Grasping the nettle

Pension tax relief is ripe for reform, I argue in a new Fabian Society report

In November Rachel Reeves needs to raise tens of billions of pounds with measures that pass four tests. Her tax rises must be socially fair, politically acceptable, economically benign and administratively feasible. Well-designed reforms to pension tax relief could pass all these tests.

Twelve months ago, in the lead up to her first budget, Reeves examined pension tax reform. In a widely-read Fabian Society report I set out the case for change. But in the end the chancellor decided not to act – apart from the important decision to extend inheritance tax to pensions. This autumn, in an even tighter fiscal position, will Reeves’ appetite for pension tax reform be higher? She needs more money, and she has ruled out many other options, so perhaps the calculus will be different this time.

The case for change

On paper, the case for reform is very strong, because pension tax rules are too generous and clearly unfair. The idea behind pension tax relief is that people are exempted from tax on pension contributions and investments, but then pay it on their eventual pension income. But in practice, the system provides almost all pension savers more in tax relief than they will later pay in tax (once inflation is factored in). In 2023/24, the tax relief was worth around £80bn, while just £25bn of income tax was paid on private pensions according to HMRC statistics.

Pensions are under-taxed in several different ways. First, most people can take a quarter of their pension tax-free. Second, national insurance is not charged on employer pension contributions, either on the ‘way in’ or the ‘way out’. Third, high earners receive tax relief at their marginal tax rate of 40p, 45p or 60p in the pound, when the average tax rate they pay in retirement is far lower.

This point also explains why pension tax relief is unfair: higher and top rate taxpayers get much more in tax relief for each pound of pension contribution than employees on the basic rate. But they do not pay proportionately more tax in retirement, driving inequality in later life. The 2024 Fabian report estimated that 53 per cent of all pension tax relief went to the fifth of employees on higher tax bands. An employee earning £110,000 per year gets more than £1.50 in tax relief for each £1 of net contribution.

Challenging politics

So, the theoretical case for reform is clear. But following a tough first year in power, Reeves’ options are constrained by practical politics. After the huge backlash to last year’s rise in employer national insurance contributions, she cannot increase the tax burden on business. That rules out applying employer NICs to employer pension contributions. Similarly, she will be very wary about measures that hit retirees after the debacle of the winter fuel payment. Any changes must protect low- and middle-income pensioners.

Perhaps raising the burden on high-income pensioners would be more acceptable to the public, as was the case with the winter fuel cuts. But it is still a risk.

Two reforms to address the systematic under-taxing of pensions are therefore only outside chances. The first is to reduce the amount of tax-free cash that can be taken at retirement from £268,000 to (say) £100,000. The second is to levy an equivalent to national insurance on large private pensions, to make up for NICs having not being levied in the past on employer pension contributions.

These are progressive policies that would raise revenue from wealthy older people who have pensions that were historically under-taxed. But the chancellor knows the media backlash she could expect. Rich savers nearing retirement would argue that their big untaxed lump sum was part of the pension ‘deal’ on which they had based their plans. Transitional protections would probably be needed for people near their pension age. Or perhaps the chancellor will proceed gradually, reducing the maximum tax-free amount in steady slices of £20,000 or £30,000 at a time?

Raising tax on pensions in payment is even more fraught, given this is covered by Labour’s manifesto commitment not to raise income tax or National Insurance. One option would be to scrap the 2p upper rate on employee National Insurance and swap it for a 2p increase in the higher and additional rates of income tax. All incomes over £50,000 would then be taxed the same, whether from earnings, pensions, rent or investments. Non- employees including rich pensioners would pay more, but it could be presented as a tax rationalisation rather than an increase in headline rates.

Likely changes

Smaller changes that tidy up the system are more likely. For example, last year’s reforms to pension bequests could be extended by making all inherited pensions subject to income tax (people who inherit a pension from those aged below 75 are currently exempt). The annual allowance for pension contributions could also be cut from £60,000 to £40,000, the limit until 2023. This would stop very high earners from maxing-out on pension tax relief, but it might need to be accompanied by tweaks to tax rules on defined benefit (DB) pensions.

Finally, HMRC has conducted research on scrapping the favourable tax treatment of salary sacrifice arrangements. These schemes allow employees to take a pay cut in exchange for a higher employer pension contribution. They enable employees and employers to avoid NICs on individual pension contributions and overwhelmingly benefit high earners. They are associated with relief on NICs worth over £4bn per year.

Medium-term reform

That’s about as far as the chancellor is likely go in one budget. But she should also consult on medium-term plans to completely restructure and simplify tax relief on contributions. Under these reforms, income tax and employee NICs would be levied on both employee and employer contributions. In exchange, a single flat-rate of tax relief would be paid to pension schemes, irrespective of an individual’s marginal tax rate or whether it was an employer or employee contribution. The government could present this as a simple cash top-up, paying £1, say, for every £3 of contribution.

Under this new system, upper and top-rate taxpayers would receive less in tax relief, and basic-rate taxpayers a little more. There would also be no tax advantage for individuals in the choice between employee and employer contributions. Importantly, the rules on employer NICs would not change, so employer liabilities would not increase.

There would be a one-off burden for employers and pension providers to set up new systems. But once ‘live’, defined contribution pensions would be simpler and more transparent than today. The only ongoing complexity would be the treatment of DB pensions that are still open to new accruals (overwhelmingly in the public sector). For these schemes there would be administrative challenges, as DB pensions would need to accurately allocate employer contributions to each employee for tax purposes. There are also potential issues of affordability if pension promises to high earners are based on former levels of tax relief. Finding answers for DB schemes should not be rushed, and a separate tax regime or transitional arrangements might be needed. But, as most open DB schemes are publicly funded, the Treasury can work out with their sponsors how to make them work.

Wholesale reform of pension tax relief will not be easy – which is why it has not happened already. But it is operationally achievable, does not hinder jobs or growth, redistributes money from high to low earners, and can raisemany billions of pounds. Labour should grasp the nettle.

This article was first published as ‘Pensions’ in a new Fabian Society report Taxing Questions: How Labour can raise the revenue we need?, edited by Joe Dromey and Iggy Wood.