How the retirement contribution deduction perpetuates inequality in South Africa

South Africa’s inequality has not changed in ten years, with the wealthiest 10% holding 86% of the country’s total wealth. Yet there is still a tax policy that contributes to maintaining inequality. Treasury has the potential to address this in the upcoming 2026 budget announcement. Will they do it? 

In 2022, R266 billion was deducted from the taxable income of individuals, and the vast majority of the deductions, R177 billion or 67%, were provided to high-income individuals who earn more than R500 000 per year. The most deductions (84%) are in the form of retirement fund contributions, with an average deduction of R60 241 per person. As you can see, this is not a small change we’re discussing. However, there is evidence that the retirement fund contribution deduction is poorly designed and can easily be improved. 

The current design of personal income tax deductions disproportionally benefits those with higher incomes. Across all deductions, individuals with an income above R350 000 deduct 12% of their taxable income on average, while those earning less deduct significantly smaller proportions of their income - 8% for those earning between R70 000 and R350 000 and 4% for those earning less than R70 000.

Unlike the medical tax credit, contributions to retirement funds are a tax deduction, deductible from taxable income. There is an important difference between a tax credit and a tax deduction. A tax deduction is applied against your taxable income, while a tax credit is applied against your tax liability. Deductions benefit those with higher effective tax rates (i.e. those who earn more) more than others, while credits benefit everyone equally. 

Under the current structure of the retirement contribution tax deduction, the higher your income, the larger the proportion of the retirement contribution that you make that you can deduct from your tax liability. So the same contribution does not lead to the same tax benefit. 

For example, if Isla earns R800 000 a year and Sophia R200 000, and they both contribute R48 000 toward a retirement fund, Isla will save R18 720 in taxes while Sophia will only save R 8 640.

This illustrates how the current structure of the retirement contribution tax deduction benefits higher-income taxpayers disproportionately, and therefore contributes to exacerbating inequality. However, the solution is simple. It can be changed to a tax credit. 

This may sound like an insignificant change, but it would significantly help the middle class in their attempts to save for retirement. The change to a credit would increase what low-middle earners get back from Sars when they contribute to a retirement fund, while decreasing what higher-earning individuals will get, levelling the playing field. 

How exactly will this work?

Professor Ada Jansen from Stellenbosch University researched the possibility of changing the deduction to a credit at a conversion rate of 26% (or the second tax bracket). This means that everyone will get 26% of the amount they contribute to a retirement fund deducted from their tax liability. Equal contribution will get equal deduction, regardless of income. 

Under such a design, Isla and Sophia would both save R12 480 in tax due to their contribution to a retirement fund. 

What about negative consequences?

Some may say that this will decrease how much high earners will save for retirement, leading to negative consequences. The current allowable retirement fund tax deduction is the lesser of R350 000 per annum, or 27.5% of taxable income. But it is rare for individuals to deduct the maximum allowable amount. Given that very few individuals contribute the maximum allowable amount, it is possible that the reform would not cause large decreases in savings. In addition, although these incentives aim to encourage retirement savings, several studies suggest that tax incentives don't lead to increased new savings, but rather a change in where savings are placed. Finally, even if the reform shifts behaviour, any reduction in contributions from high earners might be offset by increased participation from the middle class - a group for whom retirement security is more critical.

Why not just scrap the retirement contribution deduction completely?

Given that the retirement contribution deduction contributes to exacerbating inequality, there have been calls to remove this deduction for high-earning individuals. However, this poses a double taxation problem, as retirement fund benefits (the payments you receive while you’re retired) are taxed. Therefore, a complete elimination of the deduction, while possible, would also require additional policy changes in the way retirement benefits are taxed, to avoid double taxation.

An easy solution is possible

Given that a similar reform was made to medical aid deductions, this reform should be administratively and politically possible. In addition, the reform would collect R23 billion additional revenue per annum, which would provide a significant contribution to domestic resource mobilisation. In the most unequal country in the world, any policy that contributes to exacerbating inequality must be swiftly addressed. 

A simple change in the design of the retirement contribution deduction would make it fairer and equal. For more information on this research, see the AIDC’s briefing paper How Pension Tax Breaks Deepen Inequality and their new report Tax in the World’s Most Unequal Country.

* Van Biljon is the tax justice officer at the Alternative Information and Development Centre (AIDC).

** The views expressed herein are not necessarily those of Personal Finance or Independent Newspapers.

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