Why 40% tax payers will get to keep their pension tax relief

I’m not sure I can bear to add anything more to the mansion tax debate, so I’m going to ignore it this week. But the alternative idea being floated – the removal of pension tax relief (still!) – by the LibDems as their price for allowing the Tories to dump the 50% top tax rate deserves a little attention.

The first thing to note is that the question of tax breaks for pensions is something that needs to be dealt with really fast. It comes up pretty much every Budget, and incentivises behaviours that I am sure are not meant.

The pension conversation needs to be about getting everyone to save properly and sensibly for the long term via fairly-priced, diversified investment vehicles. Right now it is just about 40% and 50% taxpayers scrabbling around before every Budget to find spare cash to pile into their SIPPs just in case their pension relief disappears overnight.

So the coalition either need to take the relief away, or say that they never will. Then everyone can get on with figuring out how to make it work under some kind of long term set of circumstances. 

The second comes courtesy of the Weekly Tax Brief from Baker Tilly. In it, David Heaton lays out the numbers on higher-rate tax relief.

The Treasury has just put out a note saying that the cost of tax relief on pensions (ie the amount returned to taxpayer pensions) has risen by 87% over the last ten years to £33bn last year. That looks like a huge number in light of the fact that the income tax take has risen by only 44% over the same time period.

But as Heaton points out, the release doesn’t exactly tell the whole story. Ten years ago there were only three million people (10.5% of 28.6 million taxpayers) in the 40% tax band. Now, thanks to the way in which Brown, Darling and Osborne have all dragged extra people in, there are four million – (13.3% of 29.9 million taxpayers).

Add in to that the 50% band, and you can see that the ‘cost’ of tax relief on pensions has only risen so far because the number of people paying more tax (and therefore getting more relief) has risen by 33%. How’s that for unintended consequences?
The third point to make is that it is surely impossible for higher-rate tax relief to be removed without various other changes being made. There isn’t that much financial benefit to a pension if you only get 20% relief, and there is very probably none if you run a risk of paying 40% tax on your income when you retire. So assuming the coalition wanted to keep higher earners saving too (maybe they don’t – I don’t know) they’d have to pledge to only charge pensioners 20% on their retirement incomes too.
Finally, there is the public sector and its lucky bunch of highly-paid people with final salary pensions. What happens to them if higher rate tax relief disappears?

Richard Evans, writing in The Telegraph, gives the example of a headteacher earning £80,000 and getting a £1,000 rise in final salary pension for every year he stays in the job. The tax rules currently state that every £1,000 rise in pension payout is taxable as a £16,000 pension contribution. But with no higher rate relief, the teacher would end up with an actual tax bill of £3,800 – payable immediately (details here) .

I can’t see that going down well with nation’s doctors, senior civil servants, police officers and hospital administrators: the public sector houses around three quarters of a million higher rate tax payers.

The upshot? I don’t see 40% relief being removed but I wouldn’t be surprised to see 50% payers being told they’ll only get 40%, and the annual contribution limits being cut back to £20,000-30,000.