The Taxation of Policyholders' Life Insurance Income

Canadian Public Policy

The Taxation of Policyholders' Life Insurance IncomeAuthor(s): Norman CameronSource: Canadian Public Policy / Analyse de Politiques, Vol. 3, No. 2 (Spring, 1977), pp. 129-140Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3549530 .

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The Taxation of Policyholders' Life Insurance Income

NORMAN CAMERON */Department of Economics, University of Manitoba

In 1969 the federal government ended the largely tax-exempt status of policyholders' life insurance income. The actual taxes imposed reflected a mixture of the sweeping Carter Commission proposals, the industry's protests, and considerations of administrative convenience. The resulting incidence of the taxes, while an improvement over the previous system, still makes little sense in terms of equity or efficiency. The companies' marketing strategy with RRSPs suggests that life insurance protection should no longer be allowed to serve effectively as a source of tax shelter; and the provincial premium taxes of two per cent should also be reconsidered.

En 1969 le gouvernement abrogeait l'exemption d'imp6t des assures sur leurs revenus d'assurance-vie. Les impbts que etaient imposes refletaient un melange des proposi- tions draconiennes de la Commission Carter, des protestations de la profession, et des considerations de facilite d'application. Dans ses repercutions l'imp6t tout en re- presentant une amelioration du systeme precedent continue a etre ni equitable ni efficace. La strategie de marketing utilisee par les compagnies pour la vente des Plans d'Epargne de Retraite Enregistres montre qu'il ne devrait pas etre permis que la protection d'une assurance-vie serve en fait de refuge pour eviter de payer des imp6ts; et l'on devrait reconsiderer l'imp6t provincial de 2 pour cent sur les primes.

'It is essential as well, I believe, in terms of equity between those who save in the form of insurance policies and those who save in other forms, to levy some tax on the investment income which policyholders receive through the insurance companies ...' (Canada, House of Commons, 1968: 1686). With these words Finance Minister Benson introduced two new taxes which ended the largely tax-exempt status of life policy income in June of 1969.

The actual taxes imposed reflected a mixture of the sweeping Carter Com- * The author is grateful to John Gray and two anonymous referees for helpful comments, while

retaining responsibility for remaining errors. Part of the research reported was financed by a University of Manitoba Research Grant.

CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, 111:2

spring/printemps 1977 Printed in Canada/Imprime au Canada



130 / Norman Cameron

mission proposals, the industry's protests, and considerations of administrative convenience. The resulting incidence of the taxes is a peculiar mixed bag which makes little sense in terms of equity or efficiency, and which should be changed.

II THE GENERAL APPROACH

The starting point is therefore the definition of the income which policyholders do receive through ownership of a life insurance policy. For this purpose it is useful to conceive of a life policy as a peculiar but convenient form ofjoint product. In part it offers a stream of 'pure insurance protection,' defined as the right to collect a total amount equal to the policy's face value in the event of death. This is probably the major component for most customers, for whom it would provide a feeling of greater financial security for as long as they are still alive.

The other part of the joint product occurs as a by-product of the unique level-premium payment method devised by actuaries in the last century to get around the problem of mortality rates which increase exponentially with age. Briefly, the level premium method flattens out the usual rising pattern of term insurance rates by charging constant premiums which are therefore higher than the pure costs of insurance protection in the early years of the policy and lower than those costs in the later years. The cost of pure insurance protection (hereafter referred to simply as the cost of protection) is defined in this paper to be the amount levied from the premiums of the surviving policyholders during any year to help pay the death benefits of the policyholders deceased during that year. It will depend not only on mortality rates for the group of policyholders, but also on what is known as the 'amount of risk' to the company for those policies, the difference between death benefits due to the deceased and all amounts of policy reserves accumulated against the policies of the deceased (which can be regarded as being used first to pay the death benefits).

The extra payments in the early years are accumulated to back up the policy reserve against those policies, and it is the interest earned on the investment of these funds which is used both to help defray the higher cost of protection in later years and to continue to back up the accumulation of survivors' policy reserves to the full endowment value of the policy at maturity. Since these accumulating policy reserve amounts are vested in the policyholder and can be used as collateral or withdrawn almost completely upon termination as the cash surrender value, the life insurance policy provides an accumulating asset; thus it is simultaneously a savings medium.

On the basis of this conception of a life insurance policy, which has not gone unchallenged in North America (see Mehr, 1975), the income which policyholders received through ownership of their policies is the stream of interest accruals on the funds backing up their accumulating policy reserves. This can be defined also as the total increase in the policy reserve for each policy, less all principal amounts contributed to that policy reserve out of premiums (and less payments to cover investment expenses of the company, which are ignored in what follows). Where the current cost of protection plus



Taxation of life insurance income / 131

the company's insurance expense margin are less than the premium paid, such principal contributions will be positive; where the opposite is true, the principal contributions will be negative and some of the interest accrued will in effect be used to defray current protection costs instead of to build up the policy reserve.

Payment of dividends on participating policies, which represent 90 per cent of Canadian ordinary life insurance business, presents only a small problem. They can be regarded essentially as ex post premium rebates, returned ex post because it is only then that the insurer knows the actual protection costs, administration expenses, and total investment income earned. The definition of net gain on policy reserves should be revised for these policies to be the total increase in policy reserve, less the sum of differences between each annual premium net of dividends and the annual cost of protection for the policy. In practice, the cash surrender value is a fairly good proxy for the policy reserve, after about the tenth year of any policy, and the two terms are often used synonymously.

III THE 1969 AMENDMENTS TO THE INCOME TAX ACT

Instead of having each company and each policyholder calculate the net increase in the cash surrender value and the net principal contribution in each annual premium, in order to report the residual as personal interest income, the government 'worked out a much simpler and more practical method' which was to achieve 'substantially similar equity.'" This method involves two separate taxes, one on investment income in the

hands of the company and the other on any residual net gain in the hands of the policyholder. The first is a flat 15 per cent withholding tax levied on the investment income of the company each year after various deductions for expenses and for several blocks of excluded insurance business.2 The second tax is levied on the individual policyholder at either his marginal personal rate or his average personal rate for the previous three years, and it is levied on the net taxable residual gain he has made (through interest accrual) at time of surrender or maturity of the policy. To reimburse the company for the tax which was withheld in advance from its investment income, the company is also allowed to deduct from its investment income the total of any net taxable residual gains which policyholders have made on policies terminated during the year by surrender of maturity; the company therefore effectively gets a 15 per cent rebate on all such amounts.

This method has the advantages of taxing the policyholder only on realization and not on accrual, and yet giving the government some of its revenue on accrual without waiting for policy gains to be realized. In addition, it does not

I (Canada. House of Commons, 1968-69:I687). For further details of these taxes, the reader is referred to Whaley (I970), whose treatment has been of great benefit to this section. The taxes

adopted are similar in parts to a compromise proposal included in an appendix to the Carter Commission Report (Canada. Royal Commission, 1966:2:585-590).

2 The legislation provides exemptions for the investment income attributable to pre-1969 non-

participating policies, registered retirement savings plans, registered pension plans, and also for that part which accrues to the shareholders.




require the companies to report annually exactly how much of each premium payment of each policyholder has been added to the cash surrender value as a savings contribution and thus avoids a significant administrative burden. Furthermore, in a long-run no-growth state with zero mortality, the government would collect all of its revenue directly from the holders of terminating policies at their personal rates as of that date, and none from the company at the flat withholding rate: cumulated residual net gains on policies being terminated would fully offset the annual investment income of all policies combined. Such a tax scheme would reflect the different abilities to pay of the various holders, even though only as of the date of termination. Deferment of taxes to the termination date would be at least partly compensated for by the withholding tax levied on the initial set of policies before the steady state was reached.

In practice the environment and the details of the scheme are such that taxable residual net gains on terminating policies can be used to offset only a small share of the company's investment income, so that a large remainder is still subject to the 15 per cent withholding tax; the taxable remainder is large enough that the average rate of tax on total investment income is about I I- 12 per cent.

This comes about first, because gains on policies terminated by death or disability are not taxed at all, and they account for at least 40 per cent of total accrued interest income.3 Second, when business is growing at 71/2 per cent per year, as it has on average in Canada since 19oo, the same older policies being terminated account for a smaller share of the total policy reserve amount on which current investment income is being earned. Their residual net gain accordingly offsets a smaller share of that investment income than in a situation of zero growth. A rough estimate is that the share offset is about 25 per cent smaller because of this feature.4

Third, in calculating their residual net gain policyholders treat the whole premium as savings contribution rather than just the amount left over after meeting costs of current protection and administration. This lowers the residual by at least 50 per cent (see Table I and discussion below).

With all three effects at work, the share of investment income which is not offset, and is therefore taxed at the flat withholding rate, is .4 + .6(.25) + .6(.75)(.5) = .775. The average rate of tax on investment income as a whole is accordingly .775(. 15), that is, somewhere between I I and 12 per cent. The tax is expressed this way because in fact it is spread over all policies regardless of the degree of offset they might provide upon surrender. The investment income tax is a general charge on the income available to add to policy reserves and to pay policy dividends, and there is little reason to expect extra effort by the company actuaries to shift this extra charge on to particular types

3 This estimate is based on Canada, Superintendent of Insurance (1974: I6A), assuming that the average cash surrender value of policies terminated by death is roughly half of the death benefit, and that such policies are in general of above-average age.

4 This estimate is based on an assumption of 14 years as the average duration of a policy before surrender or maturity (see Life Insurance Marketing Research Association, which produced this estimate for the us), and of a constant 20 per cent per annum growth rate in cash surrender values of any one policy.




of policy, even where the appropriate type could be recognized in advance.5 The incidence of the second tax, on residual net gains, is much more varied.

In all cases, whatever tax liability there is is postponed till termination of the policy and realization of the policy proceeds, and in all cases the average withholding tax rate of I I-12 per cent could be regarded as a 'postponement fee' charged for the tax deferment privilege.6 In all cases of termination by death or disability, however, there is no tax liability at all, so the 'postponement fee' analogy is hardly appropriate.

For those whose policies are terminated by surrender or fi?aturity the rate of tax on the total accrued interest on policy reserves varies all the way from zero to almost the holder's personal rate, depending mainly on the type and age of the policy. The explanation lies in the definition of 'taxable net gain' adopted: the difference between 'total proceeds of disposition' (i.e. the cash surrender or endowment value and any accumulated dividends) and the total premiums paid in net of any policy dividends not left in the policy in one form or another. Since the net premium's paid in include not only principal contributions to the policy reserve but also the cost of protection and the administrative expense margin for each year, the taxable net gain understates the total accrued interest on policy reserves (and dividend accumulations) by exactly the total amount of the two additional items over all years of the policy. The degree of understatement and therefore of tax shelter will depend on the size of protection costs plus expense margins relative to the total principal contributions required for the policy reserve. Endowment policies, for instance, generate much larger policy reserves per $ 1,ooo of insurance protection than do whole life policies, in which the policyholder continues payment of premiums till death or disability, and as a result a smaller share of the total of accrued interest will be sheltered from tax in an endowment policy than in a whole life policy.

Table I shows some estimates of the degree of tax shelter provided by this definition of taxable gain, for large Canadian companies and using 1972 premium schedules.'

These are particular results for particular policies and as such do not tell the whole story. Other sets of calculations have shown that the use of different companies' policies would make little difference to the results, as long as a similar average rate of return was earned on the principal contributions; the use of some other plausible assumption about the cost per thousand of insurance protection would also make little difference to these results. The use of shorter or longer holding periods has dramatic effects, though. Over ten years this method shows very little gain on savings in life insurance, as a result of heavy front-end loading and a range of early termination penalties which

5 Mehr (1975:427) seems to corroborate this. Some part of the tax could be passed on to shareholders in stock insurance companies, but the latter are so highly levered that not much of this can be done without upsetting stockholders, and market structure is not such as to force it on them.

6 The Carter Commission proposed just such a tax, at a rate of 15 per cent, to be non-creditable and non-refundable (1966:586). In allowing full credit to the policyholder and some refund to the companies when the policyholder is eventually taxed at personal rates, the government is being more generous than its Royal Commission.

7 See Schwarzschild (1967) or Belth (i968, 1969) for discussions of the calculation method used.




TABLE 1

Estimated accrued interest, taxable residual gain, and degree of tax shelter for policies of large Canadian companies, after 20 years

Taxable Accrued Cost of residual Degree of

Type of policy interest protection gain tax shelter

Whole life $2,370 $1,605 $ 765 68% 20-payment life 3,510 1,335 2,175 38% 20-payment

endowment 5,970 840 5,130 14%

NOTES:

1. The rates used for these estimates refer to a $15,000 policy issued to a 35 year old male. The dollar figures above are averages of estimates for the three largest Canadian companies for which the necessary rate data was published by Stone and Cox for 1972. 2. Accrued interest is the cash surrender value of the policy, less the accumulated (estimated) principal contributions from net premiums for each policy year. 3. The cost of protection per $1,000, including expense margins, is taken from Canada Life's 5-year renewable convertible term insurance rate structure, so mortality and lapsation and expense behaviour is assumed to be consistent with those rates. This is quite reasonable and even conservative for the large, well-diversifiedcompanies involved here.

are deducted from the cash surrender values, so that even for the 2o-year endowment policies the degree of tax shelter is almost Ioo per cent for what little accrued interest the calculation shows.

IV EVALUATION: EQUITY

A brief review of the direct impacts of the two new taxes is in order. Those policyholders who die or are disabled pay tax of around I I-12 per cent on each year's investment income on the savings in their policy, on the assumptions used above. Those whose policies mature or are surrendered pay the same tax during the life of the policy, and at the termination date they pay a deferred personal tax on all accumulated accrued interest at some fraction of their personal rate; the fraction varies between zero and one depending on the type and particularly on the age of the policy, but a simple average across all policyholders is probably somewhere between one third and two thirds.

To put these in perspective, a brief sketch of some other tax arrangements is also necessary. Elsewhere in the insurance sector, customers can arrange to defer large amounts of tax through registered retirement savings plans (RRSP's). These include provision for conversion into a lifetime annuity before age 71, and that it not be assignable. All contributions are deductible from personal taxable income up to a limit of 20 per cent of income per year (or $3,500, for the majority of taxpayers) and there is no tax on accrual of investment income. On termination of the plan all proceeds are taxable as personal income. The net effect if personal rates are the same throughout the plan is deferral of tax on accrued interest on the principal contributions, to the end of the plan. If personal tax rates fall before the plan terminates there is further saving of tax.




More generally in the financial sector, the first $i,ooo of either share dividends or interest income on bonds, mortgages, and deposits is now exempt from personal income tax each year. Capital gains income is subject to tax at half the personal rate but the tax is deferred until realization of such gains. Interest and dividend income above the $I,ooo limit is taxable at full personal rates, and there is a full offset, in the case of dividend income, for any corporate income tax paid.8 As of 1975, those who have not yet bought their first home are allowed to put up to $I,ooo per year for ten years into a registered home ownership savings plan (a RHOSP) and deduct it from their taxable income on the same basis as for an RRSP above. For these plans, however, none of the proceeds are taxable provided the funds are used to buy a home, a summer cottage, or even home furnishings.

Finally, the November, 1974 budget introduced a tax exemption for the first $ I,ooo of pension income received each year from registered pension plans or RRSP'S.

One additional tax should be mentioned here to complete this sketch of the tax system, and that is the two per cent premium tax levied by the provincial governments each year. This amounts to a sales tax, but this is the only savings medium subject to such a tax. As such it increases the front-end load on life insurance savings, but does not affect the income flow thereafter.

An appropriate definition of equity as applied to the taxes on life policies would require that policyholders pay rates of tax on their income which vary according to their ability to pay, and not on any other basis.9 The new taxes are then inequitable on a number of grounds. All policyholders bear the same annual tax burden per dollar of investment income on their policies, regardless of the level of their total income from all sources, so the rich man gets the same marginal rate as the poor man. Different policyholders pay different rates of tax on residual gains, but the differences depend only partly on their respective income levels and personal tax rates; most of the differences are due to the manner of termination, and the age and type of the policy. Similarly different policyholders are able to refer tax liability for different lengths of time, though the continuing investment income tax does compensate for this at least in part.

As between income from life insurance savings and income from savings in other forms, variety rather than equity appears to be the rule. Both capital gains income and income from residual gains on a life insurance policy are deferred until realization, and both are then taxable at a fraction of personal rates. But the fractions are very different for most policyholders, and life insurance income is also subject to a withholding tax - or tax postponement fee, as the Carter Commission would call it - whose effective rate is probably about I-I 2 per cent. Other current forms of interest and dividend income are either tax-free and subsidized at marginal personal rates under the RHOSP and

8 There is no offset for the corporation income tax levied on retained earnings, which may be regarded as compensating for the tax deferment of capital gains income.

9 The ability-to-pay definition of equity is the one that applies to such general taxes as the income tax; the benefit principle definition is an alternative but really applies only to the annual levies on the companies to support the activities of the Superintendent of Insurance; these have been ignored in this paper.




pension-income provisions, or deferred till realization without postponement fee under the RRSP legislation, or else taxed at full marginal rates. This kaleidoscope is the result of explicit social and economic policy by the federal government, and is brought in here mainly to set the earlier inequities in perspective.

Some of these differences in treatment of life policy income cannot or should not be removed. Taxation of accrued interest on accrual would be an expensive proposition administratively for both government and life companies, and is best avoided if possible. Yet the accrued interest on policies terminated by death should not be subject to income tax in the hands of the policyholder even at realization, for two reasons: the policyholder is by definition not the recipient, and the imposition of such a lump-sum levy at time of death would work to frustrate the very financial arrangements most insurance policies are bought to provide. Ex ante, however, the policies to be terminated by death cannot be distinguished from the others, so that if a postponement fee is to be levied to compensate for deferment of tax on the other policies it must be levied on all policies.

The other sources of inequity both could be and should be removed. First, to the extent that life policy income is subject to income tax of some sort, the provincial premium taxes are less justifiable.10 If the provinces were to get the normal provincial share of the total tax on this income, as they would if it were all taxed as personal income at realization (and if the postponement fee were divided provincially) they might be more willing to relinquish the regressive two per cent premium tax.

Second, accrued interest would be more appropriately taxed at realization for policies terminated by surrender or maturity if policyholders were not allowed to deduct costs of protection in calculating taxable residual gain. The only rationale for this provision is administrative convenience for policyholder and company, and events since 1968 suggest that this rationale is now questionable. The administrative convenience is in not having to calculate, once and ex post for each terminated policy, the actual portion of each premium paid which was needed to defray insurance protection costs and the expenses of the company related to its insurance activities. This calculation not only would have to be done by the life companies, who alone have the necessary actuarial information, but in fact it is already being done and annually for all policies registered as RRSP's (Pedoe, 1970:229). This author has not heard significant complaints about the extra administrative burden involved for those policies. If it is worth doing annually on this large a scale to help policyholders escape tax under RRSP legislation, then it is worth doing once per policy to help the government collect a significantly more appropriate tax. The marginal administrative burden would differ between companies, just as it did between retail stores when the retail sales tax was imposed. Larger companies already using computer facilities extensively would mainly have to increase storage capacities in some cases and add new programs in others. Smaller companies not using computers might have to

Io A referee has suggested that the sales tax might be properly levied on the portion of the premium accounted for by cost of protection and administrative expense. This approach is being followed up by Ontario in its 1976 budget, in which the tax rate was also raised to three per cent.




add on new staff or else make the switch to computerization. This would affect their competitive position as these costs were passed on to policyholders via changes in dividend scales or changes in rates. The calculation required is the same as was used to calculate 'cost of protection' for Table I, but using the actual expenses and protection costs. There are a number of different ways in which the necessary interest rate assumption could be handled.

V EVALUATION: NEUTRALITY

Another criterion applicable to a general taxation system is that it not distort the allocation of resources in the economy by creating unintentional tax incentives and disincentives which would sway consumers into or out of various types of demand. In the financial sector such incentives cause savers' funds to move through different intermediaries to different borrowers and different uses, so the indirect effects will be felt on the amount and nature of the country's capital formation.

The RHOSP and RRSP legislation obviously creates large and intentional tax incentives and funnels large amounts of funds through the life insurance, trust and investment companies that might otherwise have gone through the banks, mortgage loan companies, sales finance companies, or even directly into stocks or Canada Savings Bonds. The $I,ooo interest and dividend exemption broadens part of the tax incentive to include these other instruments, so the net effect on allocation of savings flows among competing instruments is not quite as large for those whose marginal savings decisions are still within the range eligible for those subsidies and tax exemptions. There remains the large net incentive effect on saving itself, as opposed to spending, but that too is intentional and is not usefully labelled as a distortion.

Within the financial sector there are a few probably unintentional distortions that should be removed. The most problematical is that interest earned on savings in a life insurance policy is not yet eligible for the $1,ooo interest and dividend exemption from personal income tax. This puts non-registered insurance plans at some disadvantage relative to possible competing combi- nations of term insurance and a bank deposit or Canada Savings Bond. At the same time it puts the insurance companies squarely on the horns of a dilemma; if they press for inclusion of their interest in the exemption, they will have to calculate and report to each policyholder the exact amount of interest earned on his policy each year. This change will involve significant extra administrative cost for the company, but it will also go a long way towards splitting up the joint product that is life insurance into its two parts of protection and savings, and it will enable much closer comparisons of life insurance policies with other savings media and means of protection. This goes against the major selling strategy of life insurance for the last Ioo years, which has been to minimize comparison shopping and to stress product differentiation.

The industry has so far requested only a compromise rule-of-thumb solution which would allow policyholders to deduct all or part of their premium payments as a proxy for accrued interest (Toronto Globe and Mail, June 2,




1976: B I). Such a solution does not have either the side-benefit of greater comparability or the extra administrative costs of the theoretically appropriate solution, but it is not clear that such deductibility of premiums would not create a whole new set of biases worse than the old - particularly since savings in life policies are not subject to high rates of tax now. Appropriate public policy might be to offer the companies the choice of calculating and reporting accrued interest to each policyholder for inclusion in his $ I,ooo exemption, or else not calculating and not reporting it. The industry is sufficiently competitive that the change would be made whenever the extra competitive advantage outweighed the extra administrative costs. Only the public interest in a more responsive financial system might be ignored, to the extent that explicit reporting of accrued interest would affect the comparability of savings media and thereby the responsiveness of financial flows.

The second unintentional distortion is caused by the provision which allows policyholders to deduct the full cost of protection in calculating residual gain on their policy at time of surrender or maturity. This makes protection a form of tax shelter, like gifts to charity and medical expenses, and creates an incentive to buy protection-intensive life insurance plans such as whole life policies rather than short-period endowment plans. This is a complete reversal of the situation before 1969.

It is far from clear how large an effect this second distortion of relative after-tax returns is likely to have. The surrender of a policy is rarely consi- dered at the time of selection of a plan, and the maturity of an endowment plan is usually a fairly long time off in the future at the time of purchase. Also the companies are not required to report net residual gains of policyholders under

$1,ooo and so many of the gains may just evade tax entirely (Jenkins and Kayler, 1974: io). Finally, this tax bias in favour of whole life insurance goes against the bias of the sales agents' commission structure which favours the larger-premium endowment policies. Where the agent makes a larger return per hour selling the latter, he will tend not to highlight as much the special potential future tax advantages of the former.

The other side of this particular tax bias is that the company receives a larger rebate of its investment income tax, per dollar of such income, from the less protection-intensive policies. One would expect with perfect competition for all types of policy that this would tend to be reflected in the form of a higher rate of return on savings or a lower unit price of protection for the less protection-intensive policies. A broad survey by this author of rates of return in Canadian life insurance for 1972, however, showed just the opposite result: estimated rates of return on savings in whole life policies for a 35-year old male were higher than those on savings in endowment policies of the same companies, by a full half percentage point over a 2o-year holding period." Obviously this tax advantage to the company is not passed on to the particular

II The estimates were made by the method described in connection with Table I, using policy rates published in Stone and Cox (1972). The difference is statistically significant at the .ooI level and the estimates reflect almost the full range of companies selling in Canada. Many interpretations are possible, but the one which seems most plausible to this author is a difference in the degree of price competition - and therefore in the elasticity of the firm's demand - between the two types of policies.




policies which generate it; the extra tax rebate for matured endowment policies is not used to pay especially large dividends for endowment policies.

A third general tax bias remains in favour of life insurance as a savings medium, for those who have exhausted their RRSP, RHOSP, and interest and dividend exemption privileges. The combination of a 12-13 per cent withholding tax and a deferred residual tax which is levied at some fraction of personal rates only if the policy matures or is surrendered, is still probably below the marginal tax burden from income on other investments, with the exception of income in the form of capital gains. The bias is much smaller than it used to be before 1969, though, and is unlikely to cause large-scale diversion of funds since each dollar of life insurance savings must be combined with some minimum amount of current insurance protection with presumably declining marginal utility.'2

VI CONCLUSION

The Carter Commission concluded in 1966 that the tax treatment of income earned on savings in life insurance was unduly favourable, and the government set out to remove this bias in 1968. The two new taxes, on investment income in the company's hands and on residual gains in the policyholder's hands, have removed only some of the bias, and have introduced some new biases as well.

The actual impact of the two new taxes varies by type of policy, by duration of policy, and by manner of termination of the policy, in ways which serve neither equity nor neutrality. This variation is mainly the result of efforts to avoid having to identify the cost of insurance protection separately for each policy. The result has been: a. to tax interest on life insurance savings mainly through a flat rate current

tax of about 12-13 per cent, the other tax being both deferred and partially or wholly forgone; and

b. to make insurance protection itself a source of tax shelter for the three out of five policyholders whose policies terminate before death or disability.

The marketing behaviour of the companies themselves since 1969 suggests that the cost of protection can be easily identified, in which case it should not be allowed to serve as a source of tax shelter. The case for removing the two per cent premium tax and for broadening the $I,ooo interest income exemption to include life policy income is not as compelling now, though it could become so in the future.

REFERENCES

Belth, J.M. (1968) 'The Rate of Return on the Savings Element in Cash Value Life Insurance,' Journal of Risk and Insurance, December, 569-58 I.

12 In a study done for the us insurance industry, however, Peter Fortune (1973:597) found demand elasticities for per capita insurance of about three with respect to both wealth and the level of real interest rates, which suggests that the response to incentives and distortions of the size introduced in Canada may be quite large. That must be the subject of further research.




Belth, J.M. (1969) 'The Relationship Between Benefits and Premiums in Life Insur- ance,' Journal of Risk and Insurance, March, 19-39.

Canada. House of Commons (1968) Debates, ist sess., 28th Parliament. Canada. Royal Commission on Taxation (1966) Report (Ottawa: Queen's Printer) Canada. Superintendent of Insurance (1973, 1974) Report, Vol, I (Ottawa: Queen's

Printer) Fortune, P. (1973) 'A Theory of Optimal Life Insurance: Development and Tests,'

Journal of Finance, June, 587-6o .

Jenkins, R.G. and R.L. Kayler (1974) Life Insurance and Taxation (Life Underwriters of Canada)

Life Insurance Marketing Research Association, Long-Term Lapse Study Linton, M.A. (1964) 'Life Insurance as an Investment' in D.W. Gregg ed. Life and

Health Insurance Handbook (Homewood, Ill.: Richard D. Irwin, Inc. 2nd ed.) 238-245.

Mehr, R.I. (1975) 'The Concept of the Level-Premium Whole Life Insurance Policy - Re-examined,' Journal of Risk and Insurance, September, 419-431.

Pedoe, A. (1970)Life Insurance, Annuities and Pensions: A Canadian Text (Toronto: University of Toronto Press, 2nd ed.)

Scwarzschild, S. (1967) 'A Model for Determining the Rate of Return on Investment in Life Insurance Policies,' Journal of Risk and Insurance, September, 435-444.

Stone and Cox, Ltd. (1972)Life Insurance Tables (Toronto: Stone and Cox, Ltd.) Whaley, R.L. (1970) 'The Taxation of Life Insurance in Canada,' Transactions of the

Society ofActuaries, June, 81-127.



The Taxation of Policyholders' Life Insurance Income

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