Fiscal flattery – the wrong reasons for reforming pension tax relief

16 July 2015

In his Summer Budget, George Osborne announced the Treasury would be consulting on proposals to reform the way pensions are taxed. An open debate on this issue is welcome – for too long Chancellors have tinkered with the existing system, creating uncertainty and distorting behaviour. However the proposals under consideration present Osborne with a conflict of interest. While there are strong reasons for keeping some form of the existing system, reform would give the public finances a short term boost.

Pensions are currently treated on an Exempt, Exempt, Taxed (EET) basis. Money directed towards a pension is not subject to income tax, and returns are exempt from capital gains tax. When funds are withdrawn, income tax is levied.

Concerns about the existing system are widespread. Despite costing a net £21 billion in 2013/14, there is only limited evidence to suggest it incentivises additional savings. There are alternatives. The Treasury’s consultation will look into tax treating pensions like ISAs, widely used – and trusted – savings accounts that individuals pay into out of their take-home pay. Returns from ISAs are tax free, and no income tax is paid when withdrawals are made. The treatment of ISAs is therefore opposite to that of pensions, functioning on a Taxed, Exempt, Exempt (TEE) basis.

Moving pensions into line with the tax treatment of ISAs could prove irresistible to the Chancellor at a time when the deficit is still yawning. By taking tax at the beginning of the saving cycle rather than the end, TEE for pensions would shift tax revenues from the medium to short term. The result would be to flatter the performance of the public finances under Osborne’s stewardship.

This political rationale runs against strong reasons for keeping some form of the existing system. An often-cited charge against EET is its distributive impact. Indeed, two thirds of relief goes to higher income tax payers under the current system. But it is not evident that TEE would be more progressive in the long run, and the Treasury’s consultation provides no indication of their best guess. The World Bank’s own research on the distributive differences between TEE and EET is equivocal.

Against this are two drawbacks. The Chancellor’s rationale for the consultation was that “Britain isn’t saving enough.” He is right. 11.9 million of the current workforce will reach retirement with inadequate incomes. But a shift to TEE could exacerbate this further by removing the short term tax relief associated with saving under the current system. At a time when millions of small and medium sized businesses are automatically enrolling workers into a pension, root and branch reform could also put off savers concerned with the rules of the game changing again.

To this we add the considerable transition costs such a move would bring. The Government would need to run TEE and EET savings relief schemes concurrently, and there are significant questions about the treatment of defined benefit pensions under the new system. To avoid unhinging the retirement plans of working age people, the reforms would also need to be phased in over generations.

The Chancellor is right to want a more progressive pensions system, but far simpler measures could achieve this goal. However, when TEE is so closely aligned with the Government’s fiscal and political interests, radical reform may prove too tempting.

William Mosseri-Marlio, Researcher, Reform

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