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Why unfair pensions tax relief is a fair target
(Update) If the chancellor has to make big cuts, removing the extra tax relief higher earners get on pension contributions is a good place to start.
by Lorna Bourke on Nov 26, 2012 at 09:30
With £10 billion of cuts needed to balance the books, reducing tax relief on pension contributions looks a tempting target. This time it is probably not just scaremongering by the pensions industry trying to drum up business. The chancellor is believed to be taking it seriously with an announcement expected in his Autumn Statement on 5 December.
Pension tax relief is an obvious candidate for raising more revenue because it costs vast sums in lost tax revenue which benefits mostly the better off. There is a powerful ‘fairness’ case for reducing tax relief on pensions. Half the population have no pension saving at all – largely because their after-tax income is so low they cannot afford to save. Yet these individuals pay more income tax than they otherwise would in order to subsidise the relief given to their wealthier colleagues.
Whenever the subject is broached the pensions industry – life companies, fund managers, actuaries, advisers and the rest – predict doom, gloom, disaster and a mass exodus into offshore pensions if there are any further cuts in pension tax relief.
But interestingly the government has support for a cut from a surprising quarter. Pensions expert Michael Johnson, a research fellow at the right wing think tank, the Centre for Policy Studies, has published a paper, 'Why Pensions Tax Relief Should be Reformed', arguing that tax relief on pensions is largely wasted and calling for a ‘radical overhaul of financial incentives.’ He claims that the £360 billion spent over the past 10 years on encouraging pensions savings through tax relief is ‘misguided and ineffectual.’
His figures show that in 2010-11 tax concessions on pensions were £26.1 billion for tax relief on contributions, £2.5 billion in lost revenue attributable to the 25% tax free lump sum, £13 billion in national insurance relief on employer contributions plus £6.8 billion in tax relief on investment income concessions – a total of £48.4 billion in just one year. These are huge sums – and most of the money benefits relatively wealthy people.
Cuts in higher rate relief
The case for reducing tax relief on pensions is very powerful. Before this year’s Budget, Danny Alexander, Liberal Democrat chief secretary to the Treasury, pointed out that the cost of the extra income tax relief for people paying tax at 40% or 50% is a hefty £7 billion a year. And pensions have been described by John Whiting, director of tax policy at the Chartered Institute of Taxation, as, ‘the last great tax shelter.’ As Dr Ros Altmann, pensions expert at Saga, the over 50s organisation puts it, ‘it is rather perverse to give the most tax incentive to people who need it least.’
Tax relief granted to people saving in registered pension schemes reached £32.9 billion in 2010-11, according to figures from HM Revenue & Customs, plus another £13 billion in relief for employers’ NI contributions. This is slightly lower than Johnson’s figures but not far off. At the top end of the scale those paying tax at 50% can claim tax relief on their pension contributions of up to £25,000 a year. Some £3 billion of relief on contributions will go to a maximum of 250,000 people earning more than £150,000 a year.
The argument for keeping higher rate tax relief on pension contributions is feeble, relying on the claim that although people get tax relief on contributions at their highest rate paid, this is clawed back because pension income is taxed once they retire. However, Johnson’s figures show that, ‘just one in seven who pay higher rate tax whilst working ever pay higher rate in retirement. From the Treasury’s perspective, this is a bad deal. Higher rate tax relief is a huge cost at £7 billion a year.’
Cuts to maximum annual relief
An alternative is to cut the maximum annual contribution which qualifies for tax relief. Pension consultants warn that any further reduction in the annual allowance – which was cut from £255,000 to £50,000 in 2010 and is now the odds-on favourite for change – would affect both the wealthy and those lower down the income scale in final salary schemes.
This is because although the annual allowance for pension contributions is fixed at a maximum of £50,000 a year – for those with Sipps and personal pensions as well as defined contribution occupational schemes – for those in final salary linked schemes the contribution is based on the increase in value of the pension benefits each year.
Pension consultants point out that if the annual allowance was reduced from £50,000 to £30,000 per year – (and it is worth mentioning here that this is still more than the average person earns!) – it would affect those in final salary linked schemes, including civil servants, earning £30,000 to £40,000 a year – but only if they have already built up substantial benefits.
The similar claim that older employees with Sipps and personal pensions and those in defined contribution occupational schemes who are ‘catching up’ on unpaid contributions from earlier years would also lose out is something of a red herring. There are very few ordinary employees who can afford to save more than £30,000 a year in a pension even if they are ‘catching up’.
Tax-free lump sum
The third option is to reduce the amount that can be taken tax free at retirement – currently 25% of the accumulated fund. There is little justification for this concession remaining but it would create uproar if individuals who had planned their retirement expecting to be able to take the tax free sums suddenly found that it was taxable. Removing the concession for future accrued contributions would initially raise little or no revenue, although long term it could cut pension costs significantly – saving around £2.5 billion a year according to Johnson’s calculations.
Combine pension and ISA reliefs
Johnson calls for a radical reform of savings incentives including combining the annual contribution limits for ISA and tax-relieved pension saving into a single limit of between £30,000 and £40,000 a year. This would represent only a relatively small saving for the Treasury of between £1.8 billion and £600 million. More important Johnson is in favour of removing higher rate tax relief on contributions which would save £7 billion – a useful sum to a chancellor looking for £10 billion of cuts. He would also like to see the full limit of £30,000 a year available for ISA savings (which also accumulate tax free but have the advantage of much greater flexibility plus tax free income on drawing the pension.)
Finally, as many have pointed out, the notion that the removal of higher rate tax relief on pension contributions or a reduction in the annual allowance from its current level of £50,000 a year would discourage wealthier individuals from saving is nonsense. The majority of middle income and higher earners are responsible individuals who would save for their retirement regardless of tax relief – and millions of them already do so. Let’s hope the chancellor listens to Johnson rather than cutting benefits to the poorest.
Want to know more about how pensions work? Read The Lolly guide to pensions.
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- Department of Work and Pensions: Reinvigorating workplace pensions
- Michael Johnson comment on Centre for Policy Studies website
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