Why Osborne should now axe tax relief on pensions

WHEN you have no money, and you need to conserve cash for a rabbit out of the hat in the run up to the election, what do you do? The chancellor’s answer: focus the Budget on pension reform and Isas saving incentives.

That’s all fine and dandy, but it’s a missed opportunity. The chancellor reached first base with his proposal to make Isas more flexible and to give people more control over how they use their pensions. But he could have followed these radical reforms to their logical conclusion and completed a home run, by taking on tax relief for pensions.

It sounds controversial, but the progressive withdrawal of tax relief for pensions, as long as it’s used to finance direct cuts in income tax and national insurance, could be a game changer. Tax relief on pensions costs £42bn per annum, when you add together reliefs on income tax (employer and employee) and national insurance (employer). Given that just £30bn a year would let you reduce the standard rate of income tax from 20 to 15 per cent, and the higher and top rates to 30 per cent from 40 and 45 per cent, that’s an awful lot of money to make the case for less government.

Ordinarily, to make the case for a small state, big political hurdles need to be jumped. First, which hospitals and schools would be cut to finance tax cuts? Second, there needs to be sustained political support from the public, requiring big – not small – reductions in taxation. Third, tax reductions need to show clear supply-side gains that raise the long-term growth rate of the economy. And that also requires large cuts, because small cuts in taxation won’t change behaviour sufficiently.

Any radical reform on this scale might ordinarily be thought impossible, because of the large potential number of losers. But pension tax relief is unique. It’s really a re-distribution within each individual taxpayer’s life cycle. Any loss of tax relief doesn’t damage disposable income. But the income tax cuts it could finance would boost income and spending power. Also, because tax relief favours higher income households it could be an easier sell to the electorate.

The more serious challenge is the claim that it would weaken pension saving. But the opposite should occur. In a world of pension simplification, annuities reform and enhanced incentives for Isa saving, most people would understand the system far more clearly. Transparency and much higher disposable post-tax income could encourage a savings renaissance.

Something else would be happening as well. The boost to competitiveness and growth from enhanced incentives to work, save, and invest should also raise profitability, rates of return and the future size of pension pots. Higher returns in the long term could very well provide an additional incentive to save.

These are radical thoughts, but they offer a sharp contrast to the tepid thinking that characterises so much of the political debate. And to the charge that this would somehow move us towards an excessively individualistic wealth-orientated culture, I would say quite the opposite. A significant increase in disposable income provides a real opportunity to take control of your life. Some would choose to work more, some less, but big tax cuts make people free to choose. And big tax cuts are ruled out without tackling tax relief on pensions.

Chancellor, you may only have one more Budget. Is it worth a try?

Graeme Leach is director of economics and prosperity studies at the Legatum Institute in London.