Taxes and pensions.

1. Introduction

When I was a young economist, I thought methodology was uninteresting and unnecessary--just something old guys did when they didn't have anything better to do. I taught theory and public finance, and the applied theory I did was with an eye on relevance for policy questions; although, I had had almost no experience with thinking about policy--just a summer job with the Council of Economic Advisors under President Kennedy. Now that I am at a stage where methodology is age-appropriate, I think it is important.

Some of this comes from the natural aging process, and some comes from my extended involvement in various policy processes, primarily about pensions, not taxes. In particular, I am concerned that too many economists take the findings of individual studies literally as a basis for policy thinking, rather than seeking inferences from an individual study to be combined with inferences from other studies that consider other aspects of a policy question, as well as with intuitions about aspects of policy that are not in the models. To me, taking a model literally is not taking the model seriously. It is worth remembering that models are incomplete--indeed that is what it means to be a model. We construct multiple models to highlight different aspects of an issue, so, thinking thoroughly about policy calls for thinking through multiple models, and requires recognizing issues that have not made it into any of the available models. My focus here is on the connection between basic research and policy advice, particularly basic theoretical research. The argument for using multiple models to gain insight and understanding is not new and was stated clearly by Alfred Marshall. (1) Previous research (Banks and Diamond 2009) considered methodology more thoroughly as part of considering the taxation of capital income from the perspective of alternative theoretical models. This article draws on that essay, after contrasting tax policies and public pension rules, along with the normative modeling of the two. This contrast struck me when thinking back on some of the differences between the tax paper and the book on pensions (Barr and Diamond 2008) being written at the same time.

2. Policy

Contrasting pensions with taxes on earnings, two elements stand out--(i) Pension benefit determination depends on individual history far more than taxes do, and (ii) Age plays a much larger role in pension determination than in tax determination. Pension benefits are typically related to a lot of an individual's history; for example, the best 35 years of indexed earnings in the United States, and sometimes a complete history is taken into account (as in Germany and Sweden, for example). This holds for earnings-related pensions, both defined benefit and defined contribution. Even noncontributory pensions typically depend on years of residence. For example, the Dutch National Old Age Pension (AOW) gives a full pension on the basis of 50 years of residence between the ages of 15 and 65 and is reduced proportionally for years of non-residence. The New Zealand Superannuation is subject to 10 years of residency after the age of 20 and at least five years of residency after the age of 50. A full Swedish Guarantee pension is available after 40 years of residence in Sweden after age 25, also with proportional reduction for fewer years of residence. The Guarantee pension is reduced based on 18/16.5 times the benefits received from Sweden's notional defined contribution (NDC) pension, the Inkomstpension, which, in the nature of NDCs, is based on lifetime covered earnings. (2) In contrast, taxation of earnings is focused on earnings within a single year; although, some averaging over a few years has sometimes been allowed (and capital gains taxes depend on a cost basis from the time of acquisition).

As for the role of age, not only do pension rules vary significantly by age, but also the age-related rules often vary by date of birth. Taking the United States as an example, retirement benefits can be claimed after age 62 but not before. Retirement benefit claims are subject to an earnings test before the age for full benefits but not after. And the monthly benefit for a given earnings history depends on the gap between the age at which the benefits start and the age for full benefits. In contrast, age plays a small role in earnings taxation of adults. For example, in the United States there is an additional standard deduction amount ($1,050 in 2008) for a taxpayer over the age of 65. In the United Kingdom, the personal allowance of 6,035 [pounds sterling] (for the 2008-2009 tax year) becomes 9,030 [pounds sterling] for those 65 74 and 9,180 [pounds sterling] for those aged 75 and older (but subject to an income limit).

The age for full Social Security benefits in the United States is in transition from 65 to 67, varying with date of birth (see Table 1). Similarly shifting age rules by date of birth have occurred with pension reforms in other countries. This is consistent with the common expression that a good pension system should not be significantly adjusted too often (beyond its automatic indexing) and should be changed with enough lead time for workers to adjust their voluntary retirement savings. In contrast, legislated tax changes often vary by year.

Pension systems use indexing to limit the frequency of needing to adjust rules. There is widespread indexing to prices and/or wages and, in some systems, for a life expectancy measure (NDC systems as in Sweden) or for a dependency ratio (as in Germany). Moreover, the indexing might work differently for workers with different dates of birth. In the United States, wage indexing of earlier earnings up to the year of turning 60 implies that the wage indexing is done differently for workers with different birth years, (3) On the tax side there is indexing of bracket end points for prices in the United States but no adjustment for how inflation hits capital and labor incomes differently (Diamond 1975). Table 2 identifies four aspects of differences between pension and tax policies.

Interestingly, there have been recent calls for significant variation of earnings taxes with age in contrast with the minor variations that sometimes exist. (4) An age-varying tax structure appears administratively feasible and does not add an undue complexity to compliance and enforcement in advanced countries. And it does not appear to violate intuitive fairness measures; although, the transition to such a system might raise some issues of intergenerational fairness. Note that these issues, administration, complexity, and perceived fairness, are missing in the typical model of equilibrium used for tax analyses. Yet they matter for making use of the insights from those models. I favor greatly expanding analyses of how age-varying earnings taxes might be done, but that is not the subject of this article.

The work of Vickrey (1947) on income averaging notwithstanding, a considerably larger reliance on earnings histories for earnings taxation, much less lifetime reliance, as is common with pensions, appears to go strongly against the grain of the history of discussion of income taxation. (5) For example, Adam Smith (1937) writes of basing taxation on revenue, with no mention of a longer time span. (6) And two centuries later the Meade Report (Meade 1978) viewed taxable capacity as the starting place for income taxation (7) and discussed the competition between total income (Schanz-Haig-Simons income (8)) and consumption as the better measure--again considering annual measures, although arguing that consumption reflects lifetime considerations.

As noted above, a good pension system is thought to be significantly adjusted infrequently (beyond its automatic indexing) and changed with enough lead time for workers to adjust their voluntary retirement savings. No one says anything like that about annual budget expenditures. These are expected to adjust to developments on a nearly continuous basis, for example, with the outbreak of a war or risk of a recurrence of the Great Depression. And adjusting taxes along with spending is seen as important for the politics of spending and taxing, as well as part of a sensible response to changes in a country's economic, political, and spending-needs environments. Yet considerable continuity is considered good policy. The Meade Report (Meade 1978) calls for taxes that reflect a concern for both flexibility and stability:

A good tax structure must be flexible ... In a healthy democratic society there must be broad political consensus--or at least willingness to compromise--over certain basic matters; but there must at the same time be the possibility of changes of emphasis in economic policy as one government succeeds another....

But at the same time there is a clear need for a certain stability in taxation in order that persons may be in a position to make reasonably far-sighted plans. Fundamental uncertainty breeds lack of confidence and is a serious impediment to production and prosperity. (Meade 1978, p. 21)

An interesting question to muse on is why these policy institutions are so different--and I have not gone beyond musing. Complexity of the world and of analyses makes it natural to approach these areas separately. Whether thought of in terms of politics or in terms of policy analysis, "framing" seems to be a key issue in how these areas have developed. How one starts thinking about an issue can affect how one finishes thinking about an issue (anchoring). Thinking about tax policy starts as thinking about revenue needs in the short term and recognizing that revision of spending and taxes is expected in the following year and that substantial revision may occur after the next election. While thinking about pensions includes concerns about the current benefit recipients, the focus is on rules that affect current workers (as both taxpayers and future benefit recipients) as well as current beneficiaries. And the political process in the United States has been designed to incorporate long-run concerns through annual reporting of 75-year projections and legislative rules that tend to separate Social Security legislation from the annual budget cycle. The link between benefits and previous earnings subject to tax affects perceptions of fairness and political legitimacy. While the annual spending and taxation process has great inertia, this comes more from the political process than from an underlying argument that the process should have great inertia. Although some of the support for transition rules, including grandfathering, argues for a legitimate role for some inertia. Pensions are focused on a single long-run concern, acquiring adequate retirement income, while stability in tax policy matters for a large and diverse set of decisions where "reasonably far-sighted plans" matter.

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