We are used to thinking about pensions parochially, worrying about our patch and disregarding the bigger picture. But- if you are the Chancellor of the Exchequer-pensions are but a leaf on the tree. The tree is the state of Britain’s finances.
Britain’s finances, even the state of our retirement financing, rank ahead of the taxation of private pensions. If George Osborne conducts a tax-raid on pensions on March 16th, it is well that we see his behaviour in a wider context. This article tries to understand how a Chancellor approaches pensions tax-relief and why he may have wider considerations than those normally rehearsed in these pages.
Close inspection of the Government’s figures tells us that the vast majority of tax-relief being used to incentivise saving is spent on people in our occupational pension schemes.
The total annual value of income tax relief rose last year to around £35bn. Even when you discount the £14bn recouped from pensioners, there is still £21bn being used purely as a savings incentive.
59% 0f this tax-relief is estimated to have gone to those with incomes in excess of £45,000 pa. Pension tax-relief is benefiting those with high incomes, even more pertinently, it’s benefiting those who already have big pensions.This is because about half of that £35bn was paid against contributions made by employers into defined benefit schemes .
If you consider tax-relief to be a way to encourage the needy to be self sufficient in retirement, such a state of affairs is unsatisfactory.
Since the vast majority of DB accrual is in the public sector, it’s logical for a Chancellor dedicated to deficit reduction, to fix his sights on employer contributions into occupational schemes. Logically he should be focussing on the public sector pension schemes which are funded directly by Government and indirectly through tax-relief.
The deal done with the public sector and its unions has future proofed contributions and benefits till 2024. But these protections do not include changes to tax relief.
So the opportunity exists for the Chancellor to tackle the £17bn+ he’s missing out on, when public sector employees fund pensions (rather than paying salary) . He may consider this his only chance to control spending on public sector pensions.
It would be surprising if this Chancellor missed this chance. Indeed once you’ve finished reading this article, you might think the Chancellor missed an open goal if he didn’t target the well-heeled civil servants who are tax-relief’s principal beneficiaries.
What the Chancellor needs is a means to tax all pension contributions . Indeed – the Chancellor may be feeling he needs to abolish pension tax-relief altogether.
What is truly scary is that the Treasury already has got the means to scrap tax-relief . The ‘means’ are already used by large occupational pension schemes. The ‘means’ is called “Scheme Pays” and is a system of collecting tax. It is currently used to help employees exceeding the annual allowance.Were the annual allowance switched to zero, it could be extended to cover us all.
The way it works is simple. The scheme calculates the tax due and pays it to the Inland Revenue. The payment is set against the member’s eventual benefits, either by a deduction from the defined contribution pot or as an earmarked deduction from the promised guaranteed pension.
What Scheme Pays offers a cash-strapped Chancellor is the opportunity to get the Treasury round its two principal implementation issues.
Firstly it takes the strain off payroll. The administration of Scheme Pays falls to the Scheme not PAYE. If payroll is no problem, changes can be made quickly
Secondly, (and more significantly), it allows all pensions contributions to be treated as a benefit in kind – without impacting take home pay. If people feel no pressure from the pay-packet, back bench opposition should dissipate. Just as Scheme Pays provides a golden key to implementation, so it tackles the wider issues relating to pension reward .
On the downside, the taxation of the employer’s contribution presents problems of valuation that would need to be addressed by enhanced GAD conversion factors. And it will need some extra administration for schemes. But these are hardly insuperable obstacles.
Of more moment, Scheme Pays opens doors to a holistic approach to pension taxation which closes doors on abuse. Taxing employer and employee contributions as one benefit in kind , reduces the advantage of swapping salary for pensions. Making pension contributions subject to national insurance would fully close the door.
There is potential to radically reform the tax treatment of pensions. The impact of abolishing tax relief is to immediately free up £35bn of revenues to plug the deficit and to target savings incentives on those most needing help.
We think parochially about pensions and Chancellors look at a bigger picture. We have been warned to expect the unexpected. While the thoughts in this article are no more than speculation, they demonstrate the scope the Chancellor has not just to think but realise the unthinkable.
Re: “The total annual value of income tax relief rose last year to around £35bn.”
Neither fair nor accurate reporting. The £35bn number completely ignores the £14bn paid in tax by yesterday’s pension savers, now today’s pension recipient taxpayers. It is not tax relief, it is tax deferral.
You are right Harry, and I have edited out the below the line numbers in the stats HMRC publish. Even so, the incentive at £21bn is not fair not working and should be better spent
Again though, even this 21bn is not tax RELIEF, it is tax DEFERRAL. At some future point the government will collect tax back on it, and with interest because of the intervening growth.
If the government expects individuals to behave responsibly by deferring compensation in expectation of higher remuneration later on, then it should be prepared to do the same. A government that is unable to do itself what it asks of retirement savers is clearly not behaving responsibly.
But linking the incentive to save to your marginal rate of tax is a very odd way of doing it Harry! I fear that we will lose a lot of the advantages of tax deferral and that will be because the nation as a whole does not consider it value for money,
Nothing odd about it at all. HRT payers appear to get most “benefit” only because they pay most in tax. Pensions are at their core nothing other than deferred salary, and the correct place to apply tax is when salary is realized.
As for ‘nation as a whole’, Google ‘tyranny of the majority’ for why total loss of tax deferral under a chancellor motivated only by his own political ambitions and with no concept of behavioural economics and little concept of the real world at all, is a) likely, and b) wrong.
Harry,
A thorough review of all exemptions would also look at benefit in kind National Insurance Contribution Relief which should be added to the net £21bn tax relief amount. This can lead to 3 levels of government “tax” relief (ignoring marginal income tax rate rate): self- employed; where only tax relief is available; employed where NI relief on employer contributions is available; and employed where employer also pays part or all of their NI savings into the employees pension..
Fair deferred tax can also be introduced on a flat rate system , by transitioning to a flat rate of tax on pension income.
The basis of the current system has been in place for over 100 years. It was introduced to incentivise employers to provide pensions for their workers. We are moving to a world where this is being replaced by compulsion on employers. We do need a system fit for the next 100 years that encourages all workers including the self employed to save more than the minimum for their later life and reduce the future welfare bill that will inevitably fall on the state, i.e. tax payers.
I am hopeful that the Green Paper when published creates a debate that is a lot wider than just “tax relief” who wins and who loses. Hopefully we will be discussing how to create a sustainable system fit for purpose for the next 100 years that will not require constant tinkering to keep it affordable.