Labour’s assault on pensions is a recipe for class war and chaos
Watching political games play out in real time is never a glorifying spectacle. During the campaign, Labour Chancellor Rachel Reeves repeatedly insisted there would be no tax increases on working people. This was despite repeated warnings that their plans did not add up. To nobody’s surprise, yet everybody’s disappointment, the government is now laying the groundwork for fiddling with pension tax relief.
Currently, pension contributions can be deducted against taxable income, including at the higher marginal rates. The Treasury is proposing to change this to what is often described erroneously as a flat 30 per cent tax relief. This would have a dual effect of making higher and additional rate taxpayers pay more tax while providing an effective top-up to lower rate taxpayers who pay tax rates below that threshold.
This is one of those Treasury boffin ideas pulled out of the filing cabinet whenever a Chancellor wants more money. Most recently, George Osborne was considering the move in early 2016, and the idea was first put on his desk as far back as 2010. The obsession with pensions stems from the belief that your savings are not a result of hard work and thrift but rather an untapped pot of money that the Treasury feels entitled to stick its grubby hands inside.
Yet shifting the rules would not only be unfair, it is also a manifestly bad idea. It would add significant complexity to the tax system and reduce incentives to save for little to no benefit.
The current system is reasonably straightforward. You do not pay income tax on the way into your pension but you do, for the most part, pay it on the way out. This is often painted as a giveaway to wealthier taxpayers, but since you pay tax on income from a pension, it is really a form of deferral. This is an entirely sensible system design, as it directs taxation towards expenditure rather than earnings and encourages savings for retirement and associated investment.
The proposed changes would create a much messier system. Six million higher earners, and more over the coming years, would be forced into paying 10 to 15 per cent top-up taxes on their pension contributions. But then lower earners would have their savings arbitrarily subsidised. A £100 into a pension would be supplemented with an extra £30 from the Treasury – a money merry-go-round.
This would create immense new administrative burdens. Millions of businesses would be forced to change their payroll systems in very complex ways to reflect the varying rates of relief and associated new rules. HMRC would have to develop hundreds of pages of guidance and new tax code to avoid potential loopholes and unintended consequences. The change would be particularly messy for defined benefit schemes because most of the contributions are made by the employer and cannot be attributed directly to individual employees, and the change creates a new taxable benefit.
The proposal’s appeal is that it appears to raise some much-needed revenue from apparently richer people. But it’s not expected to be very much. According to the Institute for Fiscal Studies, a 30 per cent flat rate relief would raise just £2.7 billion a year. This is nothing compared to the £10 billion a year cost of planned above-inflation public sector pay increases it is meant to help fund.
In any case, revenue benefits will likely be limited in the long run. That’s because the threat of paying tax on the way in and way out of their pensions, effectively double taxation, will encourage higher earners to save less. Less money in pensions means less future pension income and tax revenues for the state.
So, rather than improving fiscal sustainability, the change would provide a short-term sugar hit to Treasury coffers while reducing future revenue and decreasing overall savings. This is not a recipe to boost responsible retirement savings and investment.
There are a few existing ways in which you pay less tax due to putting money in pensions. The first is the tax-free lump sum available upon retirement. If the government is genuinely desperate for revenue, cutting this allowance would be far less complex and disruptive than playing with the levels of tax relief. It may not be entirely advisable, but it would at least be simple.
Second, many higher earners slowly withdraw money from their pensions and end up paying lower tax rates down the track. So, someone who got “relief” at 40 per cent could end up only paying 20 per cent on their pension income. But this should be viewed as a feature, not a bug, of the system. It allows people to smoothen their taxes across their lifetimes so they do not end up paying more taxes than someone with a less variable income.
Pension relief is one of the few well-functioning parts of Britain’s tax system. Adding loads of extra complexity and arbitrariness for very little additional revenue hardly looks advisable.
Matthew Lesh is the Director of Public Policy and Communications at the Institute of Economic Affairs