Taxation of private pensions

1. Taxation of private pensions Carl Emmerson

2. How should pensions be taxed? When contributions are made When returns accrue When income enjoyed

3. Taxing pension saving (TTE) Income tax & capital gains tax treatment of deposit accounts When contributions are made When returns accrue When income enjoyed Taxed Taxed Exempt Tax on normal returns distorts towards spending rather than saving Doesn’t allow those whose tax rate drops at retirement to smooth their tax-rate

4. Taxing pension saving (EET) Income tax & capital gains tax treatment of private pensions (broadly) When contributions are made When returns accrue When income enjoyed Exempt Exempt Taxed Normal returns untaxed but above normal returns taxed Those whose tax rate drops at retirement can benefit from tax-rate smoothing

5. How does UK practice depart from EET • Annual and lifetime limits on how much can be saved in a tax-advantaged private pension • One quarter of a private pension can be drawn as a lump sum free of income tax • Employer contributions – roughly three-quarters of the total – escape National Insurance Contributions (NICs) entirely • largest component of remuneration on which NICs are not paid • Corporation tax and stamp duties are levied as some returns accrue

6. What is the cost of pension tax relief? • Need to compare tax payments by individuals under the current system to what it would be under a sensible alternative • HMRC says £38.3 billion in 2011–12 from considering income tax and NICs and comparing current system to a TTE system • revenue forgone from up-front relief for current workers less income tax paid by current pensioners • But the HMRC calculation is unhelpful because: • TTE is not a sensible alternative as the normal rate of return should be untaxed and, arguably, individuals should be able to tax rate smooth • changing demographics and rising real incomes mean that today’s pensioners will in aggregate pay less income tax than future retirees • Better estimate is less than half the HMRC estimate • NICs relief (£15 billion) + tax-free lump sum (perhaps £2.5 billion) • but this still ignores any impact of corporation tax and stamp duties on returns

7. Who benefits from pension tax relief? • Need to compare tax payments by individuals under the current system to what it would be under a sensible alternative • HMRC says that those on higher current incomes benefit disproportionately from up-front relief • for example in 2010–11 the richest 1% made 16% of contributions but HMRC estimate they received 22% of up-front relief • (big caveat is that this estimate ignores employer contributions) • But • ignores the fact that rich will pay disproportionately more tax in retirement • given the top 1% paid 24% of all income tax revenue perhaps not surprising or, necessarily, unfair

8. Reduce up-front income tax relief? • Reduce annual allowance or lifetime contribution limit • £255,000 per year and £1.8 million in 2010–11, cut by the coalition government to £40,000 and £1.25 million from April 2014 • Restrict up-front relief to the basic rate of income tax • proposed by the Liberal Democrats at the last general election • Either could raise significant sums with the better off losing more • But more general reductions would come at cost of • moving further away from benchmark EET and therefore distorting saving behaviour and restricting opportunities for tax rate smoothing • considerable complexity as valuing pension contributions in defined benefit pensions far from straightforward • Much better reform options exist

9. Cut the tax-free lump sum? • 25% of a private pension can be taken as a lump sum entirely free of income tax • extremely generous EEE income tax treatment for up to £312,500 of pension saving • Not well targeted at encouraging saving among those who might otherwise end up on a relatively low retirement income • more generous to those who pay higher rate income tax in retirement than those who pay basic rate tax • should those who have already squirreled away £1m in a private pension be subsidised to save more? • encourages a lump sum rather than a retirement income • An alternative would be to top up annuity purchases up to a limit • would subsidise retirement incomes rather than lump sums • would be worth less rather than more to those paying higher rate tax in retirement

10. Reduce generosity of NICs treatment? • Roughly three-quarters of pension contributions made on individuals behalf by their employers • these escape NICs entirely: no employer or employee NICs on either contributions or pension income • It would be straightforward to impose employer NICs on employer contributions • would raise an estimated £10.8 billion • but would be a move towards TEE rather than EET treatment • Alternative would be to charge NICs on pension income • every 1ppt of NICs charged would raise £350 million • could start low and increase gradually over time • would involve some retrospective taxation but arguably the shift from income tax to NICs over the last 30 years has unintendedly led to working age earnings being taxed relatively more heavily than retirement incomes

11. Credits for corporation tax? Exemption from stamp duties? • Currently returns in pensions are not subject to income tax or capital gains tax • But these returns may be reduced by • corporation tax • stamp duties on share transactions and property purchases • Ideally corporation tax and stamp duties would be reformed • Absent this there is potentially a case for crediting returns accrued in private pension to offset the impact of these taxes • would be a move in the opposite direction to that made by Norman Lamont in 1993 and Gordon Brown in 1997

12. Conclusions • It is not possible to raise lots of revenue through a harmless reduction in up-front income tax relief on pension saving • Better ways of raising revenue and improving the pensions tax regime exist • Why allow up to £312,500 to be saved in a private pension entirely free of income tax? • Don’t forget NICs: three quarters of pension contributions escape NICs entirely and this is excessively generous

13. The IFS Green Budget 2014 5 February 2014, Beveridge Hall, Senate House, London www.ifs.org.uk @TheIFS

14. Real household disposable income Early 90s Recession Early 80s Recession Mid-70s Recession

15. What about (re)introducing the 10p rate? • Almost identical impact to increasing the personal allowance • Hard to think of a good economic rationale for such a policy Notes and sources: see Figure 7.7 in Green Budget document