Tax relief for pension saving has hit the headlines again, and this time not in the run up to the Budget or Autumn Statement. Steve Webb has suggested that, if he has his way, the Liberal Democrats will go into the general election next year with a policy of giving tax relief at a flat-rate below 30 per cent on pension contributions, rather than the current system that gives relief at the marginal tax rate.
The tax relief system in the UK seems to have been subject to almost continual change in recent years. In 2010, the then Labour Government passed legislation that would reduce the rate of tax relief for very high earners (broadly those earning over £50,000) to 20 per cent, but this was reversed by the coalition in 2011.
Since then, although the fundamentals of the system have remained the same, there have been a number of reductions in the amount of pension saving that is eligible for tax relief, both each year and over a lifetime. Why is tax relief such an issue?
To answer that, we need to think about what tax relief is for. The main objective for tax relief on pensions is to support retirement saving by encouraging individuals and employers to contribute to pension schemes.
Tax relief compensates people for the fact that they cannot access their money before a particular date and, when they are able to access this money, it must be accessed in a particular way (although, perhaps importantly, it is worth noting that from April 2015 this restriction will be lifted). Tax relief also aims to avoid double taxation – making the tax system for pension saving neutral by ensuring that people do not pay tax twice on the same income.
So does tax relief work? Well, if we are asking does tax relief avoid double taxation, the answer is a resounding yes and then more – the current system, rather than being tax neutral, is tax advantaged. People pay less tax on income used for pension saving than on other income. This is because up to one-quarter of pension saving can be taken tax free, and that when pensions come into payment many people pay a lower rate of tax on their pension income than they received in relief on contributions.
But evidence suggests that tax relief does little to encourage new pension saving in the UK. Understanding around the tax treatment of pensions is low, something that is likely to dilute its effectiveness as an incentive to save. If people don’t understand the incentive, how can they act on it?
Despite not acting well as an incentive, tax relief is still expensive. The estimated gross cost of tax relief on pension contributions from employers, employees and other individuals under the current tax system and allowing for the full introduction of automatic enrolment is around £35bn.
But spending on tax relief is not evenly distributed. PPI estimates suggest that, even after automatic enrolment has increased the number of lower income savers, while basic rate taxpayers are estimated to make 50 per cent of the total pension contributions, they would benefit from only 30 per cent of pension tax relief. In contrast, 50 per cent of pension tax relief goes to higher rate taxpayers and 20 per cent goes to additional rate taxpayers, while these groups make 40 per cent and 10 per cent of the total contributions respectively.
This uneven distribution of a tax advantage that has such a high cost is behind many of the calls for reform of the system. To date, most of the changes to tax relief have focussed on reducing cost. The proposals suggested by Steve Webb would mean that every pension contribution would receive the same rate of tax relief, whatever the income level of the person that made it, and so tax relief would be distributed in exactly the same way as contributions. That would make the distribution of tax relief more equal.
But would it make tax relief a better incentive? Although a single relief rate at 30 per cent would be more generous to basic rate taxpayers than the current system, they would still need to know about it in order to act on it. So presentation is also important.
The Centre for Policy Studies has recently suggested presenting tax relief as a match – for every £1 the individual puts in, the Government puts in 50p. This could well make the benefit of tax relief much clearer, and also appear to be much more valuable – even though the implicit rate of relief in this formulation is 33 per cent, it somehow seems to be worth much more.
A similar approach has been taken to the presentation of contributions for automatic enrolment – a 4 per cent individual contribution attracts a 1 per cent Government contribution. Much easier to follow than a contribution attracting tax relief of 20 per cent.
So is a single rate of tax relief presented as a matched contribution the answer? Well it depends on the question. It could improve the incentive to save for lower earners, and make the incentive clearer. But it would also reduce the incentives for higher rate taxpayers who currently get tax relief at 40 per cent, or 67p for every £1 they contribute (it would, when allowing for the tax free lump sum, be broadly tax neutral for higher rate taxpayers, so they would not be disadvantaged compared to spending. But they would definitely have less incentive than in the current tax advantaged system). It would be likely to make the distribution of contributions and relief more even.
There are some important implementation difficulties too. Operating tax relief at the marginal rate is relatively straightforward for employers to do. Using a different rate would mean changes for payroll systems. And there are additional difficulties for employers with defined benefit schemes who would need to calculate “deemed” contributions for every member, and where extra payments would need to be made either to or from every employee, depending on their marginal tax rate.
So, as with most reform proposals, there are pros and cons. But, with proposals for tax relief likely to be one of the few areas of pensions policy differences between the major parties at the General Election next year, it is an area that is likely to continue being debated into 2015 and beyond.
Chris Curry is director at the Pensions Policy Institute