The welcome growth in longevity presents policymakers with a challenge: how to ensure that pensioners in the future will have an adequate retirement income. George Osborne is turning his attention in the budget this month to reforms of the system. It needs to be tackled but the chancellor would be well advised to soften the potential blow to higher-rate earners.
The problem for the government is that people are simply not saving enough to provide for their retirement. This is true in most advanced industrial economies. Many countries, including Britain, have passed legislation in the past decade with the aim of increasing working lives by raising the statutory retirement age and enhancing the incentives to save.
That is the task facing Mr Osborne too. In the budget he will announce the conclusions of a review into the system of tax relief on pension contributions. On the latest figures, providing tax relief costs the exchequer around £21 billion a year. The relief is most beneficial to higher-rate taxpayers, who receive 40 or 45 per cent relief on contributions. A basic-rate taxpayer receives 20 per cent relief.
Mr Osborne will certainly be looking to improve the incentives for lower-paid workers to save. He is also committed, for sound economic reasons, to achieving a budget surplus by the end of this parliament. Reducing the cost of these tax reliefs would help him get there.
One option that was raised in the chancellor’s post-election budget last year would be to scrap the current system and replace it with a “pension Isa”. This means that pension contributions would be taxed when they are paid in instead of being taxed when they are paid out on retirement. It would be a radical course and might actually deter people from saving more. Workers might reasonably wonder whether Mr Osborne could guarantee that future chancellors would resist the temptation to tax their pensionable income once again.
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A second option would be to stick with the current system and have a single rate of tax relief. The advantage for the chancellor would be economic, since it would cost less, and political, since he could cement his claim to be on the side of progressive, one-nation Toryism. Pensioners and those approaching retirement with assets have done well out of easy monetary policy since the banking crisis. Mr Osborne has every justification for seeking reforms that will benefit lower-paid workers who depend on incomes. A third default option would be to stick with the current system and the relief rates and make adjustments to lifetime and annual allowances.
Undoubtedly the weakness of the Labour opposition under Jeremy Corbyn and its abdication from serious economic policymaking is giving Mr Osborne the assurance that he can take political risks. The second option of a flat rate of tax relief has much logic to it, but radicalism requires calculation too. Not all of Mr Osborne’s proposed reforms as chancellor have been deeply thought-through. He came to grief most recently with his abortive scheme to cut tax credits for working families. His wish to help lower-paid workers provide for themselves is admirable but reducing the tax reliefs for higher earners who already save will be a blow to them.
There is a route out of the dilemma, so long as Mr Osborne does not count too much on the aim of raising revenue. This is to cut the top rate of income tax from 45p to 40p in the pound. The best evidence is that increases in top marginal tax rates do not raise revenue. In fact the reduction in the top rate from 50p to 45p in April 2013 was consistent with a rise in total revenues of £8 billion. In his budget, Mr Osborne has the chance to be both a reformer and a tax cutter. He should take it.