22 June 2021

A pensions tax raid isn’t just bad politics, it’s awful economics


Here we go again. The Daily Telegraph is reporting that Treasury officials are “drawing up plans” for a pensions tax raid in the autumn to help pay for Covid. It might be more accurate to say that old plans are now being ‘dusted off’, but the quality of debate does not seem to have improved.

For a start, it is wrong to assume that taxes have to rise at all. We could, and probably should, regard the increase in government spending and borrowing during the pandemic as a one-off, and accept that the level of debt will be permanently higher as a result. A strong economic recovery and a bit of inflation will still reduce the burden of that debt (as a share of nominal GDP).

Indeed, the latest monthly figures on the public finances show that borrowing is continuing to undershoot the OBR’s gloomy forecasts, as it did last year. In the meantime, despite recent jitters in global bond markets, ten-year gilt yields are still just 0.8%.

Rather than casting around for even more ways to increase the tax burden, the Treasury should focus on spending restraint and policies that would actually boost growth and investment.

Even if you do think that taxes have to go up, it is not obvious that the Treasury’s approach is the right one. To be fair, the options are severely limited by the 2019 Conservative manifesto promise not to raise the rates of income tax, National Insurance or VAT. But this has led to a scramble to raise revenues in other ways that do not make much economic sense.

The potential tax raid on pensions provides some more examples. Pension saving is a means to defer income and spread spending over someone’s lifetime, allowing people to provide for their own retirement and reducing the demands on the state. The tax system should therefore encourage this, not penalise it.

But according to The Daily Telegraph the Treasury is examining three options that will make life harder for savers.

The first is a reduction in the lifetime allowance, which is a cap on the amount of pension benefit that can be drawn without triggering an extra tax charge. This allowance is currently a wonderfully precise £1,073,100. It has been suggested that it might be cut to £800,000 or £900,000.

This would be a backward step. The lifetime allowance is arbitrary, and regular changes make it more difficult for people to plan for retirement. It would be far better to simplify the tax system by abolishing the allowance completely.

Reducing the allowance would also amount to a retrospective tax increase for savers. It is possible that they would be able to protect their pension pots (as has happened following similar changes in the past), but this would reduce the amount of money raised for the Treasury.

The second option would be to reduce the amount of tax relief on pension contributions for higher rate taxpayers. Currently, basic rate taxpayers receive relief at their marginal rate of 20%, compared to 40% for those paying the higher or additional rates.

The Treasury could replace this with a single rate of 30% for all taxpayers. This might appear fairer, because higher earners benefit more under the existing system, but this argument is not as a strong as it first seems. Higher rates of relief for higher rate taxpayers actually make sense, partly because they reduce the risk that people with fluctuating incomes end up paying more tax than people whose incomes are relatively stable.

A flat rate of, say, 30%, could also distort choices. Higher rate taxpayers would have an incentive to swap salary for pensions contributions from their employer. Basic rate taxpayers approaching retirement would have an incentive to make additional contributions and then take the money straight out again.

The third option is to increase taxation on employer contributions. Under automatic enrolment schemes these payments are currently free of tax. But any tax increase here is bound to have knock-on effects elsewhere. For example, if employers top up contributions to ensure the same net benefit to staff, they are likely to offset this by cutting wages – or even jobs.

Indeed, the potential gains to the Treasury from any form of ‘pensions tax raid’ are usually exaggerated, because they do not take account of the fact that smaller pension pots would mean that people pay less tax when they do retire.

Abolishing the tax-free lump sum would be the least-bad option for raising revenue. Pensions are supposed to provide a steady income over many years. But it would still disrupt the plans of many people approaching retirement.

Finally, while it would not matter so much if the economics were right, the politics of all this is pretty toxic too. The UK already has a relatively progressive system of income tax by international standards, and many millions could pay significantly more as a result of these changes.

Many of these are not fabulously rich either: about 3½ million people earning between £50,000 and £100,000 pay the higher rate of income tax. Plus 10 million people could lose out from an increase in tax on workplace pensions.

In short, the Treasury is flying yet another kite to test the wind. Let’s hope this one soon gets stuck in a tree.

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Julian Jessop is an independent economist.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.