Will Osborne be tempted to ‘inappropriately spend’ pension tax reform windfall?

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An influential think-tank has warned George Osborne he risks putting people off saving in the long-term if he uses funds raised from radical pension tax relief reform to pay for short-term giveaways.

The Chancellor is expected to set out fundamental reforms to the pension tax system in next month’s Budget, with the Treasury understood to favour introducing a flat rate of relief set at 25 per cent.

Policymakers are also considering flipping the tax relief system on its head so contributions, rather than withdrawals, are taxed, while reports have also surfaced in recent weeks suggesting Osborne could once again take the axe to both the annual and lifetime allowance for tax-free saving.

In its Green Budget, published yesterday, the Institute for Fiscal Studies says there is a “significant chance” the Treasury will not achieve its fiscal target of running a budget surplus in 2019/20 without further tax rises or spending cuts.

Reforms to pension tax incentives could raise billions of pounds in the short-term, but the IFS warns these revenues may only be temporary.

Moving to a taxed-exempt-exempt ‘Pension Isa’ system would have “dramatic consequences for the profile of tax revenues and poses significant political risks”, the IFS says.

It says: “Moving to a system in which contributions are taxed up front rather than on receipt would dramatically boost tax revenues in the near term.

“But levying this income tax up front would come at the expense of a reduction in revenues in the future, as the Government will no longer collect income tax on these pensions in payment.”

The IFS also suggests the Chancellor could be tempted to “inappropriately spend rather than bank” any “temporary windfall” from switching to a TEE regime.

It says: “To the extent that the policy change only brings revenue forwards in time, the right response is to bank this money rather than use it to cut taxes or boost spending in the short-term.

“But is it credible that the Chancellor or one of his successors – faced with a large surge in income tax revenues – would resist the temptation to give at least some of it away? In the longer term, when higher-income older people are enjoying their tax-free pension income, is it credible that a future, potentially cash-strapped, Chancellor will avoid the temptation to levy tax again on this income (i.e. TET tax treatment)?

“The first question suggests that future generations of taxpayers may not thank us if we allowed a Chancellor to take the tax revenue up front and spend it. The second question suggests that we might ourselves be wary of putting much into our pension funds in case a future Chancellor decides to tax us again.”

Reducing annual and lifetime allowances further would boost tax revenues in the short-term, the IFS says, but this would come at the expense of “some future tax revenues”.

Furthermore, cutting the lifetime allowance from £1m to £750,000 wold raise “significantly more” than the £600m gained from the previous £250,000 cut because “far more people would be affected”.

On introducing a flat rate of tax relief, the IFS says: “This policy…has the potential to increase tax revenues somewhat in the short-term but potentially at the cost of slightly lower revenues in the longer term.”

It says the longer term impact of the reform is uncertain because it is not clear how peoples’ savings habits will alter as a result of the shift in incentives.

In theory, lower and middle income earners should save more as their incentive is increased, boosting tax revenues when they come to draw their pension, while higher earners will save less, depressing tax revenues on withdrawals.