Tax revenues will be affected by pension reforms


The Institute for Fiscal Studies released its Green Budget on 8 February. The report looks, among other things, at the challenges chancellor George Osborne faces in relation to pension reforms in the run-up to the Budget on 16 March.

The government plans to have a budget surplus in 2019-20, but the IFS report states that Osborne needs to increase taxes or introduce further spending cuts in order to reach his target.

It maintains that "there is a significant chance that the government's current fiscal plans will not deliver the targeted surplus in that year without further tax rises or spending cuts".

The sword of Damocles

The report argues that tax revenues will be affected by the possible reforms to tax treatment of private pension contributions that are currently under consideration.

Offering a single flat rate of tax relief on pension contributions, which is one of the likely outcomes, would increase the total amount of tax relief offered up front to those on middle or lower incomes, and reduce the amount offered to those on higher incomes.

Nathan Long, head of corporate pension research at Hargreaves Lansdown, says: "The Sword of Damocles has been hanging over higher-rate tax relief for years and now looks odds on to fall as soon as next month."

The IFS report argues that the single flat rate of tax relief policy - like the option of reducing the annual and lifetime limits - has the potential to increase tax revenues in the short term, but at the cost of lower revenues in the long term.

The report raises the concern that this tendency to focus on short-term indicators of the health of public finances might lead the chancellor, or one of his successors, to inappropriately spend rather than bank the temporary windfall.

According to the IFS, the government estimates that under the current system, up-front income tax relief on pension contributions totalled £27 billion (£6.8 billion on individual contributions and £20.2 billion on employer contributions) in 2013/14.

However, much of this will be recouped in future from income tax received when private pension incomes are drawn. In 2013/14, £13.1 billion of income tax was paid on income received from private pensions. Therefore, much of the up-front tax relief is in effect a tax deferral.

Future changes

Another option under consideration is a move to a TEE (taxed - exempted - exempted) tax treatment.

Again, the report argues that moving to a system in which contributions are taxed up-front would boost tax revenues in the short term, but reduce them in the long run, as the government can no longer collect income tax on the pensions when they pay out.

That raises the risk of future governments making further changes to the pension system, it warns: "In the longer term, when higher-income older people are enjoying their tax-free pension income, is it credible that a future, potentially cash-strapped chancellor will avoid the temptation to levy tax again on this income?"

The report concludes that "future generations of taxpayers may not thank us if we allowed a chancellor to take the tax revenue up front and spend it".

There is also the concern that people may be put off from putting money into their pension because of pension policy uncertainties. The tax regime of today might not be that of tomorrow.

However, people seem keen to capitalise on current opportunities to make use of higher-rate tax relief on their pension contributions, which are expected to disappear after the Budget.

Looking at the period from 1 July to 31 December, comparing 2014 to 2015, Hargreaves Lansdown has seen a 56.3% increase in contributions.

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