From the TUC

New report highlights the unfairness and waste in pensions tax relief

17 Jul 2013, by Guest in Pensions & Investment

Earlier this week the Pensions Policy Institute (PPI) published ‘Tax relief for pension saving in the UK’, its report into pensions tax relief and in particular the effectiveness of tax breaks as an incentive to save. Even as someone who has been working on pensions issues for several years, I was genuinely shocked by some of the PPI’s findings.

The report exposes a system of tax relief that heavily favours the highest earners. But in analysing the potential impact of several reform options, it also offers an alternative approach that would be much less regressive and a better savings incentive – and cost little more, or even less, than the current system.

Pensions tax relief is currently applied at an individual’s marginal tax rate. Generally speaking, this is achieved by employers deducting pension contributions from pay before income tax is deducted. Once the introduction of auto-enrolment is complete, and the vast majority of workers are saving in a workplace pension scheme, it will cost £35 billion per year.

Because higher earners are in higher tax bands, they automatically therefore receive pensions tax relief at a higher rate. The PPI’s report highlights how this creates enormous inequalities in terms of benefiting from tax relief expenditure. Basic rate taxpayers make more than half of total pension contributions in the UK, but receive less than a third of pensions tax relief expenditure. More than half of expenditure goes to higher rate taxpayers, and 17 per cent to additional rate taxpayers, but these groups make only 37 per cent and 9 per cent of total contributions respectively.

This discrepancy is sometimes justified by the fact that tax relief is paid back once people retire, because pensions in payment are subject to income tax. However, not everyone who receives relief at higher or additional rates in working-age pays it back at the same rate in retirement.

I estimate that hundreds of thousands of wealthy of pensioner are benefiting in this way (it is impossible to give a more precise figure due to limitations in the tax data released by HMRC).

This chart from the report shows that this group are the main winners from the current system:

pensions tax relief pic

For each £1,000 they invest in their pension (for the sake of comparison, the PPI assumed a one-off contribution of £1000 at age 40), they receive £5,500 back. This is £1,000 more than an individual who is a higher rate taxpayer at work and in retirement, and £1,400 more than a basic rate taxpayer.

There is a further aspect of the pensions tax relief system that hugely benefits the better-off: the tax-free lump sum. Most pension savers are able to take 25 per cent of their pension value at retirement as a lump sum, without paying tax. Currently, more than three-quarters of individuals receive a lump sum of less than £40,000, but less than a quarter of lump sum tax relief expenditure goes to this group. Only 2 per cent of lump sums are worth £150,000 or more, but these attract almost a third of lump sum tax relief expenditure.

pensions tax relief pic lump sum

 There may be a solution to all of this: applying a single rate of pensions tax relief, irrespective of individuals’ marginal tax rate. A single rate of 30 per cent would reduce the advantage gained by higher rate taxpayers and offer a greater savings incentive to low and middle earners. Crucially, it would cost around £36 billion, broadly equivalent to the current system. In fact, simultaneously introducing a cash limit on lump sums would mean the Exchequer could save money from pensions tax relief while probably making the system much more effective.

A single rate would be more difficult to operate than the current system, but much easier to understand. In fact, the government already presents tax relief as a 20 per cent ‘matching contribution’ to the auto-enrolment target group of low to median earners.

The PPI is not alone in criticising the current pensions tax relief system. From the political right, Michael Johnson of the Centre for Policy Studies also highlights the problem of tax avoidance in the current system (and puts a figure on it – Johnson says only 1 in 7 higher rate taxpayers go on to pay higher rate tax in retirement), and calls for the abolition of higher rate tax relief and tax-free lump sums (among other things).

More recently, the National Audit Office’s inquiry into cross-government work on retirement incomes highlighted the poor targeting of pensions tax relief as a key example of how policies affecting pensions and retirement are being mismanaged. Clearly, although a great deal more analysis is necessary, it is time for the pensions tax relief system to be placed on special measures.

2 Responses to New report highlights the unfairness and waste in pensions tax relief

  1. Tax Research UK » Pension inequality: why do we subsidise the savings of the rich so much more than those of everybody else?
    Jul 18th 2013, 8:35 am

    […] TUC was one of the sponsors of a new report on pensions out this week. I need to give this issue some more attention again, but one matter highlighted […]

  2. solarman
    Jul 18th 2013, 11:00 am

    I think the idea of having the same tax relief rate for all pension contributions would be a better and a fairer solution. Should it be set at the basic rate of tax or something different?