PPI report calls for flat rate tax system to protect lower income savers

A Pensions Policy Institute (PPI) report has called for an overhaul of the UK pensions tax system, highlighting that a flat tax relief system could see the proportion of tax relief enjoyed by basic rate tax payers increase from 26 per cent to 42 per cent.

The research, sponsored by the Association of British Insurers (ABI), highlighted disparities in the current system that favours those on a higher income, stating that a review would offer an opportunity to address “the philosophy” of the system.

It found that, for the same cost, it would be possible to offer a higher benefit to basic rate taxpayers through a flat rate of relief.

It warned however, that any change would present challenges in terms of implementation, with a “significant cost to industry” and the potential for uncertainty and confusion "at least in the short term".

The report also urged the government to consider taking the opportunity to alter the parameters to “lower cost, better target incentives”, or close loopholes within the pension tax system.

Commenting on the findings, ABI director of long-term savings and protection, Yvonne Braun, said: “Pensions tax relief plays a vital role in encouraging people to save, but also in supporting the adequacy of that saving.

“However, the distribution of pensions tax relief under the current system exacerbates existing inequalities, particularly between men and women.

“We hope the research will provide food for thought on how to make the system simpler and fairer.”

In 2018, defined contribution (DC) pension schemes saw contributions totalling £29bn, with around £9.3bn of income tax relieved in respect of these contributions.

The report revealed however, that around 50 per cent of tax relief on DC contributions is associated with individuals earning over £60,000 a year, meaning that half the value of the tax relief is claimed by the 15 per cent with the highest incomes.

There was also a gender division, with 71 per cent of tax relief on DC pension contributions going to men, who make 69 per cent of the contributions.

The report explained that this gender divide is primarily driven by different employment patterns and earning levels, also highlighting that that women are "disproportionately" hired in sectors with access to a DB pension scheme, principally through the public sector.

Furthermore, despite the participation rate for younger people increasing "significantly" since the introduction of auto-enrolment, there was again a disproportionate split in the tax relief they benefit from thanks to the lower level of contributions made.

Specifically, whilst 42 per cent of DC contributors are aged under 40, they receive just 27 per cent of the tax relief, while 67 per cent of the value of tax relief goes to individuals in their 40s and 50s, two and a half times as much as their younger peers.

In addition, the proportion of pension tax relief enjoyed by younger savers had increased by just one percentage point, to 24 percent, since the launch of auto enrolment, despite the proportion of claimants increasing from 52 per cent to 63 per cent.

The PPI explained that while the number of pension contributions made by lower paid individuals has become more significant, this has not translated to a significant increase in the value of the associated tax relief, due to the low value of these contributions and the fact they attract only the lowest rate of tax relief.

It stressed, however, that a flat relief tax system could improve outcomes achieved by a "large proportion" of those brought in through automatic enrolment, with women in particular standing to benefit, as they are more likely to be a basic rate taxpayer.

Furthermore, anyone for whom the flat rate of tax relief is set above their marginal rate of income tax would stand to benefit, with a 25 per cent, 30 per cent and 33 per cent all likely to increase the benefit for basic rate tax payers.

The report clarified that whilst this would come at a cost to those on a higher income and additional rate tax payers, there would remain a tax advantage which would continue to make pension saving attractive, albeit slightly less than previously.

It also stressed that tax treatment as an incentive had already been weakened under the current system, stating that when the obligation to use savings for retirement income was removed in the 2014 budget, the incentive had been weakened.

It highlighted a number of restrictions under the current system, such as the annual allowance and the lifetime allowance, which, whilst limiting the cost of providing pension tax relief, have caused behavioural consequences, such as the issues recently faced by the NHS, which saw some doctors retiring early simply to avoid large tax bills.

The report also identified a number of issues around the two tax mechanisms currently in place for pensions tax relief, net pay and relief at source, emphasising that moving to a single approach with a single rate of income tax relief would give an opportunity to correct any loopholes, and ensure that people did not miss out on the benefits.

The PPI examined a range of alternative approaches, including the relief of national insurance contributions on employer contributions and tax free withdrawals, through either lump sums or UFPLS.

The report explored the role of national insurance contributions relief, which was valued at £16.5bn in 2017-18, emphasising that if this relief was removed, payroll costs to all employers would likely increase, with a reduction in wage inflation expected to mitigate this additional cost.

Commenting on the findings, PPI head of modelling, Tim Pike, stated that a change to the system of tax relief would offer "an opportunity to address the philosophy of the current system although implementation would present challenges".

Multiple implementation challenges were highlighted within the report, such as issues around administrative costs.

However, the report pointed to the implementation of AE as precedent for some of these issues, such as the development of payroll systems to integrate with the “changing pensions landscape”.

Perhaps the biggest challenge raised though, was that any tax relief associated with DC pension schemes could also present challenges for the DB space, with “careful consideration” needed to avoid unintended consequences.

For instance, the PPI explained that any company running a hybrid scheme would need to apply separate tax treatment to the individual elements of the pension, further complicating the tax position and leading to a “far greater chance of error”.

Furthermore, any transfer from DB to DC would be more complicated as there is an opportunity for arbitrage, where an individual may ave different rates of income tax relief upon contributions available through different schemes.

The report stressed that this “hazard” would need to be addressed, though this could in turn provide further complications for the DB to DC transfer market.

More broadly, it added that any changes to the DB pensions tax relief system would “change the financial situation of schemes”, potentially further accelerating the current trend of scheme closures.

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