From the TUC

The costs of pensions tax relief

06 Jul 2011, by in Pensions & Investment

The government has been unable to win the argument that the cost of public sector pensions is unsustainable. Right wing critics of public sector pensions have therefore changed their tune and now stress their argument that poorly paid and ill-pensioned private sector workers should not have to pay for public sector pensions.

This, of course, is just another call for levelling down. With two out of three private sector workers now getting no employer help building up a pension, the only way to make the two sectors fair would be to remove two-thirds of public sector workers from any pensions coverage. And if you take this argument to its logical conclusion you end up in the absurd position that low paid private sector workers should make no contribution to paying the wages of public sector workers with a higher income. Given that the public sector has higher median pay as it tends to employ workers with high skills and professional qualifications – all those teachers and doctors – this ends up being most of the public sector.

But there is a glaring unfairness that many critics of public sector pensions (though to be fair not all) fail to acknowledge. This is the £39 billion cost of pensions tax relief – most of which goes to the better off.

Before we get into the arguments, it is worth explaining how it works.

When you make a contribution to a pension scheme, your tax bill is reduced. This is because you are then taxed on your income less the amount that you contribute. So if you earn £35,000 a year and make a contribution of £2,000 you pay income tax as if you earned £33,000 a year.

The motivation is perfectly reasonable. It is in the state’s interest to encourage people to save for a pension as they are less likely to claim benefits, and it is a reasonable public policy objective to try and secure a decent retirement income for its citizens.

But there are two problems.

  • The simple way that it is calculated means that people get tax relief at their marginal rate – ie the tax they would pay on that £2,000 in the example. If they are higher rate tax payers it means they get 40p in the pound tax relief, while if they are standard rate tax payers they get only 20p. This means that it costs a higher rate taxpayer 60p to put an extra pound in their pension and a standard rate taxpayer 80p. The introduction of the 50p rate means that the richest can save a pound for only 50p. This is hardly fair.
  • The second issue is that the more you put into your pension the more tax relief you get. Of course any tax incentive that encourages people to save will not be very progressive. Poor people who do not save get no help and the better off who can save will get this taxpayer handout. But other savings incentives are capped. You can only put £5,340 into a cash ISA for example.  Some on the left are therefore opposed to savings incentives – just as some on the right would scrap all reliefs in favour of a flat tax – though for diametrically opposed reasons. I think both those positions are wrong, but it is right to be concerned that the very rich can get a big chunk of pensions tax relief every year.

So what are the costs of pensions tax relief; and is there a limit?

This HMRC table is helpfully reproduced by the Pensions Policy Institute.  It shows the total cost of tax relief on pensions as £39 billion or 2.8% of GDP. Public Service pensions cost 1.9% of GDP in contrast – and will fall to 1.4%.

Some caution is needed with the £39 billion figure. It is made up of more elements than the one I describe above. And public sector workers also get tax relief on their pension contributions, so this is not just a private sector issue.

But to bring the basic fairness issue back into focus, this parliamentary question shows that 60 per cent of the benefit went to higher rate tax payers.

Some change will occur from this tax year. Alistair Darling introduced a much tighter cap on the amount of pension contribution that could be used to claim tax relief. In the past the maximum amount was £255,000. So before the new 50p tax rate you could get in excess of £100,000 a year in tax relief. (40p for each pound).

In the current tax year the limit is £50,000. With the new 50p tax rate this still makes £25,000 of tax relief available for those who can afford to make more than twice the median income in pension contributions each year.

So how should this be changed? I’m certainly not against tax relief on pensions contributions in principle. As auto-enrolment starts and many people start a pension for the first time, putting tax relief into their modest pots too is undoubtedly good policy.

But there are two reforms that I think should be considered.

  • First tax relief should be limited to standard rate relief (as the Lib Dems said in their election manifesto). It should cost everybody the same to put an extra pound in their pension.
  • Second I think there should be a lower limit. Public policy should encourage pensions savings, but only up to a level that provides a decent retirement income.

The savings however should just be grabbed by the Treasury but used to improve the existing state retirement pension. The government are currently consulting on a proposal that would give a flat rate £140 pension for new pensioners. Some tax relief should be used to help existing pensioners too.