Tax and Fiscal Policy

Flat-rate pensions ‘tax relief’ would be devoid of any economic rationale


Economic Theory

Gustav Blix appointed as new director of EPICENTER

Energy and Environment

Reaction to government announcement on 'sock puppet' funding

IEA releases new pensions tax briefing Pension Tax Relief Briefing Feb 2016.pdf
Calls to overhaul pension tax relief by introducing a flat-rate of tax relief are misguided. A concise new briefing from the Institute of Economic Affairs argues that if the current system is changed in this way there would be huge practical problems, unnecessary new complexity and inappropriate over-taxation of those on fluctuating incomes.

With rumours circulating that Chancellor George Osborne will use the forthcoming budget to replace tax relief on pension contributions at a taxpayer’s highest marginal tax rate (usually 40 or 45% for higher earners) with a so-called ‘flat rate pension tax relief’, perhaps at 30%, the briefing explains why this would be incompatible within the current pensions framework, moving our system from one of genuine tax relief to a complex system of arbitrary subsidy.

Although critics claim that pension tax relief is expensive and skewed towards those on high incomes, there are several key objections to such a change.

  • Higher-rate taxpayers could end up effectively paying a “fine” to make pension contributions. Under a so-called flat-rate relief, higher-rate taxpayers could end up obtaining tax relief of 30% on a contribution used to buy a pension that is taxed at 40%, in effect people ‘fining’ people when they make pension contributions.

  • It would be hugely detrimental to those with fluctuating incomes. The current system facilitates income smoothing so that the tax system comes closer to taxing individuals with the same lifetime income at the same rate. A flat-rate would eliminate one of the corrections that the current system of tax relief makes against the injustice of a progressive tax system – that those with highly fluctuating incomes tend to pay much more in tax across their lifetimes.

  • Those on high incomes receive more relief because they pay more tax. The UK’s system of tax relief is a system of tax deferral. A high amount of tax relief can be attributed to higher rate taxpayers because these groups pay the majority of taxes on income.

  • The potential abuses would necessitate further complex legislation. A single rate of tax relief would necessitate hundreds more pages in the tax code to counteract potential loophole exploitation and to correct for incentives the new regimes creates.

  • Estimates of the ‘cost’ of tax relief under the current system hugely over-estimate the real cost. Those arguing for reform to pension tax relief misleadingly refer to the gross cost of tax relief. This implies that the counterfactual is a world in which pension contributions are made out of net income, and that pensions are taxed when received so that income tax would be charged twice on pension contributions. This is clearly a colossal overestimation of cost.

Sensible policy reform – abolishing the tax-free lump sum

Restricting tax relief or creating an entirely arbitrary rate of relief is wrong in principle and impossible to implement in practice, but that does not mean that there is no case for reform of the taxation of pensions. Other radical reforms may well be justified but, if the current system is kept:

The government should abolish – or severely restrict – the tax-free lump sum. Its existence within the current system causes serious problems by necessitating complex tax regulations to prevent abuse. It also significantly and unjustifiably benefits those on higher earnings. If abolished or restricted to around £30,000, it would facilitate huge simplification of the tax system surrounding pensions.

Commenting on the briefing, Professor Philip Booth, Academic and Research Director at the Institute of Economic Affairs, said:

“Introducing a flat rate of pensions ‘tax relief’ would be devoid of any economic rationale and prohibitively complex in practice. It would also necessitate further complex legislation to prevent anomalies arising.

“If the government wants to reform the taxation of pensions, it should abolish or severely restrict the tax-free lump sum. This would lead to significant simplification without the creation of perverse incentives.”

Notes to Editors:

To arrange an interview with an IEA spokesperson please contact: Stephanie Lis, Director of Communications: [email protected] or 07766 221 268

The full briefing, by Professor Philip Booth and Ryan Bourne, can be downloaded here.

The mission of the Institute of Economic Affairs is to improve understanding of the fundamental institutions of a free society by analysing and expounding the role of markets in solving economic and social problems.

The IEA is a registered educational charity and independent of all political parties.