Over the weekend the papers were abuzz with rumours that Sajid Javid might use next month’s Budget to scrap higher rate tax relief on pension contributions.
It’s not the first time this has been floated as a way of saving money by ending what many see as an expensive tax break for the rich. However, that perception is based on a serious misunderstanding of how the current pension system works, and it would be a colossal mistake for the government to go through with it.
Tax relief on pension contributions effectively means that you are not taxed on money you pay into your pension. So, earnings between £12,500 and £50,000 effectively avoid the 20% income tax, while earnings above £50,000 avoid the 40% income tax that you’d pay if you took them as regular income (or 45% on income above £150,000).
The reason for this is not well understood. Many people mistakenly think it’s a nudge to encourage people to save more. For example, the influential consumer magazine Which? says that the “government likes to give you a bonus as a way of rewarding you for saving for your future”.
This is a misconception that ignores a crucial fact: withdrawals by retired people are taxed as if they are income. The purpose of tax relief on contributions is not to ‘reward’ people, but to avoid penalising them by taxing their pension contributions twice – once as they contribute, and again as they withdraw. After all, doing that would make it more costly to put money into a pension than, say, an ISA or even under your mattress.
By the same token, it’s wrong to see reliefs as a form of subsidy to the well-off that could be cut to save the government money. Most of the time when people mention the “cost” of pensions tax relief, they leave out the money raised from taxing withdrawals. This is silly, unless we actually want to create a large tax penalty for making pension contributions.
You could, of course, tax people on their pension contributions today but not tax them when they are withdrawn. This is what happens with ISAs – I contribute out of my post-tax income, but any gains my ISA investments make are untaxed and any withdrawal I make is tax-free, because the money has already been taxed before I put it in.
If we had a single tax rate for all income, there would be no difference from the point of view of the saver between a system where contributions were taxed but withdrawals were not (as with ISAs) and a system where contributions were not taxed but withdrawals were (as with pensions).
However, since we tax higher earnings more, the pension system allows people to forego earnings that would be taxed at 40% today to be withdrawn at a lower 20% rate in the future. This is called income shifting, and whether we want to allow it should be the real focus of the pension debate.
Income shifting and the pension system
Most people’s incomes vary across their lives. Given that we can borrow against future income and save money we have earned in the past, what matters is not just what I am earning today, but what I will earn in the future.
Total lifetime earnings, not just annual earnings, are very important to people in their career decisions – you may choose to take a job that pays less now than an alternative if you believe it will lead you to a better paid position in the future. However, the income tax system is calculated on an annual basis, not a lifetime one. And since we have higher rates of tax for higher earners, we can end up taxing two different people whose lifetime earnings are the same very different amounts because one has had more variability in their life.
If we consider that to be a problem then we may want to allow the person with more variance in their lives to shift some of the periods of high earnings to other times in their lives, to smooth their income and avoid paying more tax in total than the person with a steady income over their lives.
That’s where the pensions system comes in: as it stands, we allow them to forgo earnings today and withdraw them instead when they have retired, by putting those earnings into a pension. That means people can avoid paying the upper rate today and end up paying the basic rate when they are retired.
Of course, if they save a lot for their retirement, some of their retirement earnings may end up being taxed at the higher rate anyway – effectively this means there is a limit to the amount of income shifting that people can do. For illustrative purposes, to get an annuity that pays out £50,000 or more requires a pot of about £1.3 million. To get a pension pot of £1.3 million over 45 years of work, at a 6% nominal annual growth rate, requires an average yearly contribution of £6,110/year (about £275,000 in total contributions).
Higher rate contributions above this average amount do not avoid any tax – they get higher rate relief going in, but pay higher rate tax coming out. (For simplicity’s sake, I have ignored the lifetime allowance for pension savings, which ends up taxing withdrawals at this level more punitively than I have described.) The tax-free lump sum creates an additional tax avoidance factor that incentivises pension saving, although we already have limits on how much can be taken out (so it is not a straightforward bung to higher rate earners relative to basic rate earners).
So in practice you can avoid tax by shifting some of your lifetime income – in my simplified example, about £275,000, but I’ve left out factors that may make it higher or lower. But beyond a certain level, there is no tax advantage to doing so.
The Treasury view
What the Treasury is apparently considering is getting rid of higher rate pension relief, so higher rate earners would pay 20% tax on pension contributions, and then be taxed again on withdrawals, either at 20% or 40%.
This would be a very crude policy – not only would people no longer be able to shift earnings from periods of high income to their retirement to smooth out their tax bills, they would also face a tax penalty on pension earnings above £50,000, paying both 20% on contributions and then 40% on withdrawals. That is effectively a 52% marginal rate compared to the 40% they would pay if they just took the money out as income when they were paid.
There is very little to recommend this. It would add a second de facto pension pot limit, and would create enormous additional complexity to a system that is already very difficult for people to understand. More and more people would have to rely on expensive tax accountants to ensure they were not hurting themselves by saving for their retirement. To specifically target higher earners who try to save for their retirement, after years of government policy encouraging people to do so, is perverse.
If ministers are looking for a workable reform, they could consider getting rid of the tax-free element of the lump sum withdrawal, a genuine anomaly that adds complexity to the system and really does distort people’s incentives to save.
Another option might be switching to a system where tax relief does not exist and pensions are simply giant ISAs, which would have the benefit of simplicity, but also stop people from being able to shift their incomes. Even if we decide that we want to do that, it would also cost the government in the long run, since taxing contributions rather than withdrawals means that it misses out on the market returns accumulated over time. From the saver’s point of view, it makes no difference if the state takes 20% of the contribution or 20% of the withdrawal, but from the government’s point of view 20% of the withdrawal will be larger – and potentially much larger.
If, like Which?, the Treasury sees tax relief on pension contributions as a “reward” for saving, it is understandable that it might wish to cut it back and use the savings to spend elsewhere. However, that view misses the vital role reliefs play in the income tax system. Barring wholesale pension reform, it would be incredibly foolish to tamper with them.
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