at market prices (the stockpiling principle) will entail that changes in interest-rate level and share prices will have a direct impact on revenue. Central-government re- Chart 2 Revenue and real-interest-tax rate, Kr. billion 20 Per cent Revenue (left-hand axis) Tax rate (right-hand axis) 10 Source: Report on Tax Policy and the Budget Review of the Ministry of Finance, October Note: Revenue is calculated excluding the Social Pension Fund. The statistics for 1998 and 1999 are estimates.

9 73 venue in individual years will therefore be far more sensitive than before to fluctuations in stock-exchange prices. The development in share prices since the share tax came into force on June 2, 1998 has thus caused the central government to lower its estimate of revenue from the real-interest tax (including the new share tax) in The Budget Review of the Ministry of Finance of October 1998 states estimated revenue from real-interest tax in 1998 at kr. 3.4 billion less than in the last assessment in August. Total real-interest-tax revenue is expected to be kr billion (kr billion including the Social Pension Fund) in The reason for the downward adjustment of the revenue estimate is not only the decline in share prices since the share tax came into force, but also the access to transfer the tax deduction entitlement between bonds and shares. This entitlement may contribute to further fluctuation in revenue. In order to give an impression of the potential revenue fluctuation an example is given of the possible probability distribution of central-government revenue. This example is explained in further detail in Box 2. This is a simplified calculation example to indicate the consequences of the transition to valuation based on market prices. Two conclusions can be drawn from the estimated distribution of central-government revenue shown in the Chart in Box 2. Firstly, it is very likely that the central-government revenue will be close to zero in each year. This is because the valuation of the taxation base at market prices can result in a negative taxation base, generating zero revenue. Secondly, the new taxation rules can potentially generate considerably greater revenue than real-interest-tax revenue so far. On average, the revenue from the realinterest tax was kr. 15 billion in the period Strong year-on-year fluctuation can be expected in the revenue from taxation of yields on pension savings, in contrast to revenue from realinterest tax. In the period the maximum variation in the realinterest-tax revenue was just over kr. 5 billion. In overall terms the revenue to the central government from the new taxation system of a fixed tax rate and valuation at market prices, as well as a share tax, can potentially be considerably higher than the revenue from continuing to levy the real-interest tax. At the same time, the revenue will be very sensitive to market development. In years with particularly unfavourable price development the central-government revenue may be considerably below expectations. Disregarding the first years after the introduction of the real-interest tax, when the exemption ratio was of great significance because most of the exemption ratio comprises yields on savings from before 1983.

10 74 Box 2 Effects on central-government revenue - a calculation example On the basis of the historical yield on shares and bonds in Denmark a probability distribution of central-government revenue is simulated with a given capital-yield tax on bonds of 26 per cent and a share tax of 5 per cent. The starting point is the share and bond portfolios of the life insurance companies, professional pension funds, ATP and LD. At end-1997 the market value of these portfolios was calculated at respectively kr. 270 and kr. 470 billion (the 1997 Annual Report of the Danish Financial Supervisory Authority). The taxation base applied is not exhaustive, but does include the main areas. The most significant omission (apart from the Social Pension Fund) is the taxable savings schemes of the banks. In 1997 the banks contributed around 15 per cent of revenue. On the other hand, no adjustment is made for the transitional deduction concerning savings from before 1983, etc. (the so-called exemption ratio). In 1997 the exemption accounted for 20 per cent of the total taxation base. The revenue can be calculated on the basis of the historical yield, plus an expected inflation rate of 2 per cent, cf. Table 2, and assuming normal distribution of the yield on shares and bonds, with a correlation between share and bond yields of A probability distribution of this revenue can thus be generated by withdrawing a large number of related yields from the distribution. The average revenue in the described distribution is almost kr. 8 billion. However, the calculation of revenue takes into account that it is possible to subtract a negative taxation base for e.g. the share tax from the taxation base for the capital-yield tax. This gives a higher average revenue, since observations with negative revenue count as observations with zero revenue. After this adjustment the average revenue amounts to kr. 12 billion. The calculation is based on one year without taking into account that a negative total taxation base can be carried to the following tax year. The probability of low revenue is therefore probably underestimated. Per cent 35 Probability distribution of central-government revenue > Kr. billion Note: The first column includes a revenue of exactly zero.

11 75 Summary The Whitsun package entails significant adjustment of the principles for taxation of pension savings, which will affect the behaviour of institutional investors and thereby the capital market. Price-setting on the Danish bond market will become more efficient and use of derivatives in risk management will be more attractive to institutional investors. Due to the counterbalancing effects involved it is not possible to clearly determine the impact of the amended framework for investment on proportional shareholdings. In view of the transition to market values the new taxation system will entail greater revenue fluctuation.