Why equalising tax relief on pensions contributions is a bad idea

A week ago, Mark Hoban, the former Work and Pensions Minister, called for a reform of tax relief on pensions contributions to 'equalise' the rate of relief given to all taxpayers at 30 per cent. This kind of call is made regularly, and often justified on the grounds that higher rate taxpayers receive the lion’s share of pension fund tax relief. Indeed, my own professional body, the Institute of Actuaries, sponsored research coming to the same conclusion recently.

These proposals not only misunderstand the purpose of tax relief, they would make our tax system even more complex and incoherent than is currently the case. Pension fund tax relief is a £30 billion issue: it is important to get it right.

Before considering the principles, it is worth considering three practical problems with these proposals:

- Higher rate taxpayers could end up obtaining tax relief of 30 per cent on a contribution that is then used to buy a pension that is taxed at 40 per cent. In other words, they could find themselves effectively paying a 'fine' to make pension contributions.

- Any highly paid employee who could only obtain tax relief at 30 per cent would simply take a salary cut and ask his employer to make higher contributions instead (this is already widely done in order to reduce National Insurance contributions). This would reduce the employee’s net wages so that the effective tax relief of 40 per cent is restored. HMRC would obviously wish to clamp down on such a loophole but the only way they could do so would be to attribute employers’ contributions to individual employees, and tax them at a special rate of 10 per cent as a taxable benefit (the difference between their normal rate of tax and 30 per cent). This would be close-to-impossible in defined benefit schemes. Even the description of this problem seems complex – let’s not go there.

- An individual paying basic rate tax who is approaching retirement could make pension contributions receiving 30 per cent tax relief and then take the contributions out of the fund and pay tax at 20 per cent the following year – in other words receive 'free money'. Again, another set of HMRC regulations would be needed to stop the abuse. Hoban used to be an accountant – this would certainly be good news for his former profession.

In practice these ideas are unworkable. But in principle, they are also wrong.

There are two justifications for pension fund tax relief. The first is that returns from saving should always be tax free. The second is to give people an incentive to save for retirement and reduce the burden on the state. Both these arguments are respectable in public finance economics, though they are also both arguable.

These objectives can be achieved in two ways. The first is via the 'ISA method' whereby investment returns are not taxed but people accumulate savings out of taxed income. Alternatively, we can use the current method of dealing with pension contributions – give tax relief on contributions and don’t tax investment returns, but then require tax to be paid when the fund is accessed. If we have a flat tax system, both systems are exactly equivalent but, in a progressive tax system, the outcomes are different.

Under the pension fund tax relief system, individuals can put money into their pension pot when paying 40 per cent tax and then take it out and pay 20 per cent tax when their income is below the 40 per cent tax band in old age. This is often criticised, but it can be seen as a way of addressing one of the injustices of a progressive tax system. If somebody’s income fluctuates, then a progressive tax system taxes that person’s lifetime income more heavily than the lifetime income of somebody with a steady income.

For example, assume that the 40 per cent tax rate starts at earnings of £40,000. Mr Volatile, whose earnings, for example, are £50,000 every other year and £30,000 every other year will pay more tax than Mr. Steady who earns exactly £40,000 a year. Mr. Volatile can reduce his total tax bill to the same level of Mr. Steady’s by only making his pension contributions in the years of plenty. The principle of using tax relief to facilitate income spreading so that the tax system comes closer to taxing individuals with the same lifetime income at the same rate is a sound one and is facilitated by allowing pension fund tax relief at the highest marginal rate.

Indeed, one of the reasons why so little of the tax relief for pension contributions goes to people paying the basic rate of tax is that people can wait until they are subject to higher rate tax before they make contributions. Furthermore, those at the beginning of their careers who expect their earnings to rise later and who currently pay basic rate tax may well have other obligations (mortgages, student loans and so on). If somebody expects to pay basic rate tax throughout their life, they may as well save through an ISA rather than a pension.

In summary, proposals to restrict tax relief and the Hoban proposal to create an entirely arbitrary rate of tax relief should be rejected as wrong in principle and impossible to implement in practice without publishing a few thousand more pages of tax code. One can certainly argue in favour of reform. However, reform should move in the direction of creating a more coherent system rather than even more complexity. Possible runners for reform would be:

- Move entirely to an ISA system of tax relief though recognising that this punishes people on volatile incomes.

- Abolish tax relief on pension contributions and ISAs altogether.

- Abolish – or very severely restrict – the tax-free lump sum which is an anomaly and open to exploitation under the Chancellor’s (sensible) proposal to give greater freedom to people to spend their pension pots.

Anything else would just involve micro-management, a jettisoning of any rational basis for the tax treatment of pensions and unbelievable complexity.

This article was originally published by ConservativeHome.

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