Pension tax changes criticised for their inefficiency

3 March 2010

Plans by the government to raise taxes on the pension contributions of high-income individuals has been described as inefficient.

A think tank, the Institute for Fiscal Studies (IFS), has argued that the better off will re-adjust their pay structures in order to sidestep the new taxes.

The government already intends to increase income tax for higher rate taxpayers - those on £150,000 a year or more - to 50 per cent.

There is also to be a gradual phasing out of the universal personal income tax allowance for anyone earning over £100,000.

As from April 2011, additional changes will be introduced for taxes on pensions.

The changes will cut back on the tax relief that those with high incomes are allowed to claim on their pension contributions when they earn more than £150,000.

What's more, some in the top income bracket will have to pay tax on the pension contributions made by their employers. Those on £130,000 a year may find themselves included in the charge if the pension contributions of their employers take them above the £150,000 mark.

The reason for the changes is that the government wishes to re-allocate the balance of tax relief on savings. In 2008/09, higher rate taxpayers claimed 65 per cent of the total £28 billion offered in pension tax relief, despite constituting only 19 per cent of the overall number of retirement savers.

But the IFS has said that many high income savers will use 'salary sacrifice' - agreeing to lower salaries in return for bigger pension contributions - in order to re-arrange their pay structures.

This would suppress earnings below the £130,000 threshold at which the new pension tax rules would kick in.

Carl Emmerson, the deputy director of the IFS, commented: "Treasury figures suggest that nearly two-thirds of the 300,000 individuals potentially affected by this reform are members of defined contribution schemes, which are inherently more flexible than final-salary schemes.

"The scope for some individuals to respond to this reform in a way that minimises its impact on their lifetime tax bill must mean that estimates of the Exchequer gain from the reform are subject to a large degree of uncertainty."

As an alternative to the current government policy, the IFS suggested a limit on the amount of tax-free cash that can be taken from pension funds on retirement.

The IFS said: "The most obvious anomaly is the fact that individuals can take up to 25 per cent of their pension as a lump sum free of income tax up to a maximum of £437,500.

"A reform that placed a much smaller cap on the amount that can be taken as a lump-sum would improve value for money for the public purse as there is no obvious justification for providing such a generous amount tax free."