Is tax relief a good incentive for pension saving?
by Dr. Ros Altmann
(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)
A flat rate 30p or 50p top up is fairer but would add complexity and may not be effective
Auto enrolment already offers £ for £ matching
In recent days there has been significant focus on the issue of tax relief for pensions. Tax relief is meant to provide an incentive to encourage people to lock money away into pensions for their future. It costs huge sums – estimated at around £50billion a year.
Given that our tax system is progressive, with the highest earners paying higher rates of tax, it is self-evident that tax relief will be regressive, giving more ‘relief’ to higher earners than others. This has resulted in concerns about the fairness of the present arrangements and calls for a redistribution of the amount spent on tax relief, giving more to lower earners.
Proposals for a flat-rate 30p or 50p in the £ ‘relief’ for everyone have been put forward, rather than using the tax system which gives more relief to top earners than to the majority of taxpayers who pay only basic rate.
The effect of tax relief can be compared with these proposals as follows:
20% tax relief = 25p extra for every £1 contributed
40% tax relief = 66.6p extra for every £1 contributed
45% tax relief = 81.8p extra for every £1 put into a pension
In addition, non-taxpayers receive basic rate tax relief as an addition to their own pension contributions but they pay no tax at all. This is the most progressive part of the current system but most people are unaware of it.
Clearly, 30p extra for each £1 is a little more generous than basic rate relief, while 50p extra for every £1 is twice a generous for basic rate taxpayers. Both are much less generous for 40% and 45% taxpayers.
The impact of ‘grossing up’, which is the way tax relief works, often confuses people and it is one of the reasons why I believe that tax relief itself is an inefficient incentive for pension saving. Most people just don’t understand it as it is not straight forward.
Auto-enrolment, however, contains a much more powerful incentive than ‘tax relief’ itself. It is a ‘buy one get one free’ offer, albeit on a limited amount.
For every £1 the worker puts in, another £1 goes into their pension. 25p comes from taxpayers and 75p comes from their employer’s contribution. This is a better incentive than any of those proposed.
I support the principle of fairer and better incentives for long term saving but I am not sure just replacing tax relief with a different top up mechanism would be the best way forward. Pensions are already undergoing seismic change and changing reliefs would add cost and complexity, especially for defined benefit schemes.
Careful modelling is required to assess the potential effectiveness of any changes. It is not as simple as just redistributing the current expenditure and, given the state of public finances, any new system would be bound to aim to cut costs.
ISAs have proved popular and they have the benefit of being tax free in retirement but using taxed money up front. This is often easier to understand and more user friendly for many savers. Before adding complexity to pension saving incentives and also creating problems for defined benefit schemes which cannot easily identify contributions, it would make sense to model different incentive regimes carefully to assess the likely impacts on both cost and contribution levels.
Dr. Ros Altmann