New Government's pensions tax dilemma

A key theme in this year’s General Election was the state of the UK’s finances, and the new Labour Government has some challenging times ahead balancing their policy ideas against what is feasible from a budget perspective.  

The Labour Party ruled out any increase to income tax, corporation tax, national insurance, and VAT as part of its election campaign, while maintaining its mantra of 'no unfunded spending commitments'.

However, this was prior to new Chancellor, Rachel Reeves, revealing at the end of July that there is a £22bn ‘black hole’ in government spending plans for essential public services, leading to some immediate decisions such as scrapping road and hospital building projects, restricting winter fuel payments, and cancelling the imposition of a cap on social care charges.

Against this backdrop, the Chancellor will be keen to explore other ways of increasing tax revenues and, given the large amounts involved, pensions tax relief might be one such temptation.

The true cost of tax relief

The cost of pensions tax relief is difficult to assess, but the true cost is significantly less than is typically quoted, and the revenue that could be raised by reducing or removing it needs to be viewed in this context.

The ‘gross’ cost of income tax and national insurance relief reported by HMRC for 2021/22 was £68.8 billion (see table 6). It is easy to see why such an eye-watering figure draws attention, but around 40% of this (£29.9 billion) relates to employer defined benefit (DB) contributions. This will include significant deficit repair contributions relating to historical service, rather than contributions for current savers.

The figure for tax relief on individual member contributions to DB and defined contribution (DC) schemes is considerably lower, at £16.2 billion.

The ‘net’ cost quoted by HMRC for 2021/22 was £48.3 billion, but this is arrived at by simply deducting £20.5 billion of current tax receipts, mostly relating to current pensions in payment, from the total above. These pensions relate to an entirely different cohort of individuals, and the tax eventually payable by those receiving relief is likely to be far greater, due to increased pension saving.

The dangers of fundamental reform

Pensions tax relief is complex, and the wider implications of changes to the system may not be immediately apparent.

Under the current system, relief on pension contributions is provided at an individual’s marginal rate of income tax, with the pension then taxed in retirement. There have been various suggestions over the years that this system should be reformed, for example by applying a flat rate of relief of (say) 30%. If set at the right level, this could potentially target relief at lower earners, while also reducing the fiscal cost to the treasury – a political ‘win-win’, perhaps?

However, it is important to recognise the risks – both practical and political – associated with such a move.

Any alternative system that does not provide relief at an individual’s marginal rate would be extremely difficult to apply to DB schemes. The relief would need to be assessed based on the value of benefits earned each year, but this is virtually impossible to achieve in a way that is fair and transparent, as the true value can only be known during retirement.

A fundamental review of pensions tax relief would also carry a significant risk of unintended consequences. For example, it could lead to penal taxation where the valuation method places a high value on DB pension earned in a particular year. This would be much like the problems faced by the NHS Pension Scheme under the existing allowances, only more significant and for a wider range of individuals, including those on lower incomes.

In theory, an alternative system could be more easily applied to DC pensions, but would a split approach be achievable? And if it could, would it be seen as fair to both DB members (mainly in the public sector) and DC members?

‘Low hanging fruit’?

It is perhaps for these reasons that the Chancellor was reported by the Financial Times as having ‘no plans’ to revisit UK pensions tax in the build up to the election. This is despite her having publicly supported a flat rate of tax relief in 2016, as a backbench MP.

The Labour Party has also abandoned its previous plans to reintroduce the ‘Lifetime Allowance’, recognising the challenges caused by its removal, and the need for stability and certainty.

Nevertheless, given the fiscal challenges, the Chancellor may seek less disruptive ways of lowering the costs of pension tax relief. For example, adjustments to the annual allowance, inheritance tax relief, or the tax-free cash entitlement could all lead to a reduction in the gross cost of pensions tax relief, without requiring fundamental changes.  

And it is worth noting that while the Labour party was said to have no current plans to revisit UK pensions tax, it also refused to rule out such a move during this parliament. Indeed, the Telegraph recently reported that Treasury officials will urge the Chancellor to consider a proposal for a 30% flat rate of relief as part of their proposals for her first budget.

So, while the initial focus might be on the low hanging fruit, we may still see an upsetting of the apple cart.