The Treasury Committee recently published a report concerning the state of Britain’s household finances; it makes for depressing reading. This is particularly so in respect of pension provision, which is, for many people, either derisory or non-existent.
Yet, last year, the Treasury spent £46.9 billion on up-front incentives to encourage people to save. This is more than we spend on defence, over half of the education budget, and more than the combined budgets for transport, the Home Office, the Ministry of Justice and the Foreign Office.
Meanwhile, Britain’s household savings ratio has plummeted to 4.9 per cent, the lowest since records began, back in 1963. Tax relief on pension contributions clearly do not work. The top one per cent of earners, who are in least need of financial incentives to save, receive more than double the total amount paid out to half of the working population.
The time has come for radical reform of the system. Fortunately, the Committee’s report acknowledges this, stating that tax relief is not an effective or well-targeted way of incentivising saving into pensions. So, what to do?
Policymakers will have to confront a fundamental conundrum. Income tax is progressive, so tax relief is inevitably regressive. Consequently, the broad acceptance by society that high earners pay higher average rates of income tax is partly nullified because they are able to reduce their income tax by harvesting higher rates of tax relief on their pension contributions. We have little choice but to disconnect the saving incentive from tax-paying status.
Replacing tax relief with bonuses determined by the amount saved (by the individual as well as employer contributions) would address the conundrum. It would also provide a much-needed reframing of the incentives language. Half the adult population do not understand tax relief, whereas the word “bonus” is readily understood. They would therefore be more appreciated.
How about a 50 per cent bonus on the first £2,000 saved, and 25 per cent thereafter, up to a cost-controlling cap of £2,500 for the total bonus that any individual could receive in one year?
A 50 per cent bonus should particularly encourage the most reluctant savers; it would be highly progressive, equivalent to double the 20 per cent tax relief incentive provided to today’s basic rate taxpayers (92 per cent of the under-40s).
An annual £2,500 bonus cap would facilitate incentivised annual savings of up to £10,500 (£8,000 of contributions and £2,500 of bonus). Saving an annual sum of this magnitude would be more than adequate (and any unused bonus capacity could be carried forward for up to ten years, say).
We do not want to disturb the success of automatic enrolment (AE) into workplace retirement saving schemes. Indeed, replacing tax relief with bonuses would provide an opportunity to bring many more people into AE’s embrace.
Today, AE contributions are determined using “band earnings”, not total income, so someone with two jobs each, for example, paying £11,000 per year, would suffer two deductions of £6,032 (the Lower Earnings Limit) in the AE contributions calculation process. Consequently they receive smaller employer contributions than otherwise, and less tax relief in respect of their own contributions, which are also smaller than otherwise. In addition, AE has a £10,000 minimum earnings threshold, and multiple small incomes cannot be aggregated to overcome this. These rules all conspire against the low paid in respect of participating in AE, and they serve no consumer purpose. They are totally unjust.
Replacing tax relief with bonuses could be accompanied by scrapping the AE threshold and permitting the aggregation of multiple incomes. Many more people could then participate in AE, and the process for determining AE contributions would be greatly simplified.
It would also help low earners, especially women: pensioner poverty is far more prevalent amongst women than men, partly because women traditionally earn less during their working lives.
In addition, people would be eligible for a bonus even if their total earnings fell below the Personal Allowance (bonuses being solely determined by contributions). Bonuses rather than tax relief would provide a much-welcomed, substantial simplification of today’s complex pensions and savings landscape.
Michael Johnson is a Research Fellow for the Centre for Policy Studies.