Flat rate pension tax relief back on agenda?
The Treasury Committee's latest report on savings seeks to get back on the agenda the idea of a flat rate of tax relief for all. It's good to see the subject being aired against but the downside is that a lot of misconceptions about tax relief, its cost and effectiveness, are being aired as well. This is something we have had plenty to say about and still do.
First, let's be positive about this new initiative. The report to Parliament says: "There is widespread acknowledgement that tax relief is not an effective or well-targeted way of incentivising saving into pensions. Ultimately, the Government may want to return to the question of whether there should be fundamental reform. However, the existing state of affairs could be improved through further, incremental changes. In particular, the Government should give serious consideration to replacing the lifetime allowance with a lower annual allowance, introducing a flat rate of relief, and promoting understanding of tax relief as a bonus or additional contribution."
When the Coalition Government's delayed in 2016 any decision on its consultation on reform of the regime for tax incentives for pension saving, we published a paper, What next for pension taxation?, whose conclusions were similar. To quote the press release:
"Hopefully this setback will prove temporary. A flat rate of relief, all physically paid into the saver’s pot, could have broadly matched the revenue effects of the complex, arbitrary and trap-filled framework of annual and lifetime allowances. Successive governments keep adding to this hated complexity to try to get it to counter the incentives arising under marginal relief. Instead of braking harder and harder to counter the foot pushing equally hard on the accelerator, flat-rate relief was the same as lifting the foot off the accelerator. The Chancellor on 16th March could have scrapped the entire framework of allowances, relying on the rate being self policing, and claimed genuine simplification – a victory for everyone except pensions advisers like ourselves.”
Inevitably, with fresh coverage, mistakes are being made about the scale of the cost of the current regime and about its unfairness. These were important prompts for our own paper in 2016.
The Committee itself shows how most of the relief goes to high earners, ignoring the fact that these are also the people who are most likely to remain higher-rate payers in retirement. Our paper demonstrated how the tax incentive relies on people paying less tax in retirement than when earning, so does not generally apply either at the top end or the bottom end of the income distribution. For these, the only incentive is the tax free cash. Without tax free cash, deferral of taxation from the point of saving to the point of taking the income acts like a loan from the government with an interest rate equal to the rate of return earned in accumulation. That is not an incentive. As it is, without a change in tax rate that may or may not arise, the only visible assurance of an incentive to defer tax is in fact tax free cash, reducing the effective rate by 25%. Indeed, it is arguably only the tax free cash, being roughly equal to the basic rate of tax, that would allow the Government honestly to 'sell' the relief as a 'bonus', as the Treasury Committee suggests. Even then, social media suggests there is a lot of mistrust of the way the current relief is described, which overlooks the 'loan rather than gift' nature. That mistrust may always apply.
The Committee's report does not help public awareness of the fact that the tax relief regime acts very differently between Defined Benefit (DB) and Defined Contribution (DC) pensions. This is important not only as a question of fairness but because one justification of tax relief, as an incentive to investment, no longer applies to DB to the same extent, because other regulations have reduced the proportion of the assets exposed to risk taking and long-term investment payoffs. This justification really only applies to individual contributions and it probably only applies when the contributions are truly discretionary rather than contractual. As we said in the press release to our 2016 paper: "Even allowing for the fact that the budgetary cost of relief for employer contributions is overstated, the proportion represented by contributions where tax decisions do not even affect choices is perhaps around 80-85%".
Our paper included an analysis of the HMRC estimates of the cost of tax relief - that's where those numbers come from. The key finding of our analysis remains true with the addition of two years data from HMRC. When the cost of the relief regime is measured by comparing the current notional cost of relief with the tax being recovered currently (representing the deferral from earlier years with the addition of a growth dividend), the gap is explained not by individual but by employer, and mainly DB, contributions. The way HMRC calculates the cost of relief, most of this is due to employer DB contributions that avoid NI. Over the period in which the gap has grown, DB contributions
have broadly doubled in size as a consequence of deficit-reducing special contributions. It is not surprising the net imputed cost of tax relief has grown so much but that has nothing to do with relief to individuals. When we have time we will update the data analysis to reflect the two additional years.
So, it's good to debate this important area of public policy but the debate needs to be informed by an understanding of the data and the assumptions being made, as well as the underlying principles of tax relief for pension saving.