Big shake-up to pensions taxation would change it for worse

That mock billboard slogan, in a Sunday Telegraph cartoon, referred to suggestions that the government was preparing a Budget pitched at its new voters in northern towns. One inspiration was a Financial Times report, summarised in the standfirst as: “Cut in pension tax relief to 20 per cent set to raise £10bn for ‘levelling up’ economy.”

The £10bn number was not attributed to government sources, but implied that, as well as restricting tax relief on individuals’ own contributions to the basic rate, the government would levy a 20 per cent tax on higher rate taxpayers when employers provided pension contributions.

Along with other bad ideas, this policy proposal is rooted in the view that tax relief is an incentive/subsidy for pension savings; some even call it a government top-up. This perspective dramatically overstates the cost of the present system relative to a neutral tax treatment of retirement savings.

Tax relief is usually only equivalent to a top-up relative to a situation where someone has masochistically invited the taxman to take a second helping of tax on the same income

David Robbins, Willis Towers Watson

Tax relief avoids punitive taxation

In fact, upfront tax relief on pension contributions avoids what would otherwise be a punitive tax treatment of pensions: contributions are not taxable because the income they give rise to in retirement is. Tax relief is usually only equivalent to a top-up relative to a situation where someone has masochistically invited the taxman to take a second helping of tax on the same income.

That is not to say there are no end-to-end subsidies for pension savings. There are, but these are the tax-free 25 per cent (or more, in some bequest scenarios) and the fact that national insurance is never levied in respect of employer contributions.

Of course, deferring income via a pension can be advantageous in and of itself, relative to alternative ways of saving. If the personal tax allowance remains above the state pension, the first chunk of an individual’s private pension income will be taxed at 0 per cent.

Higher earners can defer income that would have been taxed at 40 per cent (or 45 per cent, or even 60 per cent owing to the phased withdrawal of the personal allowance) until a time when they expect to be a basic rate taxpayer. 

Rather than see this as a ‘tax break’, however, we might think it ameliorates a problem with a tax system based on annual income: that how much tax you pay over your lifetime depends not only on how much income you receive but, less reasonably, on the timing of those receipts.

Allowing income to be deferred helps target progressive marginal tax rates on permanently high incomes.

Tax relief is not unfair

For some, tax relief must be ‘unfair’ if better-off people benefit most. But whether the tax and benefit system is sufficiently redistributive should be judged in the round. There will always be individual features that on average benefit richer people more – think of state pensions that last as long as you live.

And if policymakers want redistributive tax changes, it is not obvious why the target should be people earning more than £50,000 (including the value of employer contributions) to the extent that they would otherwise save in pensions, rather than high earners or the wealthy more generally.

Every so often, someone calls for a flat rate of relief above 20 per cent, say at 30 per cent, which would improve the deal for basic rate taxpayers and be less bad than a 20 per cent rate for higher rate taxpayers. Conceptually, that would amount to taxing income twice (or 1.75 times, if the tax-free lump sum survived) and topping it up in between.

If this ‘double taxation plus a top-up’ regime ever came about, policymakers might logically ask: ‘why not just tax people once and make the top-up smaller?’

Pension Isa model could be dangerous

Contributions could come from taxed income and be topped up, with withdrawals tax-free. That simplified ‘Pension Isa’ model has a big plus point: the top-up could be easily understood as the gain from saving via a pension.

However, the top-up could be altered at whim, with savers always having to second-guess the next change. The transition could also be bad news for the young.

Remember that, under the current system, their first tranche of saving should produce a retirement income within the personal allowance. Younger savers would miss out on the chance to put some deferred income beyond the taxman’s clutches, but would get the same top-up as older colleagues, whose future savings would otherwise produce retirement income taxed at 20 per cent.

The tapered annual allowance – which stemmed from viewing tax relief as a giveaway – has been disastrous for the National Health Service, and the system has other frayed edges. But, at a high level, the current tax treatment of pensions starts with a coherent way to tax deferred income and adds an incentive.

For most people it is comprehensible, even if not always understood: you pay tax once, on the way out, and get a quarter tax-free. For the majority not affected by allowances, it has also been stable, partly because changing it is easier said than done.

Judged against those criteria, a root-and-branch shake-up would probably make things worse, not better.

David Robbins is senior consultant at Willis Towers Watson