Pensions tax relief cuts: Why the government is vastly over-estimating what it could save from moving to flat rate relief

Sarah Brown
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The Treasury seems to be overstating how much a flat rate of tax relief will save the government (Source: Getty)

In his Budget speech on 16 March, the chancellor is widely expected to announce – potentially quite radical – changes to the taxation of pensions. This will not just be important for pensions professionals. Fundamental changes to the way tax relief is granted could have significant consequences both for members of pension schemes and for those who provide them.

Of course, we do not yet know what the chancellor has planned. But there is speculation that he will announce a system under which pension contributions are subject to a uniform rate of tax relief – a shift away from the current system in which people receive relief at their marginal rate of income tax.

The merits and pitfalls of such a system will hinge on the detail of how it will operate. Yet one of the biggest unanswered questions is how much money a shift to a flat rate of pension tax relief would actually save the government, as the figures quoted by the Treasury appear to be overstated.

The consultation last year on whether there should be changes suggested that tax relief on pension contributions currently costs the Treasury nearly £50bn a year. But this includes a number of items which should arguably be excluded from the figure, including tax relief on contributions to plug defined benefit pension scheme deficits in respect of benefits that built up in the past, relief on investment income, and National Insurance savings. Further, it includes contributions to public sector schemes, where tax savings (or costs) should ultimately filter through to the government. Excluding all of these items would reduce the government’s potential savings to under £20bn a year, so less than half of the amount quoted in the consultation.

Our estimate that the true cost of tax relief is less than £20bn a year is also consistent with Department for Work and Pensions figures. These suggest that the government has overstated the costs of tax relief on occupational pension scheme contributions by up to £14bn. There is clearly further analysis available to the chancellor, so he has an opportunity to refine any costings before he proceeds with any policy decision.

The level of savings will depend on where the flat rate is set, with many predicting relief of between 20 per cent and 30 per cent. It is clear that the higher the flat rate of relief, the greater the value of that relief to those individuals who are saving in a pension and the greater the cost to the Treasury.

Based on tax relief on pension contributions currently costing £20bn a year, our estimates suggest that moving to a 25 per cent flat rate of tax relief could save as little as £4bn a year. Further, much of this saving is likely to emerge regardless of any change to the system, as the limit on how much higher earners can contribute to pensions is already being reduced from this April. The overall saving is also likely to fall over time as levels of contributions increase under auto-enrolment, which is likely to mean higher contributions from individuals who either pay no tax or basic rate tax.

Moving to a flat rate of tax relief would be a significant change, for members, providers and scheme sponsors alike. If such a change is to go ahead, it is important that the cost analysis is based on the correct data and takes account of how contribution levels may change in the future.

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