Why pensions are an area urgently in need of tax reform
source: HMRC
On 17 March, in collaboration with Tax Justice UK and Patriotic Millionaires UK, we held a round table discussion on the topic of “fair and responsible tax”, featuring parliamentarians, expert commentators, and representatives of civil society. In this blog post, our researcher Clair Quentin shares their reflections on the event.
Our ‘fair and responsible tax’ event featured much expertise and informed, thought-provoking opinion, primarily on the question of how wealth should be more fairly taxed. For me the most instructive moment, however, took place not during the event but afterwards on a follow-up call with my fellow organisers from Tax Justice UK and Patriotic Millionaires UK. We were discussing what went well, and I said that I thought the best bit was the observations on pension tax reform made by CPS-affiliated independent researcher Michael Johnson.
It was obvious from everyone’s reaction that they just thought “typical Clair, what a nerd”. And so the learning point for me was how poorly understood the issue of pensions tax reform is, even among those whose business it is to care about such things. The purpose of this blog post is to explain to them, and indeed to anyone else who needs to hear this, why pensions tax reform is a matter of absolutely central importance so far as taxation of wealth in the UK is concerned.
The key thing to understand is that a pension is not what you think it is: it is not a thing which provides income to retirees. Think of it instead as an exceptionally tax-advantaged way of owning wealth – typically shares and bonds and the like. If you earn a good salary you can provide for your retirement by acquiring investments, and what we are talking about here is a massive (and fiscally very expensive) reward from the government for having done so.
By way of background, ordinarily the income and gains arising from wealth are subject to tax, as income from employment is. They are subject to tax at lower rates, they do not bring with them the requirement to pay national insurance contributions, they benefit from a mind-boggling array of exemptions, but the broad principle is that unearned income and gains (i.e. income and gains from wealth, such as the wealth held in a pension fund) are taxed. And that is how it should be, and much effort goes into advocating for that principle to be applied more widely and more strenuously than it currently is.
And if you were to acquire investments to provide for your retirement using income you had earned, and if you were to pay tax on the income and gains from those investments, that tax would not in any sense be “double taxation”. If you buy shares using your salary, and pay tax on the dividends arising from the shares, you are paying tax on some fresh income, not a second round of tax on your salary. There would be nothing unfair about a tax system that did this. It would be the tax system working as it should.
But if you place your wealth in the hands of a trustee who is legally bound to handle it in a certain way (essentially not paying it out to you until you pass a certain age), you suddenly acquire an astonishingly generous array of tax benefits. Not only does the ordinary tax on income and gains from wealth not apply, but (even more generously) the taxpayer at large pays you back the tax you paid on the salary that you have earned, to the extent you spend it acquiring the investments. And in the case of higher-rate taxpayers, that can be a very large amount of money indeed.
The purported theory behind this is that people need to be encouraged to save for their retirements, so as not to have to rely on the state, but this is an absolutely ludicrous pantomime justification for what is in practice, for the most part, simply a massive transfer of wealth from the public exchequer to the already wealthy, and to the already very wealthy.
The reason it is a ludicrous justification is because the rich and the very rich would be investing surplus income in bonds and shares and the like anyway. That is what they do. They do not need incredibly generous tax incentives to make them do it. Given a choice between either (A) a luxury yacht and a sensible portfolio of investments, or (B) two luxury yachts, most rich people would choose option A, with or without tax breaks on the investments.
And the key point is that the richer you are, the more these tax breaks are worth, and so the rich get the lion’s share of the benefit, at the expense of the rest of us. And of course that inequality exists across all axes, not just the rough aggregated one of household wealth. For example, according to the Office of National Statistics, for those aged 65 years and over, median pension wealth for pensions in payment for men is double that for women.
And so the already wealthy, and economically privileged demographics such as men, are being massively disproportionately rewarded by the rest of us for doing something they would inevitably be doing anyway i.e. investing some of their surplus income. And meanwhile those with lower incomes, who are at incomparably greater risk of dying in poverty, see very little of this vast subsidy because they have comparatively microscopic pension pots.
And when I say that this subsidy for the rich is “vast”, I really mean it. At the top of this blog post is a helpful graphic produced by HMRC showing pension fund tax reliefs sitting among the UK’s other principal tax giveaways, and if you have a look you will see what I mean. Just think what a difference all that public money could make to the value of state pensions for working class people if it was not being spent lining the pockets of the already wealthy, and the already extremely wealthy.
When people talk about reforming pension fund tax relief they talk about, for example, not necessarily paying back rich people all of the tax they paid on the salary they received which they spent buying assets for their pensions, but otherwise leaving the system in place. But really the starting point should be abolishing the entire system of tax relief on pensions.
People should be paying tax on their unearned income and gains, as my colleagues in the tax justice business tireless point out. And pension fund tax relief is perhaps the most fiscally significant way in which the rich avoid paying tax on their unearned income and gains, especially in view of the huge added tax relief sweetener on acquiring the investments in the first place. Pensions tax reform may sound like a nerdy technical issue, but in fact it should be at the forefront of our debate on how the wealthy can be made to pay their fair share.