Boris Johnson is said to have gone cool on proposals for a mansion tax following negative comment from aggrieved mansion-owners. But that still leaves the other significant change which has been floated in advance of next month’s Budget: possible cuts to pension tax relief. Given that pension tax relief will reduce government revenue by £39.9 billion this year, according to HMRC, it is not surprising that it should have become a tempting target – albeit one which Chancellors of both main parties have tended to shy away from. George Osborne did reduce the annual allowance available to people earning more than £150,000 a year. But proposals to cut the upper rate of tax relief have come and gone without any action being taken.
Will Rishi Sunak go the whole hog and abolish pension tax relief altogether – in return for making pension income tax-free? As things stand, pension rules are the opposite for those for Individual Savings Accounts (ISAs). With an ISA you get no tax relief on money you put in, but you can take money out of your ISA at any time without paying tax (to say it is entirely untaxed is not quite right because dividend income comes from company profits which have been subject to corporation tax). With a pension fund, on the other hand, you are refunded the income tax you have paid on the money you put into the fund, giving your fund a substantial boost. But then when you come to take income, or take a lump sum, from your pension fund in future you will have to pay income tax on three quarters of the money.
For the Exchequer there is a big disadvantage to the latter arrangement: the tax relief constitutes an upfront cost. Any income tax on pension incomes, on the other hand, will not arrive until the future – in some cases in several decades’ time. Change the rules so that pensions run along the same lines as ISAs and it would shift a huge lump of government revenue from future financial years into the current year. As it happens, the £39.9 billion lost in tax relief on pensions matches very closely the £38.7 billion public deficit last year. In other words the Chancellor could eliminate the deficit at a stroke.
Converting pensions into ISAs would have another significant advantage – it would do away with an anomaly which has, for example, hollowed out the NHS of GPs and senior hospital doctors. Under current rules, people with pension funds are stung with a punitive tax if their fund ever exceeds the ‘lifetime allowance’ of £1.055 million. If so, they face a tax of 55 per cent if they take the money as a lump sum and 25 per cent tax if they take it as income. In order to avoid the burden, many people with sizeable pension funds have chosen to take early retirement rather than face the charge.
There is an issue as to how such a change could be introduced. Change the system wholesale overnight and it would be of huge benefit to people with existing pension funds – they have enjoyed substantial tax relief over the years, and now they would be getting their pension income tax-free, too. A fairer way would be to keep taxing existing pension funds as they are, but to prevent any further contributions to them. Instead, anyone who wants to save into a pension fund would be obliged to take out a new-style fund with no tax relief upfront but with no tax payable on future income. There will always be some people who would squeal at the unfairness of it all but it would be a lot simpler – and allow the government to balance the books for the first time in two decades.