Removing tax breaks on pensions would cause confusion and could stop people saving

Every Budget is accompanied by speculation about potential changes to pension tax relief. Rumours abound in the press in the weeks before the Budget: will this be the year when the tax free lump sum is finally scaled back? Will high earners see a cut in the amount they can contribute whilst still qualifying for tax relief?

One reason for the speculation is that successive governments have tinkered with the system but without looking at the big picture. Why do we give tax relief at all? Does it benefit the right people? Is the tax treatment of pensions on death fair?

Whilst the Government has not come up with any answers to this question, the independent Institute for Fiscal Studies (IFS) has come up with its own answers. The IFS proposals have the advantage of being comprehensive and systematic, but there are real questions about their political feasibility and about the length of time it would take to move to the IFS’s “pure” system.

The starting point of the IFS is that the tax system should be “fiscally neutral”. Unless policy makers specifically decide otherwise, the tax treatment of an activity should neither penalise it nor subsidise it. Against this benchmark, the IFS argue that the system of pension tax relief is too generous, especially for high earners.

Areas which the IFS highlight as ripe for reform include:

The tax free lump sum. People already get tax relief on their pension contributions and pay no tax on the investment returns within the pot, but they can also take a quarter out completely tax free. This gives most benefit to those who can build up the biggest pots and the IFS propose the tax-free lump sum should be abolished. The problem with this is that tax-free cash is one of the few elements of the system that people have heard of and which makes pension saving more attractive. Capping or withdrawing this would undermine plans which had already been made and could put people off pension saving altogether.

The treatment of pensions on death. Unlike other forms of wealth, pension wealth is generally ignored for inheritance tax purposes. In addition, if someone dies before the age of 75, their heirs can inherit their Defined Contribution (pot of money) pension free of income tax. The IFS would abolish both of these tax breaks. I would have some sympathy with this idea, as there is no good reason why pension wealth should have a privileged treatment on death compared with other forms of lifetime saving.

The way the National Insurance system treats pension contributions and pension income. Employee pension contributions are paid out of take-home pay (after National Insurance contributions have been deducted), employer pension contributions are completely free of NICs, and pensions in payment are not subject to NICs. This offends the fiscal purists at the IFS who propose that pension contributions should be treated the same way for NICs as for income tax, with relief given on contributions made but NICs charged on pensions in payment. However, introducing what would be perceived as a new tax on those who had already retired would be seen as very unfair, so it could probably only be phased in over a long period of time, and this would add complexity to the system.

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In the pure world of the think tank, these ideas may seem logical, but it would be a brave politician who put them in a manifesto.

A key objection is that those who have planned for their retirement on one set of assumptions would find the goalposts moved at the last minute.

For this reason, the IFS grudgingly propose that their measures might be phased in. The tax-free lump sum would not be scrapped overnight but would apply to no more than the first £400,000 of any pension pot. Similarly, the introduction of NI contributions on pension income would be phased in, recognising that those approaching retirement had not enjoyed NI relief on their contributions so should not pay NI on their pensions.

The problem with this nod to political reality is that it could leave us in the worst of all worlds. Rather than a swift move to a more efficient system we end up in a prolonged transition, with tax and NIC rules potentially changing every year and the whole process at risk of being revisited every time we have a change of government.

There is already a feeling that tax rules cannot be relied on not to change from one year to the next, and a massive programme of reform, changing several different parts of the system all at the same time could cause great confusion. Some people might decide that saving in a pension was just too unpredictable and give up on pension saving altogether.

Steve Webb is a partner with pension consultants LCP and was pensions minister from 2010-15