Craig Mackinlay is Member of Parliament for South Thanet. He is also a Chartered Accountant and Chartered Tax Adviser.
It would be fair to say that recent years have seen little short of a revolution across state, public and private sector pensions. Whereas decades ago, the UK had a healthy pensions outlook, much of which was underpinned by the certainty (for employees) of Defined Benefit Schemes, Gordon Brown’s changes to dividend taxation in 1997 – preventing pension schemes from being able to reclaim the tax credit on dividends – took a significant slice out of schemes’ income and future compounding growth. The cost of this raid was calculated in 2006 at £150 billion.
The 1997 changes can fairly be blamed as the start of the end of final salary schemes within the private sector. Auto-enrolment is forecast to dramatically increase the percentage of the population building a personal fund, but low investment returns means a meaningful retirement income needs to be founded on a substantial fund, unlikely to be built on minimum statutory contribution rates within auto-enrolment as proposed.
Further tax restrictions to Lifetime Allowances and annual contribution allowances, whilst estimated to have saved the public finances £6 billion per year, have added complexity and confusion.
Therein is the great problem with pensions over the past 20 years: shifting sands, tinkering and uncertainty. For the pension investor, the great questions to be answered personally are: “will there be another change of direction?” and “is putting good money away today worthwhile for a hopeful return in the future?” Little wonder that many who are able have chosen ISAs as their preferred choice. Others may have chosen the route of “buy to lets”. As with ISAs, they offer the ability to cash in at any time, as well as growing rental returns and a reasonable expectation of capital growth. The July 2015 Budget changes cast doubts on this route with phased restrictions to deductibility of interest. New entrants are likely to be deterred further by the new 3 per cent stamp duty surcharge from April 2016.
The start point is the consideration of the current system of “Exempt-Exempt-Taxed” (EET). Exempt from tax by relief on the way in, exempt from tax on income during the accumulation period, but taxed as PAYE income on the way out with 25 per cent of the fund allowed tax free upon retirement. This well-trodden system has been subject to restriction as to the size of the Lifetime Allowance, introduced at £1.5 million in 2006, increasing to £1.8 million by 2010, and now marching back down the hill to £1 million from 2016 to rise again later by inflation. Further, the annual amount that can be invested, receiving full tax relief at the highest margin has been successively restricted from £255,000 per year in 2010/11 to £40,000 today – but again this is not the end of new complexities, with the July 2015 Budget introducing tax relief restrictions from April 2016 to those with earnings over £150,000. This measure was the quid pro quo for changes to Inheritance Tax, allowing an extension of IHT reliefs to £1 million for a couple when including the family home. Do keep up! The restrictions above form the £6 billion of calculated annual savings as of today.
It is obvious that higher earners have had the lion’s share of tax relief, and despite fairly draconian changes, this route remains desirable to the higher rate taxpayer. If employers make pension contributions directly, in agreement for a salary sacrifice, there are tax savings, but also employer and employee National Insurance savings as well due to base salary reductions. This is the complication that I fear will lead to complex drafting of any changes if advanced in the March 2016 budget.
It is fair to say, for higher rate taxpayers, the reason for pension contributions has little to do with the goal of saving for the future; other savings and investment strategies will probably see to that based on surplus income beyond expenditure on an annual basis. The main goal is tax relief. For 2013-14, total tax relief on pension contributions is published as a fairly staggering £31.3 billion (so probably nearer £35 billion for 2015/16). Including national insurance losses this is closer to £50 billion per year. Now we’re into the realms of significant inroads into the current budget deficit.
It is the basic rate taxpayer that needs encouragement into pension saving.
Which way do we go? There are suggestions of an ISA style “Taxed-Exempt-Exempt” (TEE) system being preferable. No tax relief on the way in but accumulation income growing tax free as now, with ultimate returns of income free of tax. But how much confidence would the taxpayer have that a subsequent government might argue for tax on the way out in the future as well – “Taxed-Exempt-Taxed” (TET)?
What might emerge, more importantly – what should emerge
As a Chartered Accountant and Chartered Tax Adviser, the close to 20,000 pages of UK tax code (vs Hong Kong’s 235 pages) is way too complex already. My fear is that change will add to an already burdensome regime.
I do see appeal in a flat rate, and it is not an alien concept as a tax reducer, rather than a tax relief at source. Similar exists in tax relief under Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCTs) whereby, if a taxpayer has paid sufficient tax during the year, 30 per cent of the EIS investment is returned as a tax refund, not related to the marginal rate of tax that the taxpayer is in. Rates already suggested are between 25 per cent and 33 per cent. My plea is to follow tax reducer rates deemed appropriate in other parts of the tax system, so please let’s choose 30 per cent.
The main problem arises in salary sacrifice arrangements, and this is where pages of anti-avoidance legislation could slip in to counter an obvious potential abuse. What would be recognised as avoidance – current defined benefit schemes? Employers deciding to reduce an expected salary increase to take account of new employer contribution requirements of auto-enrolment? New employer contributions at any level? A bad trading year? Would this be dealt with as a tax and NIC-able benefit-in-kind? Probably.
- A flat rate of tax subsidy relief of 30 per cent up to the amount of tax paid by the taxpayer (akin to EIS) whilst retaining existing top-up available to basic-rate and non-taxpayers by the government.
- Salary sacrifice of up to £10,000 should not be recognised. There would be some tax and NIC loss but a significant measure to reduce complexity and would exempt a huge majority of normal behaviours from coming within benefit-in-kind anti-avoidance legislation.
- A restriction to “tax free” lump sums to 25 per cent (as is) or £50,000, whichever is the smaller. This would skew favour towards basic rate savers who would be unaffected.
- The first £5,000 of pension income to be tax-free up to the higher rate threshold. This portion of retirement pension should be taxed in a way similar to UK-based single premium investment bonds, deemed to have suffered basic rate at source. This would mirror many features of the new dividend tax regime together with the extension of tax-free interest income.
Other aspects of the new pension freedoms and taxation thereon should remain unchanged.
What would be the impact on the Treasury of these proposals? Large pension contributions by higher rate taxpayers would lessen, with a greater take-up by basic rate taxpayers – this is the behavioural benefit. Overall, I estimate an additional annual saving to the public purse in restricted tax reliefs that predominantly benefit higher rate and additional rate taxpayers to be in the order of £10 billion per year.