The Institute for Fiscal Studies (IFS) has published analysis suggesting the government could raise substantial revenue through reforms to pensions taxation. With the cost of pension tax relief projected to exceed £60 billion this financial year and rise further in the coming decades, the IFS argues that the current system is both expensive and skewed, disproportionately benefiting higher earners and those in defined benefit schemes.
Among the key proposals is the introduction of a single, flat rate of pension tax relief. The IFS notes that the current system provides relief at an individual's marginal income tax rate, meaning a basic rate taxpayer receives 20% relief, while a higher rate taxpayer receives 40% (or 45% for additional rate taxpayers). A flat rate, for instance at 25% or 30%, would reduce the benefit for higher earners while potentially increasing it for basic rate taxpayers, depending on the chosen rate. This change alone could generate billions for the Treasury.
Another area for reform highlighted by the IFS is the taxation of employer contributions. Currently, employer contributions to pension schemes are exempt from income tax and National Insurance contributions for both the employer and employee. The IFS suggests that taxing employer contributions, perhaps in a similar manner to employee contributions, could unlock significant revenue. Such a move would represent a fundamental shift in how workplace pensions are treated.
The report also examines the long-standing tradition of the 25% tax-free lump sum at retirement. While popular, this feature adds to the overall cost of pension tax relief. Reforming or even abolishing this provision could free up considerable funds. However, the IFS acknowledges that such a change would likely be met with significant resistance given its entrenched status within the UK pension system.
The context for these potential reforms is a challenging fiscal environment for the UK government, coupled with an ageing population. As more people enter retirement, the financial pressures on the state will intensify. The Bank of England's ongoing efforts to control inflation through higher interest rates also impact the cost of servicing government debt, making revenue generation even more critical. While the FTSE 100 might not directly react to these proposals immediately, any significant policy changes could influence investor sentiment towards UK equities over the long term, particularly for companies with large pension liabilities.