Raising Revenue From Reforms To Pensions Taxation

13th September 2024

Recent weeks have seen speculation that the new Chancellor will make changes to pensions taxation to raise revenue in the upcoming inaugural Budget. The current system of pensions tax provides overly generous tax breaks to those with the biggest pensions, those with high retirement incomes and those receiving big employer pension contributions, and there is a strong case for reform. However, insufficient support for pension saving could risk inadequate accumulation of private retirement resources and greater reliance on the state. The taxation of pensions needs to be carefully designed.

Previous research at IFS, funded by the abrdn Financial Fairness Trust, has considered the design of pensions taxation in detail. Here we summarise some of the main options for reforming the tax treatment of private pension saving. We start with what we argue should not happen, before moving on to more desirable reforms.

Capping up-front income tax relief should be avoided
The most commonly suggested way to raise revenue from changes to pensions taxation involves reducing up-front relief from income tax.

Currently, pension contributions (up to an annual limit) attract income tax relief while pension income is taxed. This is a coherent approach. Earnings put into a pension are taxed once - at the time they are withdrawn from the pension.

One implication of this approach is that some people get up-front tax relief at the higher (or additional) rate of income tax but pay the basic rate of income tax on pension income. It is debatable whether this is a problem. By allowing people to smooth their taxable income over time, it creates a more equitable income tax treatment between people whose incomes are spread more or less evenly across years. But clearly some people think this system is unfair.

It may therefore be tempting to reduce up-front relief for higher-rate taxpayers. The sums at stake are large: limiting up-front relief to the basic rate of income tax would be a £15 billion a year tax rise, the vast majority of which would come from those who are in the top fifth of earners when making pension contributions. But it is worth noting that this reform would not only affect those who are higher-rate taxpayers under the current system: more people would be brought into higher-rate tax if their (and their employer's) pension contributions were no longer excluded from tax. For example, an experienced nurse earning £45,000 would typically get an employer pension contribution that the government values at an additional 23.7% of salary - more than £10,000 a year. Given that valuation, about half of the pension contribution would fall into the higher-rate income tax band, leaving the nurse with an additional tax bill of about £1,000 a year if relief were restricted to the basic rate.

Tempting as it may be, there is no coherent logic to making relief on contributions flat-rate while continuing to tax pension income at the individual's marginal rate.

The same logic that says it is ‘unfair’ for people to get higher-rate relief on contributions and pay only basic-rate tax on withdrawals would presumably imply that it is equally ‘unfair’ for people to get basic-rate relief on contributions and pay no tax on withdrawals if their income in retirement was below the personal allowance – yet that argument is never made. And restricting relief on contributions while leaving the taxation of pension income unchanged clearly would be unfair on those (few) who are higher-rate taxpayers both while in work and in retirement: they would in effect be taxed twice on the same income, creating a large penalty for saving in a pension.

The point of both these examples is that a coherent tax treatment of pensions must consider the treatment of pension contributions and the treatment of pension income together. If there is a case for relieving all pension contributions at the same rate, there would equally be a case for taxing all pension income at the same rate. And if the real aim of reform is simply to increase income tax on higher earners, then this should be done directly, through increases in income tax rates or cuts in income tax thresholds.

Principled arguments aside, moving away from up-front income tax relief at the taxpayer’s marginal rate would raise major practical challenges for defined benefit pensions as the value of employer contribution that should be assigned to each individual employee is not straightforward to measure. This is not a minor issue: HMRC estimates that almost half (46%) of all up-front income tax relief is attributable to defined benefit schemes. A reform that treated these schemes (many of them in the public sector) more favourably would be inequitable. There are more coherent and implementable ways to reform the system – including better ways to raise revenue from those with the highest income and wealth.

Pensions should be subject to inheritance tax
Unlike with housing wealth or other savings, if someone dies and passes on a pension pot to a non-spousal heir, the pension does not count as part of their estate for inheritance tax purposes. Ending this inequitable treatment could raise several hundred million pounds a year in the short term, rising quickly thereafter (potentially to as much as £2 billion a year, though probably less) as the introduction of ‘pension freedoms’ in 2015 means more and more people will be dying with pension wealth.

The 25% tax-free component should be targeted towards those with smaller pensions, not those with higher incomes
When withdrawn, 25% of a pension can be taken tax-free (up to a limit of 25% of £1,073,100, i.e. £268,275), with income tax payable on other withdrawals. This subsidy to pension saving has an estimated long-run annual cost of £5.5 billion, with 70% of the relief going to pensions accumulated by those in the top fifth of earners when making their contributions. This well-known part of the pensions landscape could have some justification if it encouraged saving on the part of those who would otherwise save too little. However, it is poorly targeted in two regards.

First, the 25% tax-free component subsidises further pension saving even for those who already have large pensions. While there is a case for encouraging people to save at least a certain amount for their retirement, it is hard to justify continuing to subsidise extra saving for individuals with pension wealth little short of £1,073,100.

The incentive should be removed from those with larger pensions. Reducing the amount that can be taken tax-free from £286,275 to £100,000, for example, would affect about one-in-five retirees (and almost half of those who had been employed in the public sector) but would mean about 40% of pension wealth lost the benefit of the tax-free component. Such a change would raise around £2 billion a year in the long run (40% of the long-run revenue yield from abolishing the tax-free component completely), with losses concentrated among the relatively wealthy.

Second, the 25% tax-free component provides a more generous subsidy for higher-rate taxpayers than for basic-rate taxpayers, and provides no subsidy at all for the part of pension income below the income tax personal allowance – that is, for those low-income pensioners whose pensions arguably most need boosting. A better alternative would give an equal top-up on all withdrawals from pensions. A top-up of 6.25% (before applying income tax), for example, would be equivalent to the 25% tax-free component for someone who is a basic-rate taxpayer in retirement. But such a change would mean a bigger subsidy than now for non-taxpaying pensioners and a reduction in the subsidy going to those paying the higher or additional rate of income tax in retirement. Overall, it would be a tax cut of around £1½ billion a year in the long run – although such a change could be implemented alongside a cap on the cumulative amount of pension income to which the top-up was applied, further reducing the subsidy for those with large pension pots and therefore the overall cost.

One complication with such a change is that it would (unless implemented over a generational time frame) involve some degree of retrospection: people could reasonably argue that they had saved on the understanding that they would be able to take 25% of their pension tax-free. A slower transition would temper that retrospection but would also need to be weighed against the ongoing costs of providing large tax subsidies for individuals with sizeable pension pots.

Reform the generous NICs treatment of employer pension contributions
Employer contributions to pensions are not subject to employer or employee National Insurance contributions (NICs). These subsidies to saving are generous, opaque and poorly targeted, and could be sensibly reformed – though Labour’s manifesto pledge not to increase NICs might make that difficult.

Different ways forward are required for employer and employee NICs. It would be sensible to move towards levying employer NICs on employer pension contributions. If levied at the full rate (13.8%), this would raise around £17 billion per year. We estimate that £14 billion of this rise relates to contributions for new pension accrual (as opposed to contributions plugging deficits in defined benefit schemes), with around £6 billion of that £14 billion coming from contributions made to pensions held by the top 10% of earners. A ‘big-bang’ change that completely eliminated this subsidy would risk a large decline in contributions to pensions. A more cautious approach could be taken where employer NICs are levied on employer pension contributions while a subsidy to employer contributions is introduced at a lower rate. For example, levying employer NICs (at the rate of 13.8%) alongside a new subsidy for employer pension contributions of 10% would mean a tax rise of around £4½ billion per year.

In the case of employee NICs, there is a good case for moving towards a system with up-front relief for employee, as well as employer, pension contributions. In return, employee NICs would be levied on private pension income. In the long term, such a change could raise substantial revenues (if pension funds’ investment returns are strong) and re-target financial incentives to save away from the top tenth of earners and towards those in the middle of the distribution. The transition to such a system would need to be carefully considered. If relief from employee NICs were given immediately for all new employee pension contributions, the annual cost would be around £2–3 billion. This initial outlay would be less than the £4½ billion that would be raised by replacing the existing employer NICs subsidy on employer pension contributions with a flat 10% subsidy. In addition, each percentage point of NICs levied on private pension income would raise around £¾ billion currently; but immediately charging full employee NICs on private pension income might be seen as unfair because current pensioners may have paid employee NICs on their employee contributions (implying some paying employee NICs twice) and many might have saved in the expectation that they would not face this tax in retirement. There is no perfect solution here, but one way forward might be to phase in NICs on pension income by date of birth, with later-born cohorts (more of whose pension contributions would have received NICs relief) paying higher rates of NICs on their pension income.

Stability is valuable
There are sensible reforms to the taxation of pensions which could refocus the support for pension saving towards those more at risk of undersaving. A package of reforms along the lines set out above could be designed in such a way as to raise revenue while ensuring that the bottom eight deciles of earners gain on average (in the long run) – and see their incentives to save in a pension strengthened. Comprehensive reform is preferable to reintroducing a lifetime limit on tax-privileged pension wealth (a change which Labour had pledged to make but dropped during the election campaign). There would be political choices to be made about how quickly to phase in some reforms.

Constant tinkering with pensions taxation is not welcome, though. Whatever package of reforms is pursued at the Budget, it is important to set out a clear and coherent direction of travel for pensions policy and, as far as possible, provide a predictable environment for savers. As the government undertakes its promised review of the pensions system, it should articulate how it sees tax fitting into an overall plan for state and private pensions.

https://ifs.org.uk/articles/raising-revenue-reforms-pensions-taxation