Mark Wadsworth is a Chartered Tax Advisor. He blogs here.
The eternal fall back when people talk about pensions is that “We must encourage people to save” and give the matter little further thought apart from assuming that the only form of encouragement is tax breaks. It is, in fact, mathematically and logically impossible to improve people’s incomes in retirement by tweaking the tax system, and by and large it reduces it. A few salient facts (annual figures unless stated, figures for 2011-12 where available):
1. The total value of all the tax breaks for pensions saving are soaked up in fees and charges by the pensions industry
The total cost of income tax and National Insurance reliefs before netting off income tax withheld from pensions in payment is £51.9 billion (pdf) (total income tax withheld from pensions in payment is £8.4 billion) and the total value of fees and charges levied by the pensions is in the order of £50 billion. Thus all the tax breaks taken together do not increase the retirement incomes of pensions savers by one penny, and it is far cheaper to top-up the state pensions to the level of Iain Duncan Smith’s proposed Citizen Pension of around £150 per week.
2. Sixty per cent of the value of tax breaks for pensions saving accrue to higher rate taxpayers
In other words, if the value of the tax breaks were not siphoned off by the pensions industry, higher rate taxpayers would receive tax relief worth £30 billion. If the value of the relief were halved it would save £15 billion, more than enough to scrap the higher and additional rates of income tax. Using HMRC’s ready reckoner (pdf), this would only ‘cost’ £13.1 billion. In other words, higher and additional rate tax only have to be imposed to fund tax breaks for higher and additional rate taxpayers, the whole thing is a negative sum game. Please note, this would actually lead to regressive tax rates, because of National Insurance, so is not necessarily the best kind of tax reduction (see point 4).
3. Relief from National Insurance is as important as relief from income tax
According to the Public Sector Finances Databank, total income tax revenues are £150.7 billion and National Insurance revenues are £102.4 billion. Income tax is ‘progressive’ but National Insurance is ‘regressive’ in almost equal and opposite measure. The true marginal tax rates on employment income (taking Employer’s National; Insurance into account) are as follows:
- Basic rate taxpayers = 40.2%
- Higher rate taxpayers = 49.0%
- Additional rate taxpayers = 57.8%
So if basic rate taxpayers/their employers make a contribution to a pension scheme out of gross income, the effective rate of relief is 40.2%, against an effective tax rate of 15% on the final fund (one-quarter can be taken tax-free and the pensions in payment are largely taxed at 20%). The total cost of relief from National Insurance for pension contributions, included contracted-out rebates is given as £24.6 out of the total £51.9 billion.
4. If tax relief for pensions were reduced to basic rate only – the same rate as income tax on pensions in payment – this would enable us to reduce income tax and National Insurance to a combined flat rate of tax of 38%
This is 2% lower than the overall effective rate paid by basic rate taxpayers and a lot less than the overall effective rate paid by higher or additional rate taxpayers. (Contributions to pension schemes are about £85.6 billion a year, assuming that this is the net of tax amount, the average rate of relief is 40%. So halving the rate to 20% would free up £26 billion a year. Using HMRC’s ready reckoner, capping income tax and Employee’s National Insurance at 32% would be about £7 billion – there are two ways of calculating this – leaving £19 billion to reduce Employer’s National Insurance to 9.3%.)
5. If tax relief for pensions were scrapped entirely, this would enable us to reduce income tax and National Insurance to a combined flat rate of tax of 34%
This is 6% lower than the overall effective rate paid by basic rate taxpayers. Of course, HMRC’s ready reckoner is to be used with caution, as they show the effect of incremental changes; the required tax rate might indeed be higher than this on a static basis, but if we factor in Laffer effects, the rate might be lower. Surely, there are many people who are willing and able to save up for retirement and would do so in the absence of tax breaks (for example, using an ISA); some people are neither willing nor able to save up; and so the best that the entire taxpayer-subsidized pension system can achieve is to push a few marginal wavers into saving, but to some extent this just lulls them into a false sense of security – so their pension contributions might come at the expense of paying off their mortgages.
6. One final thought
Logic says that there is a limited pool of potential investments that pensions funds can hold. UK pension funds already manage investments worth £2,000 billion, which is about half of all suitable investments (quoted shares and bonds; commercial land and buildings). If UK pension funds owned all potential UK investments with an overall annual yield of (say) 4% and half of this were re-invested for current savers and half paid out as pensions to 12 million people over pension age, the average private pension would be less than £7,000 a year. If some people want to and can afford to build up a larger pension fund to earn more than £7,000 in retirement, then this not only reduces the potential private pension income received by others but also pushes up the price of stocks and shares (or pushes down their yield) and so again, this is a negative sum game, taking all pension savers as a whole.