‘The Chancellor of the Exchequer must, no later than 1 April 2012, compile and lay before the House of Commons a report containing an assessment of the impact of this section and Schedule 17, including the impact in creating marginal effective rates of taxation of over 100 per cent. (when considering the impact of this section and the relevant income tax rates in force)’.
On 14 October 2010, the Treasury announced that it would reduce the annual allowance from the current level of £255,000 a year, to £50,000 a year, and the Finance Bill confirms those figures. Amendment 188 is our attempt to tease out from the Government how they are addressing circumstances in which people in defined benefit schemes have a large deemed charge in a single year and are therefore hit by additional tax charges. The reduction in the allowance will bring many more individuals within the scope of the tax changes. Those changes will apply to all pension scheme members, whether they are in defined benefit or defined contribution pension arrangements, and will include both occupational and personal pension schemes.
Substantial numbers of people are now likely to be affected, and I would welcome the Minister’s assessment of the impact of the changes as far as numbers are concerned, particularly those in final salary schemes who have long service or have had large salary increases. The Government estimated in 2010 that 100,000 people would be affected. I would welcome confirmation from the Minister that that figure is still in place, or whether it has been revised up or down since the initial assessment. As there is no current intention to increase the allowances, my worry is that many people may be caught up in future years, as salaries and incomes change. Up to 200,000 people could face additional tax in future if inflation increases and tax allowance limits remain the same. Even if only the originally estimated 100,000 are affected, a much larger number will need to be involved in checking to see whether they are affected.
My first point is that we need some current assessment—not for October 2010, but for June 2011—and for future years, of the numerical impact of these changes in the annual allowance. My second point is that the tax charge may be quite substantial for those affected. For example, an executive earning around £150,000 a year with 20 years’ service, in a final salary pension scheme, will face tax of £12,200 on a pay rise of £9,000, which is a marginal rate of tax of 135% on a pension increase plus 50% income tax. That makes a combined tax rate of 185% on the pay rise.
We can have many debates about how to tax higher earners but, under clause 1 of this very same Bill, the Minister indicated that the Government would undertake a long-term review of the 50p rate of tax. Yet we face a situation in which final salary pension schemes might well be threatened with a combined tax rate of 185% on the pay rise being brought forward.
A number of affected employees will face complex choices, about whether to accrue benefits and pay the tax, or not to accrue benefits and face a much poorer retirement. Wealthy individuals who might want to save more than £50,000 in a pension scheme will not be the only ones affected. Many individuals currently choose to pay off debts—for example, mortgages—and not to save into pensions, given that debt interest is usually much higher than interest on savings; they might then be planning to save hard for retirement using spare income, having paid off the mortgage. The effects of the measure will mean that they are less likely to be able to do that in the longer term. The total pension would be reasonable, but it would have been funded in the second half of their working life rather than uniformly throughout their life, and that could create some difficulties. I wish the Minister to examine such issues and to give some response today.
Potential concerns include parents returning to work after a period of raising a family, who might feel under-pensioned; they might therefore wish to divert significant amounts of their income into ensuring a decent pension in old age. They, too, might be hit disproportionately by the proposals before the Committee today. Entrepreneurs are another good example: they might have had a long period of building a business and putting their resources into it, expecting rewards for their hard work to flow in only after some years. Their ability to save for a pension might only arise once the business starts to pay decent profits, which could be towards the latter part of their careers. All of those groups—those who pay off debts first, those who are out of work and then in work because of family commitments, and those who are building a business—might find themselves disadvantaged by the proposals.
Complexity in tax legislation on pension schemes potentially creates barriers to encouraging people to save. Clearly, there is a large reduction in the amount of the annual allowance in the clause. Before April 2009, individuals could contribute significantly more of their income into a pension and benefit from tax relief at the marginal rate of tax on such contributions. The changes will have a significant impact on the ability of individuals to save.
In addition to the preamble, I have two particular areas on which to question the Minister today. First, the costing of the changes: when the Government came in, they said that they did not want to continue with the changes we had proposed to restrict pensions tax relief but, to square that, they needed to raise the same amount of money for the Exchequer. The costings for how much the changes will raise may be over-optimistic. A commitment from the Minister today about the cost of the changes and a robust assessment of the stress testing of those costings would be helpful.
Secondly, as I outlined, in some circumstances the new annual cap of £50,000 on contributions before a tax charge is triggered will create some difficulties—not in every case, but for some people. Those are people in defined pension schemes with large deemed contributions if they get a promotion. I want some explanation of the Minister’s view of those changes.
In summary, I have drawn attention to changes that will have a significant impact, although admittedly on a small group, who are probably higher earners. However, it is important for the Minister to give an explanation to the Committee of the impact of the changes, so that we can assess them fully before agreeing to the clause.
It is worth giving some background to the change. The Government provide generous tax relief to save for a pension, to encourage individuals to take responsibility for retirement planning and in recognition of pensions being less flexible than other forms of saving.
Under the previous Government, the cost of tax relief, net of income tax on pensions paid, doubled to nearly £20 billion per annum by 2009-10. To ensure that pension tax relief remains fair, affordable and sustainable, we confirmed in the June Budget last year that we would proceed with the previous Government’s aim of reducing the cost of tax relief on pensions by £4 billion every year.
The right hon. Member for Delyn will remember the previous Government’s plans. They were complex and seen as unfair and anti-competitive. He raised the issue of cost and asked how much revenue would be raised by the measures. For the period between 2011-12 and 2015-16, the proposals put forward by his colleagues when in Government—once updated to reflect new economic data—would have raised £15.6 billion in total. Across the same period, the measures that we have proposed will raise £16.6 billion. Therefore, we will raise additional tax revenue as a consequence of introducing this legislation, and I hope that the right hon. Gentleman will recognise that.
Those estimates are compiled by HMRC. They are robust and we have tried to take into account data on earnings, growth, and ways to prove the model in terms of assessing the impact of the measures. They are our best estimates, and we believe that the amount of revenue raised will be marginally greater than that which would have been raised under the previous Government’s proposals.
The previous Government’s approach to achieving a reduction in pension relief introduced significant additional complexities to the tax system; it undermined pension saving and damaged UK businesses and competitiveness. We believe that an approach which limits the amount of tax relief for those who make the highest contributions is better than restricting the rate of tax relief available to those on incomes above an arbitrary threshold. In our proposals, those whose pension contributions exceed £50,000 will not receive any tax relief. Under proposals put forward by the previous Government, even those earning the highest salaries and paying the highest rate of tax would have received tax relief at a rate of 20% per annum.
We wanted to ensure a more flexible and simpler system, and we consulted on that basis. Several commentators commended our approach; the Institute for Fiscal Studies stated that perhaps the most welcome change in the 2010 Budget was the decision to rethink the previous Government’s “complex, unfair and inefficient” plans for pension contribution relief for high earners. The responses to the informal consultation held last summer confirmed our view that reducing the allowances to tax-privileged pension saving would be fairer. That approach preserves incentives to save and lessens the impact on the ability of UK businesses to attract and retain talent. It is also more straightforward to understand and implement.
In October, we announced that from the 2011-12 tax year, the annual allowance for tax-privileged savings would be reduced from £255,000 to £50,000. Such a move recognises that it is right to provide generous tax relief to save in a pension, but that it is also right to ration that relief at a more appropriate level. The CBI responded positively to our approach, saying that
“these new proposals are a significant improvement on the approach proposed by the previous Government, which was simply unworkable.”
Clause 66 reduces the annual allowance to £50,000 for tax year 2011-12 and beyond. Individuals making annual pension savings above that level will face an annual allowance charge to recoup the tax relief that has been granted to them. The reduced allowance of tax-privileged saving will apply to all individuals receiving UK tax relief in all types of registered pension schemes. An annual allowance of £50,000 is a level that far exceeds average annual contributions. That will protect those on moderate incomes on whom a lower limit would have impacted. The reduction in the annual allowance goes hand in hand with the reduction in the lifetime allowance to £1.5 million, which we will cover in detail when we discuss clause 67.
The reduction in the lifetime allowance allowed a higher level of the annual allowance to be set than we originally proposed, while still raising the intended revenue. That combined approach also provides individuals with greater flexibility around when they make their annual pension contributions. With the changes to the lifetime allowance in clause 67, the reduced annual allowance will generate £4 billion-worth of annual revenue in steady state, thus protecting public finances.
Reducing the allowances will affect individuals with the highest levels of pension savings only, leaving the vast majority of pension savers unaffected by the changes. In fact, less than 1% of pension savers will be affected. That alternative approach to restricting pension tax relief has been welcomed by pension and employer groups, and we have continued to work in consultation with them to finalise the design of the new scheme.
As a result of ongoing consultation with the pension industry since the publication of the Finance Bill on 31 March, changes have been indentified that would make the application of legislation simpler, and therefore reduce administrative burdens on the pension industry. Government amendments 129 to 133 ensure that the legislation will work as we intend.
Amendment 133 addresses a simple drafting issue. The annual allowance charge operates by reference to pension savings made over a certain period. In changing the dates of when that period begins and ends, the Bill inadvertently provided for, in certain circumstances, a period of 364 rather than 365 days. The amendment corrects that so that the period will be 12 months unless the scheme or, in other circumstances, its members nominate otherwise.
Amendments 130 to 132 concern individuals who have high annual allowance charges. The schedule provides for them to nominate to meet their tax charge out of their pension savings. If they so nominate, an offsetting adjustment is made by the pension scheme to reduce the individual’s pension savings to reflect the tax paid on their behalf. Schedule 17 provides for the amount of the adjustment to be reflected in the valuation of the individual’s savings when determining their annual allowance charge in the year the adjustment is made. Amendments 130 to 132 address an imbalance in carrying out the adjustment between individuals in defined benefit or cash schemes and those in defined contribution schemes. Amendment 129 relates to the year in which a pension comes into payment.
In calculating the increase in pension rights, there is a choice between continuing to use a notional valuation and using the actual amount of pension benefits taken. Schedule 17 provides for the notional amount to be used, but representations received since the Bill was published have shown that that is confusing for individuals, who could expect the actual amount of their pension to be taken into account. The representations also show that the practical application of the provision is administratively burdensome for pension schemes. Using a notional value in those circumstances also has the unintended consequence of excluding all enhancements paid to an individual who retires early on grounds of ill health. It was not the intention to preclude ill-health retirements that do not meet the definition of serious or severe ill health from the annual allowance charge. Amendment 129 removes that disjoint and makes a value used in the year of retirement easier to understand for those taking benefits.
Amendment 188, in the name of the right hon. Member for Delyn, requires the Government to lay before the House by 1 April 2012 an assessment of the impacts of clause 66 and schedule 17, including the impact of creating marginal tax rates of more than 100%. He has given more explanation of why he tabled the amendment. He talked about marginal tax rates, but I point out to him that under the scheme the previous Government proposed that it was possible for income to rise by only £2,000 before having a marginal tax rate of 650%. We very carefully learnt lessons from the flaws in the design of that scheme. [Interruption.] He has become Mr Macavity—he was not around at the time, because he was in the Home Office. It is a fair comment, as we cannot all be held to account for the detail of legislation proposed by our colleagues.
The right hon. Gentleman needs to be a little careful because the measure does not alter the rate of tax relief. It will still be at the marginal rate. The measure simply imposes a stricter rationing on how much tax-privileged saving any one person can make. There will be no relief over £50,000 of saving. As such, tax charges are a direct result of a change in the level of pension contributions, rather than a change in income. In that sense, the concept of marginal effective tax rates is not a useful way—[Interruption.]
Thank you, Mr Hood.
The concept of marginal effective tax rates is not a useful way of considering the measure’s impact on individuals. Marginal effective tax rates relate to how an additional pound of income affects the rate of tax that an individual faces.
The right hon. Gentleman got to the nub of the question in his remarks on the impact that the measure could have on people. He asked whether it would affect only 100,000 people. The 100,000 estimate is based on a detailed model that makes use of data from HMRC’s operational income tax systems and the administrative returns provided to HMRC by all pension providers. The methodology is consistent with previous estimates of the policy and the previous Government’s approach. The methodology underpinning the estimate was set out in the Budget 2011 policy costings document and has been scrutinised and certified by the Office for Budget Responsibility.
The 100,000 figure is lower than the number of people we expected to be affected before the details of the regime were announced in October. We were able to reduce the number of people affected because we were able to increase the annual allowance above the amount initially expected. Additionally, the factor of the value of an increase in savings to defined benefit pension schemes is also lower than originally expected, which has helped soften the impact.
That does not mean that 100,000 people will be paying tax charges from their pension benefits. We expect that individuals and employers will look to adapt their pension saving behaviour and remuneration terms to aim off and ensure that their pension contributions remain below the annual allowances, so that they will never face a charge. We expect about 40% of people to aim off in 2011-12 and for that to increase to 65% of defined benefit scheme members and 90% of defined contribution scheme members by 2015-16,
The other issue raised by the right hon. Gentleman is the impact that the measure will have on flexibility, the way in which people save for their retirement and the extent to which that triggers a large tax bill. I will take a few moments to set out the steps that we have taken to mitigate that impact.
To reduce the likelihood of individuals exceeding the annual allowance, we first set a more generous annual allowance than originally proposed. Secondly, we ensured that individuals would be able to carry forward any unused allowances from the previous three years. Citing the right hon. Gentleman’s example, someone who is out of the market for three years would effectively accumulate a £50,000 annual allowance in each of those three years, which they could use in a year in which they were in employment and pay higher pension tax contributions. Similarly, someone setting up a business could achieve exactly the same goal. They could choose not to make pension contributions for three years and use the accumulated unused annual allowance to make a larger contribution in one particular year.
We recognise that there may be circumstances, despite the mitigation measures, in which people pay a higher charge. Individuals with an annual allowance charge exceeding £2,000 will be able to elect to meet their full charge from their pension benefits instead. That recognises that a substantial increase in pension wealth has led to the liability in the first place.
I hope that I have reassured the right hon. Gentleman that we have thought carefully about the impact of the measure on people who may in one year face a sudden one-off increase in the value of their pension and consequently face an increased tax charge. There are ways in which they can mitigate that. I think the overall package of measures that we have here achieves our goal of making sure that the cost of pension tax relief is fair, affordable and sustainable and that there is sufficient flexibility in the scheme.
Our amendment simply asks for a review of these matters. I appreciate the Minister’s explanation but I still feel that we need to examine the impact of this downstream. In the interests of having a participatory democracy, I would like to enable members of the Committee to participate by dividing on this issue.