Nice try, but no cigar: the Chancellor and pension tax relief

We’ve known for some time that George Osborne wants to make radical changes to how the UK’s tax system encourages people to save for their pension. Yet we’ve now learnt that his preferred change is not going to happen. Here’s why he was right to agitate for reform (even if not for the particular change he preferred), but also why (despite being the Chancellor) he’s not going to get his way.

It is no secret that the Chancellor has a clear preference for moving away from today’s system of tax relief on contributions, to an ISA-style pension in which contributions are taxed but pension income is tax-free. He floated the idea in his Summer Budget speech last July, he launched a consultation on making the switch, and right up until yesterday the Treasury has been expending valuable pre-Budget time trying to persuade fellow ministers, the industry and themselves that now was the time for this big move.

That charm offensive has now failed – but most of the motivations that lay behind reform of pension tax relief were right. Here’s three of them.

First, the status quo is very expensive. The gross cost of relief topped £34 billion in 2014/15.

That compares to roughly £30 billion spending on tax credits. Now you can’t simply compare those two numbers because a sizable chunk of the tax relief is in fact tax deferred and paid in retirement – but there are real economic costs of the existing relief (and the in-year net cost still amounts to around £21 billion). These are driven by the fact that people tend to pay much lower rates of tax in retirement (when they draw down a pension and pay tax) than when they are working (and making tax relieved contributions), and by the 25% of a pension pot that can be taken totally tax free.

This is a lot of money, and that’s before you look at the £14 billion or so spent on National Insurance exemptions on employers’ contributions. These costs grew significantly during the 2000s, although they have flattened out since the introduction and subsequent tightening of restrictions on access to tax relief for higher earners from 2006.

Second, the current approach is incredibly regressive. The bottom half of pension savers receive just 8 per cent of relief, while the top 1 per cent benefit to the tune of 14 per cent. This is partly a simple reflection of the fact that richer people save more – in 2012/13 higher and additional rate taxpayers made up 8 per cent of the 16+ population, 13 per cent of all taxpayers and 30 per cent of pension savers. But it’s not just that. This 30 per cent of pension savers made 47 per cent of employee pension contributions but received a huge 71 per cent of tax relief. So as well as the fact that the richest contribute more, they also benefit from receiving relief at their (higher) marginal rate.

Third, recent wider pension changes have potentially further undermined the effectiveness and role of the existing system. Tax relief beyond simple tax deferral exists for two principal reasons. To compensate for restrictions on savings locked into a pension and to encourage people to save more than they otherwise would. But in recent years we have seen the first of these reasons undermined by the introduction of much more flexibility about how a pension pot is used (including ending the requirement to turn it into an annuity) and the second delivered much more effectively by the introduction of auto-enrolment (forcing firms to offer pension schemes to their staff and requiring people to actively opt out if they do not want to take part). Auto-enrolment has in fact been about as close to a triumph as public policy gets, with millions of new pension savers and only around 10 per cent opting out. For the first time in decades (during which tax relief was in place), the proportion of the working population saving into a pension scheme is consistently rising. Now that doesn’t mean people are saving enough, or that incentives to encourage them to go further aren’t needed, but it does mean that it’s far from unreasonable to consider reform.

For all three of these reasons I think George Osborne was justified in looking at changing the system. So if there were good reasons for pushing for reform, why has the Treasury pulled the plug? Largely it’s down to concerns surrounding the particular reform option favoured by the Chancellor – a big bang of scrapping the current system and moving to a pensions ISA style approach. In simple terms this would have meant ending up-front tax relief, while also scrapping tax paid on pension income in retirement (moving from what is called an EET system to a TEE approach – tax paid up front, not in retirement). An incentive would have been retained in the form of some degree of matching of savings (i.e. you put in a pound, the government adds 50p), up to a cap.

This approach is not without some merits, but it would have been risky. Crucially it failed to build support from others in government, and more broadly across the Conservative Party, for three reasons.

First, there would be losers. Big ones. And they would be about as close to core Tory voters as you can get. Depending on the exact approach chosen, many higher and additional rate taxpayers – what the Telegraph calls ‘middle Britain’ upwards – would have been worse off.

This is unsurprising given they are the winners from the current system. You can’t spend less, make the system more progressive AND avoid hitting these groups. The scale of the losses could have been significant – simulations of some options show pension pots over 25 per cent smaller for some higher earners.

Second, the scale of the change would have brought wider risks to our pension system. Some of these could have been managed – but it would have been a gamble. When a similar (if even more radical) change was made in New Zealand 25 years ago it had a huge negative effect on pension saving that they are still dealing with today. In particular, if done in the wrong way, there would be a risk that employers’ engagement with the pension system would be undermined.

Third, the politics made this a challenging time to sell such a radical approach. The Conservative Party has enough to row about with the Europe referendum, without adding a major issue of policy to the flames. A party division on this issue could have become big enough to sustain the splits we are currently seeing beyond the June 23rd vote. And the legacy of the tax credits climbdown last summer also seriously limited the ability of the Treasury to tell others to accept their judgement for how sellable a radical policy change could be.

George Osborne was right to look to improve our system of pension tax relief. The pensions landscape has changed and we spend too much on what remains a highly regressive system. But the scale of the change proposed and the wider context mean reform has fallen by the wayside. For the first time with this Chancellor, the Budget he delivers won’t be the Budget he wanted to give.