Abolishing pension tax relief tapering outright is unlikely, but not necessarily impossible
If there was a competition for the most absurd and complex feature of the UK tax system, there would be many entrants. But a guaranteed finalist, if not the outright winner, would have to be the system of “tapering” annual allowances for pension tax relief.
There has been a lot of focus recently on the impact of this taper on NHS consultants, but the problem goes much deeper.
Although there are minor tweaks that could marginally improve the system, in my view it should be scrapped altogether – even if the price is a revenue-neutral cut in the across-the-board annual allowance.
One of the most outrageous features of the current system is that the amount of money you can put in to a pension this year within tax relief limits is determined by the amount you earn this year. Yet many people do not know how much money they will earn.
It is not just senior doctors doing extra shifts who have this problem. Successful self-employed people may have little idea as to their profits by year-end, while anyone whose income depends on commission or other forms of performance-related pay cannot know what they will earn.
This could lead to the ridiculous situation where people might be steadily paying in to a pension during the course of a financial year, only for it to turn out after the event that money they have already contributed was in excess of their annual allowance.
They can, of course, hold off making any pension contributions beyond £10,000 until very late in the year when their income will be clearer, but this is likely to cost them investment growth and also requires a good deal of self-discipline not to do something else with the money instead.
A sticking-plaster response would be to change the rules so that your income in the current financial year determines your annual allowance the next year. This would be a marginal improvement and would improve predictability.
However, it would throw up new anomalies, and might create some strong incentives for moving income before or after 6 April, depending on the individual’s situation.
Another very unwelcome feature of the tapered annual allowance is the “cliff-edge” way in which the system switches on for those with “threshold income” over £110,000 per year. For those who enjoy a significant increase in their defined benefit rights in a given year (such as doctors who get promoted), the difference between having threshold income a pound below £110,000 and a pound above it can easily result in a five-figure tax bill.
A much better solution would be to abolish the system of tapering outright. But the Treasury is unlikely to make such a change in isolation.
Given the chancellor has already described the cost of tax relief as “eye-wateringly expensive”, it is politically inconceivable he would make a change that would increase the overall cost of the system, especially if the beneficiaries would be those on the highest incomes.
The political reality is that any potential abolition of the tapered annual allowance is likely to be accompanied by parallel measures to claw back the revenue foregone, probably focused again on higher earners. A government with a big majority (and possibly one of a different political persuasion) might be tempted to go for a much more radical reform and abolish higher rate relief, perhaps giving everyone relief at a rate somewhat above the current basic rate.
But, leaving aside the very serious issues about how this could be done in practice in a world where five million public sector workers are still accruing rights in (largely unfunded) DB schemes, the politics of this are likely to be very unattractive to a chancellor with no majority at all.
Changes like this create large numbers of gainers and losers. While the gainers will often receive relatively modest amounts and may not even understand the changes, the losers will miss out on relatively large sums and are likely to be vocal in the press.
A chancellor without the political strength to put a few pence on a litre of petrol for fear of a parliamentary backlash stands no chance of getting such a measure through the present House of Commons.
This suggests that the most likely offsetting measure if the taper were to be abolished would be some across-the-board reduction in the annual allowance itself, perhaps to a figure such as £35,000.
While few advisers would welcome a reduction in the annual allowance in isolation, if the total cost of the system was unchanged but absurd complexities such as the tapered annual allowance were removed, this might be regarded as a price worth paying.
Steve Webb is director of policy at Royal London