Taxation of life-cycle savings Essay Example | Topics and Well Written Essays - 2000 words

Taxation of life-cycle savings - Essay Example Further, 25% lump sum can be withdrawn from pension funds tax free (Lymer & Oats, 2013). Due to these treatments, most of the savings in the UK are made in pensions, housings and ISAs. They discourage savings in all other forms and put limitations on economic activity. Further, the current tax laws are complex. According to the current system, neutrality can neither be achieved over time nor across assets. It discourages people from saving because the present value of their income increases. They become better off spending their income now than later. Also, this system does not take inflation into account. The returns on savings are taxed on nominal returns. Therefore, tax on returns on savings actually increases with a rise in inflation rate. Further, the phenomenon of compound interest reduces the effective rate of return and its reducing effect is directly proportional to the passage of time (Mirrlees et al., 2011). Adam Smith (1776) proposed four canons of taxation for an optimal tax system. These canons are: ‘Equity, Certainty, Convenience and efficiency’ (Lymer & Oats, 2013, p.43). Economic efficiency relates to fiscal neutrality which refers to an ideal tax condition which does not ‘distort the economic and commercial decisions made by individuals’ (Lymer & Oats, 2013, p61). The concept of neutrality demands that people’s choices should not be distorted. However, in standard income tax, neutrality is foregone both over time and across assets. The current system makes people prefer investing in pension funds and ISAs but discourages saving through other opportunities as it taxes them at a higher rate. Further, it actually subsidises investing in a pension fund as it allows a tax free withdrawal of a lump sum. This discourages people from taking risks and limits economic activity. It also defeats the prospects of achieving neutrality over time. This system treats capital gains differently