Tax rise may be a saving grace for our pension pots

PEOPLE in rich countries are getting older. This means that pensions will be a greater burden than they have been in the past, something that will create all sorts of problems depending on the way they are paid out.

In continental Europe, pensions are mainly paid for through social security contributions deducted from the pay packets of people who are still working. As the number of pensioners rises and the number of workers goes down, this situation becomes hopeless. The contributions shoot up and employees receive less in their pay packets.

This is most discouraging and in increasing numbers people either give up work or move into the black economy. This is one reason why unemployment is so high in Europe.

One answer to this is to pay pensions from general taxation rather than social security contributions. This eases the problem a bit as the elderly make a greater contribution to their own pensions. But it is only a palliative. Most pensions are linked to wages and higher taxes push these up through higher inflation.

Another answer is to opt for funded pensions, which has been the private sector's answer in the US and Britain. This means saving now to pay pensions later. This can help if the savings that come from funding lead to faster growth in gross domestic product. Higher pensions can then be paid without cutting the take-home pay of those still working.

Even if faster growth is not generated, the increased amount of savings can still help. It can, for example, replace the flow of savings from abroad. This means that the balance of payments will improve and we will have a lower current account deficit.

THERE is, however, a big risk that the rise in savings created by funding pensions will be at least partially offset by a fall in Government savings, which is the same thing as a rise in the budget deficit.

This can easily happen because savings are taxed much less than consumption. The British Government does not tax most savings. But through income tax and VAT it takes about 40% of the money we spend. With national insurance, the figure can be even higher.

The result is that Government revenue from tax can change a lot, without any change in tax rates or GDP. If we have a greater amount of savings, tax rates will have to rise sharply just to generate the same revenue as before.

Everybody is talking about tax rates going up just to meet the rise in Government spending. Sadly, this is only half the story. In Britain, the problem we face is simple. The contributions made to company pension schemes have been too low for many years. This was disguised by the stock market bubble of the late 1990s, but is now obvious.

As the amount of savings has been too low it will have to go up if retired people are going to have decent pensions. But if savings must go up, so must tax rates.

www.smithers.co.uk