Dr Hugh Pemberton (Reader in Contemporary British History at the University of Bristol) writes for the GW4 Modern British Politics and Political History blog:
The history of British pensions provides some lessons for the Treasury’s proposals to change the basis of UK pension taxation? The experience of the 1980s is a salutary one, for instance, signalling trouble ahead for both consumers and the state if the changes are implemented.
In its July consultation paper (Strengthening the incentive to save) HM Treasury outlined its plans to change the basis of UK pension taxation. It proposes to abolish the present system in which people saving for a pension are given tax relief on their contributions but the pension, when it is eventually taken, is taxable. Instead the Treasury proposes to tax the income from which contributions are made, but for the pension in payment to be tax free. (Thus moving to a so-called Exempt-Exempt-Taxed or EET system to a Taxed-Exempt-Exempt, or TEE, system). In the Treasury’s view this will simplify the system (aligning pensions saving with ISAs), increase incentives to save via the offer of tax free income in retirement, and boost tax revenues.
But history suggests the proposed reform is unlikely to achieve its professed long-term aims. Instead it is likely to reduce tax receipts, result in lower pensions for consumers, complicate the system, and decrease saving (in turn producing pressure for higher state spending). In other words it will fail comprehensively except in generating increased short- to medium-term tax revenues – which will be vastly outweighed by the long-term costs to the state and to individuals.
Anybody familiar with modern British political history will know there is a consistent pattern of political decision-making made with the short-term in mind which then turns out to have unwelcome long-term consequences. Of all areas of policy, pensions are the most long-term and the proposals set out by the Treasury risk repeating such mistakes.
For an example from history, take one of the changes being examined by the AHRC’s Thatcher’s Pension Reforms project at the University of Bristol’s Department of History: the then Conservative government’s decision in 1980 to link increases in state pensions to the rise in retail prices instead of the rise in average earnings. This alteration, made entirely for reasons of short-term economy, looked small at the time but over the long-term the change, compounded annually, served to slash the value of the state pension from an already meagre 26 per cent of average earnings in 1979 to just 16 per cent within 20 years.
Figure 1: Erosion of BSP as a percentage of average earnings, 1980-2010
Source: DWP Abstract of Statistics, 2014.
The present proposals would produce similarly malign long-term consequences.
First, the loss of tax relief will remove an important incentive for people to save into their pension (because the offer changes from a tax bonus now to a tax bonus in the distant future) and so we can expect levels of pension saving to fall.
Second, contributors’ final pension pot will be smaller because they will lose the compounded annual capital growth on the value by which the present system of tax relief raises their contributions.
Figure 2: An illustration of fund growth with and without tax relief on contributions
Assumptions: 25 year-old makes contributions of £1000 p.a. to retirement on 68th birthday (c.4 per cent of current average earnings); income tax rate 20 per cent; annual rate of return on investment 7 per cent.
Third, receiving the pension tax free will probably not make up for this shortfall. On reasonable assumptions, a 25-year old today will find their net pension will be 7 per cent lower in retirement under the proposed regime.
Fourth, over the long-term the initial revenue for the Exchequer gained by initial tax relief on contributions will be significantly less than the tax revenue lost by paying the pension tax free (in our modelled example the total tax taken from this individual drops from nearly £40,000 to just £8,600).
Finally, the promise of simplification held out by the Treasury consultation document is entirely illusory. Like virtually every change to the UK system since 1945 implementation of this proposal would complicate not simplify the system – because pension contributions pre-dating the proposed tax reform will continue to yield a taxable pension and so there will actually be two parallel tax regimes.
We conclude that the Treasury’s consultation documents is an attempt to dress up a policy aimed at bolstering tax revenues over the short- to medium-term as a long-term reform to incentivise pension saving and improve the level of income replacement in old age. It is inconceivable that it will achieve either long-term aim.
We recommend that government should look to the long-term security of British pensioners and resist the temptations of a short-term boost to public finances from abolishing tax relief on pensions. If the Treasury is determined to reduce the cost of tax relief on pension contributions it should instead consider removing higher-rate relief, a costly subsidy to those least in need of an incentive to save into a pension.
A version of this post was previously published on the LSE’s British Politics and Policy blog.
About the author
Dr Hugh Pemberton is Reader in Contemporary British History at the University of Bristol and Principal Investigator on the AHRC Thatcher’s Pension Reforms and their Consequences project