On 31 July, HMRC published new estimates of the cost and distribution of pensions tax relief, covering 2022/23[1].
HMRC’s statistics routinely spawn a confusing array of claims about how much the current tax treatment of pensions “costs”, because different commentators add and subtract different things to produce a total. Accordingly, the official “cost” of the system in 2022/23 was:
£42.5bn if you just look at income tax relief on pension contributions. Crucially, three quarters of this relates to the cost of not taxing employees on the value of employer pension contributions.
£46.8bn if you add the £4.3bn cost of not taxing members on the scheme’s investment income.
£70.6bn if you also add the £23.8bn cost of not charging employee and employer National Insurance on employer pension contributions; but this falls to
£48.7bn if you deduct tax collected on private pension income and (much less significant) through Annual Allowance/Lifetime Allowance charges.
These estimates are not comparable to other HMRC’s statistics that count the revenue attributable to specific taxes. Unlike such “real world” numbers, estimates of the cost of pensions tax relief are produced by first imaging an alternative tax treatment regarded as having zero cost, then using imperfect data sources to estimate the revenue effects of transporting taxpayers to this fictional regime, all on the assumption that no-one’s behaviour would change. The benchmark system that HMRC uses is one where:
Pension contributions are made from post-tax income (with employer contributions subject to income tax as benefits in kind);
Scheme members pay tax when their scheme receives investment income, though not on capital gains; this is a harsher treatment than currently exists within ISAs.
Pension withdrawals are tax-free; and
Employee and employer National Insurance is applied to all pension contributions.
In other words, this hypothetical tax regime for money locked away in pensions is a little less favourable to savers than the current regime for immediately accessible ISAs.
Commentators who pick the biggest available number (£70.6bn) implicitly attach no value to the revenue that the Government will eventually receive from future retirement incomes derived from today’s pension contributions. But the net numbers do not represent the end-to-end cost of the tax relief being provided now, either: they deduct tax paid by today’s pensioners, not an estimate of what current contributors will end up paying.
The Institute for Fiscal Studies has tried to put a number on the “difference in the lifetime tax burden on contributions made in a single year”, comparing the current system with potentially suitable benchmarks. It put this cost at £46bn compared to ISA-style treatment. However, the existing approach cost just £4.4bn relative to a system that applied income tax and National Insurance when income was received in retirement (with no tax-free lump sum)[2]. 90% of the cost of tax relief disappears if you think people should have some scope to smooth income across their lifetime so that high marginal tax rates are better targeted at high lifetime (rather than annual) incomes.
While HMRC’s estimates should be approached with caution, they do contain some useful points for policymakers.
3/4s of income tax relief on contributions relates to not taxing employees on the value of employer contributions. Any departure from the principle of giving marginal rate relief on pension contributions would therefore have much less effect if confined solely to the contributions that individuals pay – and that’s before higher earners respond by asking their employers to substitute pension contributions for salary.
Almost half of income tax relief on contributions relates to defined benefit (DB) schemes. 2022/23 was the first year in which this proportion was less than half – but the share is still far too big for DB to be regarded as a fiddly detail to sort out once the principles have been settled. Relatedly, almost one third of total income tax and NI relief on contributions relates to public sector schemes. The proportion might be different if the value placed on DB accrual for tax purposes did not match the value of contributions, but it would be significant on any plausible approach.
Some basic rate taxpayers would pay more tax if higher rate relief ended: HMRC looks at the tax that would be charged if employer contributions were added to taxable income. Where this would take a basic rate taxpayer’s gross income above the higher rate threshold (£50,270), the basic rate taxpayer is treated as getting some relief at the higher rate. A key policy decision would be whether and how to move tax thresholds at the same time – though any increase would eat into the fiscal savings (and principally benefit higher rate taxpayers – indeed, those not saving in a pension could be net winners).
Includes impossible-to-collect revenue from deficit reduction contributions (DRCs): £2.8bn (7%, down from 13% in 2020/21) of tax relief on contributions relates to DRCs paid by DB sponsors – as does an unspecified proportion of NI relief. DRCs improve the security of past pension promises (often for former employees, including pensioners), rather than boosting pension entitlements. HMRC’s estimates apply average tax rates, but DRCs would have to be allocated to individual taxpayers before they could be taxed.
£5bn of potential revenue from ending NI relief is really a spending cut: £5.3bn of employer NI relief benefits public sector employers. Without this relief, more of the budgets allocated to employers such as NHS Trusts would go straight back to the Exchequer. Increasing budgets to compensate (as the Government did after reductions in the discount rate used in public sector schemes’ valuations[3] increased pension costs) would remove this fiscal gain.
Tax and relief are distributed very differently: HMRC estimates that 63% of income tax relief on contributions was given at the higher or additional rate (which is not the same as saying it benefited higher and additional rate taxpayers – see 3, above). By contrast, 84% of employee National Insurance relief in 2022/23 was given at the rate paid by basic rate taxpayers (though this will be less pronounced in later years, following cuts to the main rate of employee NI).
Interaction with quirks of the tax and benefit system: HMRC’s estimates include the effective 60% relief given to people on the personal allowance withdrawal taper. They exclude the way in which pension contributions can improve entitlement to Universal Credit[4] or Child Benefit[5].
Lots of moving parts: The latest HMRC estimates are for 2022/23. Some factors can be expected to push these figures up (frozen tax thresholds, changes to Lifetime Allowance and Annual Allowance). Others can be expected to push them down (lower DB costs; lower employee NI rates; more tax on private pension payments as State Pensions increasingly consume all/virtually all of pensioners’ personal allowances).
“Contributions to public sector schemes reflect the cost of providing benefits on particular assumptions. One of these is a discount rate that is informed by the OBR’s view on the economy’s long-term growth rate. Return to article undo
“People on the Universal Credit can effectively exchange £3.60 of current income for £10 in their pension pot: a £10 contribution costs £8 from post-tax income but increases Universal Credit entitlement by £8 x 55% = £4.40. Return to article undo
“Child benefit is tapered away on incomes between £60,000 and £80,000. Employee pension contributions reduce income for this purpose and employer pension contributions do not count towards it. Return to article undo
