Osborne’s latest pensions raid: Flat rate tax relief would be both irrational and unfair

Private pensions have always been a soft target for cash-hungry chancellors. Nigel Lawson made pension funds restrict the size of their surpluses under threat of losing their tax-exempt status. Gordon Brown abolished Advance Corporation Tax in the great pension raid of 1997. And George Osborne has done his bit by slashing the annual and lifetime allowances by 84 and 44 per cent respectively.

However, if rumours are to be believed, he is about to go the extra mile and replace the current system of tax relief on pension contributions at marginal rates (someone who pays 40 per cent income tax gets 40 per cent upfront relief on pension contributions, while basic rate taxpayers receive 20 per cent relief) with a single, flat rate. If this happens, the system really is about to lose all sense of fairness and rationality.

The most commonly cited gripes with the current system of providing relief at marginal rates are twofold: it “costs” the Treasury billions and higher earners get most of the relief.

The first complaint is only valid if you believe that income should be taxed more than once. The system is specifically designed to prevent this from happening by making contributions and investment returns tax exempt while taxing pension income. So figures thrown about stating the “costs” of relief are in fact more indicative of the amount of tax being deferred until today’s contributors start receiving pension income.

Besides, as the Institute of Economic Affairs has noted, figures from HMRC overstate any such “cost” because there are presently more contributors than pensioners. Eventually, today’s contributors will start receiving pension income and the tax will be reclaimed.

And of course higher earners get more relief – they pay more tax in the first place.

But today’s basic rate taxpayers will not necessarily be basic rate payers all their lives – many will see their incomes increase and they will become higher rate taxpayers. Many more will have volatile incomes that fluctuate between income tax thresholds.

At today’s rates and thresholds, over a two year period, someone who earns £40,000 in both years will pay a total of £11,760 in income tax. But someone who earns £30,000 in one year and £50,000 the next will pay £13,283.

Because of this, the argument that it’s unfair for people to receive tax relief at 40 per cent on pension contributions but only be charged 20 per cent tax on pension income collapses. Providing relief at marginal rates allows the second individual to put more into their pension in the “good years” tax-free. Individuals who benefit from this apparent inequity are merely smoothing their lifetime income to undo the actual inequity inherent in a progressive tax system.

And as the Bank of England observes, income from self-employment is more volatile because it behaves more like company profits. So any move away from the current system would pose huge problems in a country where self-employment is at a record high of 4.7m. The self-employed are also on average seven years older than employees and thus closer to retirement with less time to adjust to any changes.

Then there are the administrative problems. An enormous raft of legislation would be required to prevent abuse of a system far too complex to describe in these few column inches.

Even the painstakingly neutral Institute for Fiscal Studies branded the idea “superficially attractive but fundamentally misguided” as recently as last year.

But with calls for this superficially attractive policy to be implemented growing louder by the day, there is a real danger that our Byzantine tax system is about to get a lot more incoherent.