What’s Wrong with our UK Tax System: Update March 2023

 I first put out a blog on this subject in February prior to the latest budget. The aim of this was to put forward the arguments for some radical changes in the tax system which I thought were necessary in order to remove disincentives and stimulate growth. Many of the arguments still stand.

 The following is an update describing the effects of the March budget, and the likelihood (or otherwise) that they will have the desired effect. It also reflects changes over the summer.

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There has been much argument following the recent budget about whether the pension tax changes, which were aimed primarily at retaining senior NHS medical staff, are justified at a time when many other workers and less well-off pensioners are struggling with continued and rapid cost-of-living increases.

At first sight it does seem that the Chancellor might have been overly generous to well-off pensioners, and it’s easy to see why many are more sympathetic to the plight of others lower down the age scale. Before we come to a hasty judgment on this, however, let’s consider the implications of the changes, and see how generous the measures really are to this group – and, perhaps more importantly, why they might have been introduced as an alternative to other, and arguably more urgent and effective, tax changes.

Firstly, let’s consider the abolition of the lifetime allowance, which seems to have been the most contentious move. This will undoubtedly help those who are lucky enough to have pension pots close to the current limit of £1M. However, they will be limited to £60k additional input each year, so it will take many years to make significant gains, given that their pension plans will also be subject to management charges of up to 3% p.a., which in combination with the current inflation rate just announced of 10.4%, is likely to outstrip any gains in value from their additional salary sacrifice. The number of people likely to be in this 'happy' position is very low (i.e. in the tens of thousands at most).

The uplift of the £40k maximum eligible for tax relief to £60k, while probably affecting more of our older workers, only applies to those who have not yet retired. This is an important distinction because anyone who has already stopped work is likely to have started drawing on their pension pot to provide them with a retirement income, particularly if they have retired relatively early, and are not yet old enough to claim their state pension.

And here’s the catch - once they start drawing down income in any form from their pension pot, they are deemed by HMRC to have undergone what’s colourfully termed a ‘Benefits Crystallisation Event’ (BCE). Before the March 23 budget, under HMRC rules a BCE immediately (and irreversibly) reduced their £60k entitlement down to £4k, a measure introduced by ex-chancellor Hammond, in his words to ‘prevent undesirable recycling of funds’. Even after the recent budget changes, further investments are still limited to as little as £10k, and what’s more, the tax relief is only available on salaried earnings – anyone wanting to invest non-salary generated funds in a pension pot is still limited to a paltry £3600 p.a.

This has two obvious consequences – firstly it will do little to encourage early retirees back to work, since they can only invest £10k p.a. in a pension pot before relief stops and additional tax charges on their pension investments start to apply. The rest of their additional income is likely to be taxed at 40% or more, given that their basic income will probably take them above the higher rate threshold. The measures may help anyone fortunate enough to have £1M plus already in a pot and who hasn’t yet retired, but my guess is that anyone that well-off will be likely to place more value on being able to call any remaining time they have left their own, than on building up yet more pension benefits while continuing to work ‘till they drop’.

Given the state of the NHS in particular, with junior doctors now effectively forcing their consultant colleagues to take the strain until their dispute is settled, how likely is it really that an experienced consultant already actively considering early retirement will be tempted to stay on by an additional £20k tax allowance p.a. on their pension contributions ?

Since retaining senior staff was billed as the primary reason for the pension changes, the measures announced are likely to fail in their objective.

Secondly, the measures will have scored yet another political own-goal in that they will appear to have been over-generous to so-called ‘rich’ pensioners without actually doing so.

Why, then, have the Government done this at all ?

My guess is that the Treasury has played a numbers game and decided quite correctly that the number of people likely to benefit from any pension changes is relatively tiny compared to the working population as a whole. The cost of the benefit to the Treasury would therefore be limited to a few tens of millions p.a.

Maintaining a tight grip on tax thresholds at all costs is likely to have been the other side of their equation. Even a modest sub-inflation rise of, say, 5% in the basic rate threshold by contrast would involve the loss of several billions for the Treasury, while a comparable rise in the 40% threshold would at least double that loss now that so many additional relatively modestly paid workers have already been drawn into the 40% 'trap'. This may even be an underestimate, now that the pay increases in line with inflation that are necessary in a tight labour market are dragging yet more workers into 40% tax territory. Hence the pension measures are basically ‘peanuts’ in comparison, and moreover could not possibly be regarded as ‘generous’ - to anyone. They should rather be seen as a clever manoeuvre on the Treasury's part to camouflage the very significant, progressive and arguably somewhat callous, increase in the tax burden resulting from an established 5-year plus freeze in tax thresholds, which affect everyone. And this is at a time when the majority of lower-paid workers are struggling to make ends meet. Whether Labour would relent and remove the freeze after winning the 2024 election is another matter - as traditionally the party of 'tax and spend', I don't see much likelihood of Reeves doing this quickly - if at all.

So much for a party that prides itself on lowering taxes…..if the freeze is not actually lifted as a ‘last gasp’ giveway as predicted in next year’s budget, which is the final opportunity for some largesse before the next General election, I suspect they will indeed be toast…and deservedly so.

Viv

First published 27.3.23