Flat rate tax relief, discussed in article four: Ending marginal rate tax relief on UK pension contributions, effectively involves taxing people twice on the same income (or 1.75 times, after allowing for the tax-free lump sum) and topping it up in between. The obvious challenge is: why not just tax the income once and apply a smaller (or even no) top-up? This might be where flat rate relief would ultimately end up – and policymakers could decide to get there all in one go.
This idea – taxing pensions like ISAs but with an additional incentive – was considered in 2015-16, when George Osborne’s Treasury undertook a major review of pensions taxation. This would have turned the taxation of pensions upside down: tax would be charged before income found its way into a pension, rather than on the way out. In the run-up to the Brexit referendum, the then-Chancellor told the House of Commons he would not be taking this forward, saying, “it was clear that there was no consensus”[1].
Under this system, rewards for saving would be transparent and easy to communicate - at least if people trusted the future governments not to move the goalposts and make supposedly tax-free withdrawals taxable. That is a big plus, but not the be-all and end-all when designing a tax treatment for pensions. As well as providing incentives (which are needed if asking people to lock their money away until retirement), the tax system should also be coherent and relatively easy to administer. Nor should policymakers assume that more transparent incentives would transform saving behaviour: people leave matching employer contributions on the table even when these are much more valuable than any possible Government top-up[2].
The flat rate article in this series describes difficulties with taxing employer contributions or defined benefit accrual under flat rate relief. Most of these would also apply under this model. One difference is that, even for basic rate taxpayers, the upfront tax on employer contributions would exceed the top-up.
Additional considerations include:
Revenue acceleration: Tax on income saved for retirement would be paid earlier. Even if this happened in a way that did not increase the tax someone could expect to pay over their lifetime, it “could provide a huge boost to the public finances in the short-term” – in the words of Spencer Thompson, who is now an adviser to Rachel Reeves[3]. Ignoring changes in the age profile of the population, it might be argued that this provides a one-off gain, as we never reach the point where pensions are being paid out but new contributions are not being made. However, with population ageing, this could exacerbate demographic pressures on the public finances. The OBR projects that government revenues are on course to start declining as a share of GDP after 2028/29 while spending rises, and that the proportion of the population in work will peak around 2040[4].
Old pensions vs new pensions: If new pension contributions were to produce tax-free pension income, they would have to be segregated from existing pension wealth, which will be largely taxable when drawn down.
Conversion: Old pensions could be converted into new pensions, after paying a one-off tax charge. This would further bring forward revenue from the future, potentially on a large scale (with correspondingly large asset sales required). If conversion were voluntary, it would not be universal, so administrative complexity would remain. Compulsory conversion might require generous terms to minimise any impression that it was confiscatory – in which case a move to a less generous system might be accompanied by rewards for people who had done well under the old system.
Less money to invest? The Government’s pension review is looking at how to get more DC and local government pension money into UK assets. Replacing upfront tax relief on contributions with a smaller top-up would mean that less would be invested overall[5]. The Government could invest the revenue and become an asset owner itself, if it wanted to enter “politically controlled investment” territory.
‘Abolition of tax-free lump sums’: Because 75% taxable pension income would be replaced with 100% taxable contributions, this policy could be portrayed as a stealthy way of abolishing the tax-free lump sum (as it was in some newspaper stories when previously was under consideration).
Distributional considerations: The personal allowance currently exceeds the full New State Pension, though no longer by much and not for much longer under current indexation policies. Depending on future policy decisions, it may be that, under the current system, the first chunk of people’s private pension income falls within their personal allowances and is therefore 100% tax-free at both-ends. In that case, moving to T+EE would remove the ability of younger workers with little to no existing pension saving to benefit from a particularly generous feature of the current system.
In 2013, WTW analysed 15 schemes with over 120,000 members, where employees were enrolled at the bottom of a matching scale but could benefit from higher employer contributions if they contributed more themselves. 47% of these members remained at the default level, while only 36% contributed at the rate required to attract the maximum employer match. In 2022, DWP’s qualitative research with employers found that “take-up rates of matching were variable” “Workplace Pensions and Automatic Enrolment: employers’ perspectives,” DWP, October 2022. Return to article undo
This could also be true, to a lesser extent, if flat rate relief were implemented in a way intended to reduce the overall amount of relief. Return to article undo
