The pensioners caught in the 53% tax trap

Around 200,000 low-income pensioners are going to face a marginal income tax rate of 53 per cent as a result of the Budget. This has come about as a result of years of freezes on the tax allowance, combined with some large state pension increases, which have led to the new state pension rising above the tax-free personal allowance for the first time next April. The Government is embarrassed at the prospect of taxing people who have nothing but a standard state pension to live on so it has introduced a new tax break for this group. Shorts Those who are on the standard new state pension rate – or an equivalent figure from the old state pension plus private pensions – will not have to pay income tax, despite the annual amount they receive rising to £13,036. The £94 they would have paid – the amount over the personal allowance – will be rebated down to zero. In addition, this group will not have to pay tax next year or the year after. But what about people who are, say, just £1 above the cut-off of £12,570? It would clearly be unfair for this to cost them the full £94 rebate. So, in response, the Government has added a new complexity. If you have income just above the rate of the new state pension, you will lose £1 of rebate for every £3 of extra income. It means those on just over £13,300 will get no rebate at all. The problem is that this group of around 200,000 pensioners who are caught in this taper face an unusually high rate of tax. For each extra pound above the cut-off, they pay 20p in income tax and lose 33p in the tax rebate that those on lower incomes get. Added together, each extra pound costs them 53p – a “marginal income tax rate” of 53 per cent. Given that the highest earners in the land (outside Scotland) only pay 45 per cent on each extra pound they earn, this does seem rather harsh. And it also adds yet another complexity to the income tax system which HMRC may struggle to implement by April 2027. More generally, the policy announced in the Budget is clearly a “quick fix” to get the Government out of a short-term hole, but it risks creating a long-term problem. The small print of the Budget reveals that the Government has set no money aside to keep this policy going beyond the end of this Parliament. ‘A quick fix designed to get the Government out of an embarrassing hole between now and the next election could become a permanent feature of the tax system,’ writes Steve Webb (Photo: Ian Vogler/Daily Mirror) So, what will happen beyond 2029-30? One option is that they simply cancel the policy at this point. But if they do this, then hundreds of thousands of pensioners on modest incomes would suddenly face an income tax hike. And the size of the rebate by this point is likely to be over £200 per year (compared with £94 next year). It seems unlikely that any government would want to do this straight after an election. The other alternative is to keep it going. But the cost of keeping it going will rise every year. Even if the income tax threshold finally starts to go up, the state pension is likely to go up faster because it will still be linked to the growth in the average wage. This means that the rebate needed to protect people from tax on their new state pension will rise every year and so will the cost to the government. But more importantly, it will then get even harder to switch the whole thing off, if the rebate being taken away starts to be worth (say) £500 a year or more. Before we know it, a quick fix designed to get the Government out of an embarrassing hole between now and the next election could become a permanent feature of the tax system, creating more and more complexity for more and more people. We urgently need a fundamental rethink of how we decide the income level at which people are subject to tax, rather than keeping it frozen for a decade and dragging millions more into the tax net. We also need to reflect on whether all of this is fair to those who are in work. If you are a pensioner on £13,037 next year, you will pay no income tax because of the £94 rebate for pensioners. But if you are a part-time worker on the same wage you will pay £94 in tax. It is not clear why one group is more deserving than another. Today’s announcement solves one problem – embarrassment at taxing people on the standard state pension rate – and dilutes another, namely the risk of creating a cliff edge when the new tax rebate is withdrawn. But it sows the seeds of greater cost and complexity in the long term. Steve Webb is a partner at pension consultants LCP, and was pensions minister between 2010 and 2015