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...longer work more rewarding many seniors.
The Study in Brief
While income-security arrangements for older Canadians have greatly reduced poverty among their recipients, the means-testing provisions of many of these programs reduce the rewards from work and saving for many seniors and near-seniors. One acute problem arises from the interaction of the rewards the Canada and Quebec Pension Plans (CPP/QPP) provide for later retirement, and the clawback provisions of the Guaranteed Income Supplement (GIS).
CPP/QPP retirement benefits are 0.5 percent higher for each month the recipient delays commencement, and 0.5 percent lower for each month the recipient brings it forward. This provision aims to reward later retirement. But the GIS, which operates outside the tax system, reduces its benefit by 50 cents for every dollar of outside income (other than Old Age Security). This provision aims to target the benefit to those most in need. By adding a 50-percent clawback to other taxes recipients face, however, the GIS makes longer working life much less rewarding for modest-income Canadians.
While the impact of high taxes on work effort generally is a matter of debate, the net effect of the GIS clawback is likely to induce older workers to retire earlier. The clawback of the GIS with higher CPP/QPP payments and earnings can account for a reduction of as much as 11 percent of potential work between the ages of 60-69 for some groups of Canadians. Those affected are, by definition, at the lower end of the income scale--people for whom a few more years of work would provide a welcome boost to their standard of living in retirement.
One solution to this problem would be to shelter the actuarial adjustment in CPP/QPP payments from the GIS clawback. The calculation of income for the GIS clawback could, for example, assume that the recipients CPP/QPP income was whatever the recipient would have been entitled
to had he or she commenced receipt at age 60. This solution would reward work better and also ensure that no one receives lower GIS payments under the reform.
The pace of change in Canada's public pension policy has abated following a flurry of reforms in the 1990s. This slackening may result from success: the 1998 reforms of the Canada and Quebec Pension Plans (CPP/QPP) delivered long-term stability for future contribution rates, albeit at the cost of substantially higher contributions and a slightly reduced pension benefit. Meanwhile, on another important front, poverty among Canada's elderly has diminished greatly over the past generation./ Compared to the severe public pension problems most other member countries of the Organisation for Economic Co-operation and Development (OECD) are experiencing, Canada is in a relatively strong position.
Notwithstanding these accomplishments, Canada's income security system exhibits some flaws. One common critique, advanced by Shillington (2003) and Poschmann and Robson (2004), concerns the impact of income-tested benefits, such as the Guaranteed Income Supplement (GIS), on incentives to save. Because extra income reduces GIS benefits by 50 cents on the dollar, low-income Canadian seniors who receive this benefit face extraordinarily high implicit tax rates on the return to their savings.
Beyond their effect on savings, high implicit tax rates also influence the labour market decisions of older workers. Because earned income decreases the GIS income-tested entitlement, older Canadians receiving the supplement have stronger incentives to retire earlier than they otherwise would. In simulations, I compared retirement decisions under the actual system with those in a "neutral" system with no financial incentives to retire early, and found that work after age 60 for low-income males decreases by about half a year because of the distortions imposed by Canada's income security system. The system encourages retirement too early with too little pension income. It is particularly striking that this problem hits low-income seniors the hardest--precisely those who may want to work a few more years in order to buttress their retirement well-being.
As a partial solution to the problem, I propose that the GIS be expanded in a way that improves work incentives. The GIS should allow exemptions that remove the distortions imposed on low-income workers and that encourage them to stay in the labour market until their pensions reach a desirable level.
In this Commentary, I first explain why work disincentives for older workers present an important policy concern. I then detail the exact mechanisms that generate the work disincentives, and I demonstrate the magnitude of these effects. I close with the details of my proposals for reform of the GIS and an assessment of different options.
The Nature of the Problem
The long-run trend in labour force participation among older Canadian men is down, as Figure 1 shows: for males ages 65 and older, the participation rate dropped from 47.5 percent in 1946 to 11.8 percent in 2004. In contrast, the participation rate of women in that age group has remained low and relatively flat. Although there has been a recent upsurge in labour participation among those 60 to 64 years old, today's male elderly Canadians are working less than did their fathers.
[FIGURE 1 OMITTED]
The trend toward earlier retirement has important implications. (2) When an individual stops working earlier, the annual pension income he receives for the rest of his life typically will be smaller than if he had retired later. Earlier retirement means that the build-up of savings stops sooner and that existing savings must be stretched over more years. As well, actuarial reductions imposed on the pensions of those who retire early might reduce their income from both public and employer-provided pensions. Furthermore, the economy as a whole loses a worker and the government loses the worker's tax payments on employment income. On the positive side, earlier retirement allows the individual the obvious benefit of more leisure time to pursue other activities and to rest after a life's work. The timing of retirement, therefore, is a tradeoff between more income and more leisure.
Should this decline in labour market activity by older male Canadians concern policymakers? If the decline reflects older Canadians' undistorted choices about the right mix between income and leisure, then there is no obvious role for policy--after all, the goal of Canadians is surely not to work for as long as they can, but to maximize the enjoyment they glean from life. If Canadians' enjoyment is maximized by their retiring earlier, then government should not interfere. Evidence strongly suggests, however, that part of the decline in labour market participation by older Canadians is the result of disincentives to work contained in public pension plans. To the extent that this is a factor, increased retirement reflects not the older individual's undistorted decision to trade off higher income for a longer retirement but a choice from a distorted set of options imposed by policy. (3)
The international literature on public pensions and retirement is extensive. One of the most interesting recent studies is Gruber and Wise (2004), who compare the effect of public pensions on retirement behaviour across 12 OECD countries by focusing on two effects. The first is the rather obvious one that the greater the total retirement income an individual receives, the more leisure time he or she can afford; the capitalized value of this future income therefore influences the retirement decision through a "wealth" effect* The second effect is that the rate at which one earns the right to a higher pension income also affects the retirement decision* If working an extra year increases future retirement income, then there is an incentive to work longer* On the other hand, if working an extra year causes a decrease in future retirement income, then there is an incentive to retire earlier. Because the rate of public pension accrual affects the retirement decision, this is known as the "accrual" effect.
In the Canadian context, Baker, Gruber, and Milligan (2003a) find evidence for both the wealth and the accrual effects. For example, it appears that changes in the structure of the public pension system might account for around 20 percent of the increase in male retirement between 1985 and 1995. The effect is strongest among those with the lowest lifetime earnings--that is, those who are most likely to receive the GIS. In another study, Pollock and Sargent (2004) run simulations showing that removing the...
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