Conservative and Labour proposals to cut pensions tax relief for those with an income above £150,000

Published on 12 April 2015

The Conservatives and the Labour party have proposed significantly reducing the amount of income tax relief available on the pension contributions of those fortunate enough to have an income in excess of £150,000. This IFS observation argues that both reforms would add considerable complexity to the pensions tax regime and would have the potential to distort savings behaviour and work incentives in a significant and undesirable way.

The Conservatives today announced that they want to reduce the generosity of pension tax relief for those with an income of above £150,000 a year. The Labour party have already announced that they want to cut pension tax relief for this group. While only affecting a relatively small number of high income individuals both sets of proposals have the potential to be complex, damaging and counter-productive. The Labour proposals involve the introduction of a “cliff edge” such that an increase in income could leave people substantially worse off. The Conservative proposals have the odd effect of allowing anyone with an income of up to £150,000 to put £40,000 tax free into a pension, but allowing those on higher incomes to put in much less. Their proposals effectively increase the marginal tax rate faced by many of those with an income between £150,000 and £210,000 a year.

The Conservative proposals

At present those with taxable incomes over £150,000 a year – there are about 300,000 such individuals – pay income tax at 45%. Any pension contribution they make up to an annual allowance of £40,000 a year attracts income tax relief at that rate. Income tax would be paid at the point at which the pension is withdrawn – as an annuity or in some other form. The exception is that a tax free lump sum worth a quarter of the accumulated pension pot can be withdrawn.

The Conservatives propose to reduce the annual allowance to £10,000 once income reaches £210,000. In other words 50p of allowance will be lost for every additional £1 of income in a range between £150,000 and £210,000. For anyone who continued to put their income into a pension that would effectively raise their marginal income tax rate to 67.5%. Those making other choices – to consume their income immediately or to save in a somewhat less tax privileged form – will face some increase in their effective marginal tax rate, though not always to the same extent.

Whilst affecting a relatively small number of high income individuals a reform such as this would further complicate the pension tax system. It would have the curious effect of allowing those with an income of up to £150,000 to save £40,000 a year in a pension but restrict that to £10,000 a year for those with an income of more than £210,000. Given that there is a great deal to be said for a pension tax regime which allows savings to be made free of tax and then tax to be paid upon withdrawal this complication would not improve the efficiency of the system.

The biggest effect of this change would be on those with incomes between £150,000 and £210,000. It becomes proportionately less significant for those on the very highest incomes.

The amount it would raise in the long run will depend on how people respond. To the extent that those affected spend their income now rather than in the future, at least some of the apparent additional tax revenues will be brought forward rather than increased in total. Similarly if people respond by putting more money into ISAs the Exchequer will get more revenue now and less later on.

The Labour proposals

The Labour party has also proposed to reduce the value of pension tax relief for those with an income of over £150,000. Their proposals are at least as complex.

They want to reduce the rate of income tax relief for those with an income of more than £150,000 a year. This is similar to a policy proposed by the last Labour Government in its 2009 Budget. At that time, they proposed restricting tax relief on pension contributions to the basic rate (20%), but only for those with incomes above £130,000 and whose gross income plus employer pension contributions was above £150,000 (see here for a discussion). The way the policy was designed meant that some with large employer pension contributions would face a substantial increase in their income tax bill if their income rose from just under to just above the £130,000 threshold: For example an individual earning £129,000 plus an employer pension contribution of £40,000 would face an increase in their annual income tax bill of over £10,000 if their current wage were to rise to £130,000 (assuming a top rate of income tax of 50%). Effects of this kind are almost inevitable when introducing complexities such as this which result in treating people very differently once their incomes rise above a certain level.

The policy was thankfully dropped by the incoming coalition government in favour of a reduction to annual and lifetime allowances designed to raise the same amount of money.

In conclusion

We risk rushing towards something like chaos in the taxation of pensions for those on high incomes. Both Conservative and Labour plans will have substantial incentive and behavioural effects for those with incomes in the £150,000 to £200,000 range – potentially bigger effects than the 45% (or 50% under Labour) income tax rate itself.

This matters. Of course nobody on these sorts of incomes is going to be pushed into penury by such changes. But the undesirable distortions to savings behaviour and to work incentives have the potential to be significant. The two main parties seem to be competing to tie their own hands on the main tax rates whilst scooping up apparently free money from “the rich”, non-doms and tax avoiders on the other. There is a danger that the tax proposals being put forward through this general election campaign will have a long term malign influence on our tax system and economic welfare.