Tax relief for the many
A call for an ambitious reform of the tax relief system, which would significantly boost government support for low and middle-income savers.
By Benedict Dellot, Associate Director, and Fabian Wallace-Stephens, Data Researcher for Economy, Enterprise and Manufacturing at the RSA
Strapped for cash
This report began by sounding an alarm about the perilous state of long-term finances among the self-employed. Just 17 percent of people who work for themselves contribute to a personal pension, and as many as a quarter (26 percent) of those closest to retirement have nothing stowed away in a pension. At any one point, the average employee is around 10 years ahead in terms of how much pension wealth they have accumulated. This study has also exposed several myths, including that the self-employed are saving instead into ISAs (they aren’t), can rely on their partners’ pensions (they can’t), and have found a better savings vehicle in the form of property (they haven’t). A large scale survey undertaken by BEIS found that 21 percent of the self-employed have made no plans for retirement beyond relying solely on the state pension.
The question is what to do about it. The last chapter took a tour through twelve possible interventions that were framed around four key pillars: saving something, saving enough, accessing savings during work, and accessing savings during retirement. Among our recommendations are to clarify the confusion surrounding the Lifetime ISA, redouble efforts to find a form of auto enrolment for the self-employed, turn the Pensions Dashboard into a full Money Dashboard, and default savers onto a drawdown scheme as they approach retirement. If readers feel underwhelmed by the scale and scope of these proposals, they shouldn’t be. We have purposefully avoided ‘common sense’ ideas that make for good headlines but abysmal policies. This includes giving the self-employed greater access to their pension pots mid-career, which has a radical edge and alluring simplicity to it, but in practice would lead to a haemorrhaging of funds.
Yet common sense is useful in at least one respect. It draws our attention to the elephant in the room which has yet to be fully addressed: where the money will come from to save for retirement. The second chapter on barriers to saving revealed the self-employed take home on average a third less than their counterparts in salaried work, while half earn less than the National Living Wage. These figures should be interpreted with caution given the different ambitions and make-up of the self-employed. However, the point stands that many are too focused on making ends meet in the here and now to be thinking about saving for a time many decades away. The same BEIS survey showed that a quarter (26 percent) of the self-employed have a ‘big problem’ with not being able to save enough for the future.
Nor is this just a problem for the self-employed. The Pensions Policy Institute calculates that an employee on the median income who is auto enrolled for their working life would still only manage to reach a 45 percent income replacement rate when they retire, assuming they hit the minimum combined pension contribution rate of eight percent with help from their employer. Underlying people’s inability to save for the future is a broader problem of low and stagnating wages, and all around economic insecurity. Recent RSA polling found a third (31 percent) of all UK workers have less than £500 in savings, while a third (30 percent) are concerned about debt. What makes today’s insecurity particularly troublesome is that it stretches across the labour market and seeps through multiple income groups. Of those who report to be ‘just about managing’, 31 percent live in households with gross incomes above £34,000.
Why tax relief is regressive
Money cannot be conjured out of thin air. Yet one source of funds is often overlooked: the tax relief system. Tax relief is an incentive designed to encourage people to save more into a pension. However, it operates differently for workers depending on their marginal rate of income tax. Anyone who earns below the Personal Allowance or 20 percent income tax bracket (ie below £45,000) can claim 20 percent tax relief, while anyone earning within the 40 percent tax bracket can claim 40 percent. A small contingent earning over £150,000 a year can claim tax relief at 45 percent. For the majority who are basic rate taxpayers or below, this means they only need to contribute £80 to add £100 to a pension, with tax relief making up the difference. The annual allowance means tax relief can only be claimed on contributions up to £40,000 a year.
This multi-tiered tax relief system is neither socially just nor effective in spurring overall saving rates. According to our estimate, the top 10 percent of earners take home 40 percent of all tax relief, despite making only 24 percent of net pension contributions. Their share of tax relief is more than double that of half the working population. While it is true these unequal figures merely reflect the large amount of tax paid by a fraction of society, if we consider income tax to be progressive — meaning that higher earners shoulder more of the burden — then tax relief on these payments is regressive. One riposte to this argument is that high earners will eventually pay the 40 percent tax rate as they take out their pension in old age. But the reality is that most will fall into the 20 percent tax band by this point. Only one in seven people who receive the higher rate of tax relief during their working life ever go on to pay the higher rate of tax in retirement.
Figure 9: The distribution of tax relief under the existing system (Source: RSA pension tax relief modelling)
The case for reforming the tax relief system is overwhelming, and indeed would free up billions of pounds to bolster the savings of those at the sharper end of the labour market. In 2016/17 the government spent £31bn on upfront Income Tax relief for registered pension schemes, and £16bn on top of this for NICs relief to employers who contribute to the pensions of their workforce. At £47bn combined, this tax relief amounts to more than what the state spends on transport (£29.6bn), public order (£30.1bn), and even defence (£37bn). This figure excludes the billions spent on the 25 percent tax-free lump sum that pension holders are entitled to. With such a large amount being spent to top up pensions in the UK, it is incumbent on policymakers to reconsider how it is allocated.
The case for a new tax bonus
The RSA is not the first to express concern about our tax relief system. In 2016, the pension provider Hargreaves Lansdown recommended that tax relief be abolished and replaced with a system of age-based top-ups. Under this new regime, the government would give savers — including the self-employed — a bonus of ‘100 minus age’, meaning that a 30 year old would receive £7 for every £10 invested, whilst a 50 year old would receive £5. The rationale here is to correct intergenerational imbalances and encourage people to save earlier in life. However, while this proposal has an attractive simplicity about it, the risk is that it simply inflates the pension pots of wealthy millennials, while ignoring the challenges facing low income adults.
A better proposal would be to establish a single rate of tax relief, but at a notch higher than the current basic rate. We recommend the government aim for 30 percent in the first instance. This means anyone wishing to save £100 in a pension would only need to contribute £70. Every person would be entitled to the same rate, regardless of their employment status, age or income. This would boost the pension pots of low to middle earners, while simultaneously acting as an incentive to save more than previously. To cement the offer in the minds of prospective savers, we also recommend swapping the opaque phrase ‘tax relief’ with ‘tax bonus’ — which is unambiguously positive. While qualitative research from the ABI suggests the word ‘bonus’ is contentious, owing to the fact the money is merely a rebate of tax already paid, its connotations with gaining something could have a strong effect on saving incentives.
Table 4: Distributional impacts of tax relief reform
Who would benefit from such a scheme and to what extent? Our modelling suggests a new single tax bonus of 30 percent would leave approximately 75 percent of existing pension savers better off, while 25 percent would lose out. Basic rate taxpayers who currently take home 30 percent of all tax relief would accrue 50 percent under a single flat rate, while higher rate taxpayers who for now capture 50 percent of all tax relief would benefit from 40 percent in future Additional rate taxpayers would go from taking home as much as 15 percent of all tax relief to just eight percent (see Table 4 and Figure 10). At an individual level, the financial consequences are significant:
· A self-employed worker on an income of £15,600 who contributes five percent of their salary to a personal pension would see their tax relief climb from £195 a year to £335.
· A self-employed worker on an income of £30,000 who contributes five percent of their salary to a personal pension would see their tax relief climb from £375 a year to £645.
· A self-employed worker on an income of £60,000 who contributes five percent of their salary to a personal pension would see their tax relief fall from £2,000 to £1,286.
Figure 10: The distribution of tax relief under a flat rate of 30 percent (Source: RSA pension tax relief modelling).
A fiscally neutral intervention
With a few high earners losing out and a large number of low and middle income savers gaining, is a single tax bonus of 30 percent tolerable to the Exchequer? The answer is yes. According to our calculations, these changes would have been revenue neutral in 2015/16 (the last year for which HMRC data is readily available). In this year nearly £31bn was spent on pension tax relief. A 30 percent flat rate could have resulted in marginal savings (less than £1bn). While we would expect the pension contributions of lower and middle earners to increase as a result of the reform, any extra costs incurred in future could be cancelled out by making changes elsewhere in the tax system. Three options in particular stand out:
· Reducing the Annual Allowance down from £40,000 — Savers are currently able to claim tax relief on yearly pension contributions up to a value of £40,000. This is a high figure given many people struggle to save £40,000 over their lifetime. The Treasury could reduce the Annual Allowance and reap savings in the process, without notably deteriorating the living standards of high earners.
· Removing the NICs rebate on pension contributions for employers — Employers are able to claim relief on their NICs bill for the contributions they make to their employees’ pensions. It is unclear why this rebate exists other than to lessen the burden faced by organisations that take on staff. But this burden could be better addressed through direct measures such a general reduction in Employers NICs.
· Ending the NICs exemption for older workers — Workers over the state pension age do not pay NICs. This concession is often justified on the grounds that NICs pay for the state pension and therefore it would be unfair to continue paying after retirement. But in practice the link is not so clear cut. Paying NICs for 30 years gains someone entitlement, but they continue contributing after this point even if they are not retired. As Jolyon Maugham asks, “If logic does not dictate that you stop once you’ve qualified, why should it dictate that you stop once you hit state pension age?”
Answering the critics
A 30 percent tax bonus on pension contributions cannot be dismissed on grounds of affordability. But for some, the cost of a flat rate system was only ever a secondary concern to that of technical feasibility. One critic described the proposal as an ‘arbitrary subsidy for pension saving’. But this is what pension tax relief is designed to do, so it matters not whether people receive tax relief at a higher rate than the tax they paid ie 30 percent vs 20 percent. Another complaint is that higher rate tax payers would be ‘fined’ for making pension contributions, in that they would gain 30 percent tax relief on contributions but could end up paying 40 percent tax on pension withdrawals during retirement. This is incorrect. The PPI and Resolution Foundation show there is still a tax advantage for these savers because of the 25 percent tax free lump sum and the fact that income tax is not all paid at the higher marginal rate.
Legitimate concerns do exist, however, and must be addressed. One of these is the scope for abuse in the system. Under a flat-rate tax bonus, it would be possible for a basic rate tax payer close to the age of 55 to make a pension contribution, benefit from a tax bonus of 30 percent, and then withdraw the money shortly afterwards while paying tax at just 20 percent. Containing abuse of this nature would require careful terms of access to be drawn up. Another challenge comes when tax relief is awarded through a ‘Net Pay’ arrangement (ie when pension contributions are made before income tax). This means that contributions are not subject to tax and therefore savers immediately benefit from tax relief at their highest marginal rate. Net Pay arrangements would not be able to factor in a single flat rate of 30 percent, and therefore most savers would need to shift onto another arrangement — ‘Relief at Source’ — whereby tax relief is claimed by pension providers after income tax is paid (this will already apply to most of the self-employed).
Then there is the concern that a flat rate tax relief would not sync well with Defined Benefit (DB) pension schemes. Unlike Defined Contribution programmes where savers have individual pensions, DB plans ask employees and employers to pool their contributions into a common fund, which pension payments are withdrawn from during retirement. The first obstacle is that most DB schemes operate on Net Pay arrangements. The second is that a boost in contributions, aided by the flat rate, would see many individuals surpass their Annual Allowance. For DB pension holders, the Annual Allowance sets a limit on how much the real value of their pension entitlement can increase in a year (for DC holders, it sets a more direct limit on their actual contributions). While the formula for working out this ‘real value’ growth is complex — known as the Deferred Contribution — the fear is that the flat rate would take many people beyond their Annual Allowance, thus landing them an income tax bill. This in turn could serve to confuse people with DB plans and lead to mistrust in pensions as a savings vehicle.
Any attempt to establish a 30 percent tax bonus will need to consider these obstacles carefully, and resolve them in a manner that does not add excessive complexity to an already bewildering pension system. But they are not insurmountable. The prize of a fairer pension system that radically improves the economic security of millions in old age is too valuable to ignore. Still, given the seismic shift that a reform of tax relief would create, it is critical not to rush into making changes. Policymakers need to spend time exploring all possible manifestations of a tax bonus, and gradually inform the general public of the logic behind such a move. This means committing to stick with a given level of tax bonus (30 percent in our model) and not be tempted to change this to suit political ends. The final recommendation of this report is therefore to commission an independent review on the modernisation of tax relief in the UK.
- Read more from the RSA on retirement security for the self-employed: Twelve fixes
- Download the RSA Venturing to Retire report (.pdf)
- Follow the RSA on Twitter @theRSAorg
