Michael Johnson
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Pointmaker COSTLY AND INEFFECTIVE WHY PENSION TAX RELIEFS SHOULD BE REFORMED MICHAEL JOHNSON SUMMARY Today’s incentives to save for retirement are These tax incentives are clearly flawed: essentially financial. They comprise: they are crude and mis-directed tax relief on contributions (cost: £26.1 (primarily towards the wealthy) billion in 2010-11) they lack any emotional resonance and a tax-exempt 25% lump sum at they do little to encourage a savings retirement (£2.5 bn) culture amongst younger workers. NICs relief on employer contributions The savings incentives framework should (£13 bn) and be radically realigned. This paper’s nine tax relief on investment income (£6.8 bn). proposals are listed overleaf, and include: combining the annual contribution limits Over the last decade, relief on income tax for ISAs and tax-relieved pension saving and NICs has totalled £358.6 billion, into a single limit of between £30,000 and (excluding tax foregone on the tax-exempt £40,000 (saving between £1.8 bn and 25% lump sum). £600 mn annually, respectively). The full Over the same decade, the Treasury’s cost of limit should be available for ISA saving; funding tax relief (i.e. the yield on gilts) shelving higher rate tax relief, thereby averaged a real 3.9% per annum, yet the saving £7 billion annually but, as a partial average real annual return on all UK pension quid pro quo, reinstating the 10p tax funds was a paltry 2.9%, i.e. 1% per annum rebate on pension assets’ dividends and less. Thus, the return on the Treasury’s co- interest income, at a cost of roughly £4 investment with people saving for retirement, billion per year; and through the medium of tax relief, has been replacing the 25% tax-free lump sum negative £17.5 billion. With most gilts being concession with a 5% “top-up” of the purchased by pension funds, this is partly pension pot, paid prior to annuitisation. explained by industry charges. This would be cost neutral. 1 SUMMARY OF PROPOSALS Proposal 1: The annual contribution limits for ISAs and tax-relieved pensions saving should be combined at between £30,000 and £40,000, with the full limit available for saving within an ISA. This combined limit could be used as a key cost control lever, with adjustments to it (driven by affordability) becoming a regular feature in the Budget. Proposal 2: Higher rate tax relief should be abolished, the annual £7 billion saving being partly used to reinstate the 10p tax rebate on pension assets’ dividends and interest income (costing some £4 billion). Alternatively, this would more than meet the cost of foregone tax on dividends and income, were the ISA subscription cap raised to £30,000 to £40,000. Proposal 3: The Chancellor should consider replacing all income tax relief with a single flat rate of 25%, or even 30%. This would particularly incentivise low earners to save for retirement. Costs could be controlled by adjusting the annual contribution limit on which relief could be gained. Proposal 4: The 25% tax-free concession on lump sum withdrawals at retirement should be replaced with a “top-up” of 5% of pension pot assets, paid prior to annuitisation. Proposal 5: To be eligible to make any lump sum withdrawal at retirement, the individual should meet the Minimum Income Requirement of £20,000 a year (subject to trivial commutation rules). Proposal 6: Salary sacrifice schemes are essentially a tax arbitrage at the Treasury’s expense. As such, their cost should be reflected alongside income tax relief, to provide a clearer picture of the total cost of tax-based retirement saving incentives. A simplification step would be to ban them. Proposal 7: The rate of tax relief on contributions to children’s pensions should be increased to 30%, irrespective of the donor’s marginal rate of income tax. Proposal 8: Employers should be incentivised to encourage basic rate taxpaying employees to boost their pension contributions. This could take the form of a 5% distribution reward from the Treasury, paid in respect of employee contributions above 4% of band earnings, say. Proposal 9: “Safe harbour” guidelines (not regulation) should be swiftly introduced (not least because of the onset of auto-enrolment), to exempt employers from class actions, provided it can be demonstrated that they were acting in good faith. 2 1. INTRODUCTION would be better to repay such debt; basic rate Today’s incentives to save for retirement are taxpayers would effectively be generating a essentially financial, comprising tax relief on risk-free, pre-tax annualised return of 22%: contributions, the tax-exempt 25% lump sum at “negadebt” (negative debt) saving. retirement, and NICs relief on employer 2. TAX RELIEF contributions. They are crude and mis-directed (primarily towards the wealthy), their (a) Hugely costly effectiveness is woefully under-researched and The state invests a huge amount in tax relief, they lack any emotional resonance. Behavioural primarily in the form of up-front income tax traits, such as loss aversion and hyperbolic relief on employee and employer contributions discounting, have far more influence on savings (at a cost of £26.1 billion in 2010-11). NIC relief behaviour than financial rationale. on employer contributions totalled a further £13.0 billion.1 To put this into context, this is The challenge is to design incentives that equivalent to the UK defence budget (£40 resonate with what matters to people, not least billion), and is 70% more than the Government because the underlying objective is, 2 spent on Transport in 2011-12 (£23 billion). An unwittingly, to move them into the clutches of additional £6.8 billion was spent on tax relief on an industry that is widely distrusted. investment income; the cost of relief in respect Furthermore, the products are often mind- of capital gains realised by pension funds is numbingly complex because of, principally, deemed too difficult to estimate. their multi-various tax treatments. It is no surprise that consumers are bewildered, not (b) What is the purpose of tax relief? least because product pricing signals are Before savaging tax relief, its purpose should almost irrelevant. Unlike almost all other be debated. The state’s main motivation for consumer decisions, the outcome of any encouraging savings is to mitigate future social purchasing decision is typically unknown until security costs, necessary to alleviate pensioner perhaps decades later. poverty. Given that the effect of these costs is likely to increase with old age, the state has an Furthermore, the framework of saving incentive to encourage retirement savings incentives (as well as some aspects of the ahead of discretionary (rainy day) savings with State Pension) is entangled with unrelated their ready access. But the current distribution objectives (often political), notably wealth of tax relief is heavily skewed towards the well- redistribution; this adds to complexity. Ideally, off; the 8% of taxpayers who earn more than wealth redistribution should be confined to the £50,000 per annum receive almost 50% of all income tax framework. 3 pensions tax relief. Clearly, reducing pensioner poverty is not the result. Indeed, one There is also a moral perspective to consider. We should, for example, question whether tax relief is an incentive (i.e. morally neutral) or a 1 HMRC; Registered pension schemes: cost of tax bribe, mindful that the Government would like relief, Table Pen 6, February 2012. 2 people to save for retirement to help reduce HM Treasury; Budget 2011. the social welfare bill. But for people who are 3 HMRC; Survey of Personal Incomes 2009-10, Table regularly servicing consumer loans or credit 3.5, Income and deductions, 2012. (It is accepted that this distribution is not surprising given that the card debt (average APR of 18% per annum), wealthy pay more into a pension and their relief is at saving is unlikely to be in their best interests. It higher rates of tax.) 3 could conclude that tax relief serves as a rate tax whilst working, go on to pay higher reverse form of wealth redistribution (the rate tax in retirement. From the Treasury’s conventional approach being to favour the perspective, this is a bad deal; higher rate tax poor). Arguably, the wealthy do not need such relief is a huge cost to the state, not an an incentive to save, and even if it were investment. deemed appropriate to reduce their tax (ii) Tax relief: eroded by industry charges burden, why not democratise the benefit by The most damning aspect of tax relief is that ending higher rate relief and simply cut the higher rate of income tax? over time it could be entirely consumed by industry charges. Consider a single A thorough reappraisal of up-front tax relief is contribution of £100 net, paid into a pension required (investment income should remain fund by a higher rate taxpayer. This is grossed untaxed, and reinstating the 10p rebate is up to £166.67p by 40% tax relief. Assume that further discussed, below). In extremis, it could the assets subsequently return 2.9% per be abolished, the £26 billion annual saving annum (i.e. the average real annual return of being used to boost the basic State Pension UK pension funds over the last decade4), after (BSP, expected to cost some £63 billion in deduction of an Annual Management Charge 2012-13) by roughly 40%. Such an approach (AMC) of 1.5% per annum (which is typical). would be beautifully simple and, crucially, Every year thereafter, the industry deducts its politically appealing, the beneficiaries (future AMC from the pension fund. Within 37 years, pensioners) outnumbering the recipients of tax 40% of the total cumulative AMC exceeds the relief.