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Means-tests are taxes

09 Feb 2012

Means-testing can act as a tax on older people and their familiesA typical reaction to universal pensions is "That's a great idea, but we can't afford it, so prefer to give pensions only to those who need them". This reaction appears to be common sense, but it is wrong. Means tests shift costs, but do not lower them because means tests are taxes on income or assets. They are paid by elderly citizens and, sometimes, their families. It is more efficient to fund basic pensions with general taxes paid by everyone. All taxes, with the exception of lump-sum taxes, distort choices. Of particular concern are taxes that discourage work and saving. Low taxes levied on an entire population are less distorting than high taxes levied on the elderly.

This is the efficiency argument for universality. It is valid even with costless and perfect targeting, with no stigma, no exclusion errors, no erosion of political support. It is a simple argument, yet often ignored because means tests are usually recorded as expenditure reductions rather than as tax collections. Framing is important.

It is important to recognize that, even though universality is optimal, all means tests are not equally bad. Clear, simple rules are preferable to complex regulations that leave discretion to government bureaucrats. Rules matter more than whether the number disqualified by targeting is small (an ‘affluence test’) or large (a ‘means test’?). The term ‘affluence test’ is imprecise and adds nothing to our understanding of means tests.

Targeting as tax

To show that means tests are taxes, even when disguised, we examine typical tests. Our base scheme is one in which everyone who reaches a specified age has a right to a pension, regardless of income, wealth or employment history. The cost of this pension is the number of beneficiaries times the size of the pension, plus administrative expenses.

Governments sometimes include benefits in taxable income, lowering the net fiscal cost. This is a very mild means-test, one that ensures that pensioners and non- pensioners with equal incomes pay the same tax. The test is simple, and has a ‘fairness' rationale. But it does penalise paid work by the elderly if the taxable pension moves them to a higher tax bracket.

The next test to consider is the pension test. Anyone with other pension income receives a smaller basic pension or none at all. A pension-tested benefit is a "universal minimum pension". The test is a tax on other pension income, which discourages participation in earnings-related schemes. For this reason it is seldom applied to benefits from voluntary pensions.

A broad income test is also possible, and is equivalent to a tax surcharge on earnings and savings of the elderly. The test works best when integrated with the income tax system, clawing back the basic pension from all other income. Canada, for example, claws back its basic pension at the rate of 15%, after a large ‘exempt' amount. Any basic pension left after clawback is taxed as ordinary income.  This test is a tax surcharge on retirement savings and on earnings of those who continue to work beyond the state retirement age.

Finally, a comprehensive test of income and assets is common, especially in low-income countries. Such a system, Amartya Sen (1995) wrote, "rewards cheating and penalizes honesty". I would add that it also facilitates corruption. Even when well administered, the test discourages work beyond retirement age and saving for retirement. The United States basic pension (SSI), for example, provides maximum benefits of $698 a month. SSI rules are stringent. To be eligible, a person cannot own assets (real estate, bank accounts, cash, stocks and bonds) worth more than $2,000.  Benefits are reduced 50 cents for each dollar of wage income (after $65 a month), and dollar for dollar for other income (after $20 a month). Elderly pensioners living in poverty are subjected to high taxes (clawbacks) on incomes that attract no tax at all for non- pensioned workers.

In developing countries, means tests typically consider the income and assets of entire households, even of adult children who live independently. Small pensions intended for households in poverty represent a small, lump-sum tax on those above the cut-off point for benefits. With the heroic assumption of perfect targeting at no cost, this tax might be relatively efficient (resulting in little effect on choice), but it is ineffective in providing income security.

What does this mean for means-testing?

Means tests can help finance basic pensions, but we should not ignore their consequences. Almost always, general taxation is a better option.

About the author

Larry Willmore is a research scholar at the International Institute for Applied Systems Analysis.

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Larry Willmore

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