Jane Fuller looks at the issues around tax relief.
- We expect an announcement on pension tax relief in the Budget.
- There are other options available than a shift to a taxed, exempt, exempt structure.
- While the UK still has a big gap in long-term saving, the simple incentive of a government top-up to pension contributions is desirable.
In the debate sparked by the UK Treasury's consultation: "Strengthening the incentive to save: a consultation on pensions tax relief", the first part of that title has lost out to the second. This is not surprising with the UK's annual deficit running above £70bn. The danger is, however, that the baby of tackling a retirement income crisis will be thrown out with the bathwater of poorly targeted tax reliefs.
It is worth remembering that the "baby" represents the 9m workers who have been saving little or nothing for later life. The auto-enrolment regime, which is nudging them into work-based schemes, is about half way there on the headcount, but the minimum being saved at this stage is a pitiful 2% of (most but not all of) their pay, rising to a barely adequate 8% by 2019.
The bathwater is the near £50bn of exemptions from income tax and National Insurance Contributions (NICs) on saving for later life, with the biggest beneficiaries being higher earners on 40% or 45% tax rates.
A policy announcement is expected in the Budget on March 16, so there is still time to point out ways in which the government can save money while increasing incentives to save for the vast majority of workers. This can be done without reversing the principle that pension contributions and investment gains are tax exempt, while the income withdrawn in later life is taxed - known as EET (exempt, exempt, taxed).
What might the target be for reducing tax "giveaways"? Starting with income tax, the total reliefs in 2013-14 came to £34.3bn, while pensioners paid £13.1bn in tax (HMRC PEN 6 table). So the net cost alluded to in the Treasury consultation paper is £21.1bn.
Already in the bag is £6bn a year from reducing the annual limit on tax-free contributions to £40,000 and the lifetime allowance for the entire pension pot to £1m. To save a few more billions, a further cut in the annual allowance could be made; and/or a cap placed on lifetime contributions, which would be much simpler for individuals to calculate than potential pot size.
The hot topic is the rate of tax relief since two-thirds of the overall cost goes to five million higher-rate taxpayers. A 40% taxpayer gets a £40 top-up for every £60 in post-tax income put into a pension scheme, while a 20%, standard-rate, taxpayer gets only £15. Not surprisingly the case for a flat rate of relief has gathered momentum.
According to a Pensions Policy Institute report last October, commissioned by the Association of British Insurers, "the break-even rate of flat-rate tax relief is between 30% and 33%" based on year one costs. However, the government will have in mind that auto-enrolment is increasing the number of pension savers getting income tax relief.
If the priority is to cut costs, restricting all savers to the standard 20% rate has been estimated to save between £9bn and £11bn. If the priority is to redistribute tax relief while making a minor saving (about £1bn), 30% would make sense. That would provide the individual with a "top-up" of about £25 for every £60 saved.
Tax free lump sum
What about the tax-free lump sum on withdrawal of savings? Under a strict EET principle, it would be phased out altogether, saving £4bn according to the PPI. Halving this cost by capping the amount that can be withdrawn tax-free would only affect a quarter of pension savers.
Then there is the £14bn a year cost of exempting pension contributions from NICs collected by the employer. Phasing out the exemption on the employers' side alone would save about £10bn, according to the Institute for Fiscal Studies.
The case for this is strong but the timing would be sensitive because from this April, defined benefit pension schemes will no longer be "contracted out" of NICs payable towards the state pension. This will raise the NI take by about £5.5bn a year - a nice bonus for the government that is outside the scope of the current consultation.
Overall, at least half the net cost of tax breaks could be cut while providing those nine million under-savers, and millions more standard rate taxpayers, with an additional incentive to save for old age.
Long-term saving is a risky business. It requires deferred consumption, faith in long-term investment gains and trust in the government not to move the goalposts.
In a perfect world there would be no tax breaks. But while the UK still has a big gap in long-term saving, the simple incentive of a government top-up to pension contributions is desirable; so is the less visible one of exempting investment gains. Coupled with reforms to the state pension, this should help most of today's workers reach a tolerable, but by no means enviable, position in their eventual retirement.
Jane Fuller is co-director and pensions fellow of the Centre for the Study of Financial Innovation
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