Editor’s view – Does pension Isa really steal from future generations?

John Greenwood
John Greenwood

A switch to TEE does not take money from future generations says John Greenwood

Intergenerational unfairness is a potent political emotion, and it is being used against the idea, reportedly strongly favoured by the Chancellor, that we switch from an Exempt, Exempt, Taxed structured to a Taxed, Exempt, Exempt one.

At first glance it seems obvious that bringing forward the tax take on pensions would serve to deprive future generations of money. But I am not convinced that this is the case. And the sums of money at stake are so important to the nation’s economy that the EET/TEE switch idea should be given a thorough

So it is a shame that is the extent to which a switch to a pension Isa structure steals tax revenues from future generations is a subject that is yet to be properly debated by macroeconomists.

Leaving aside the many other problems with pension Isa – and there are more than a few – let’s focus on this intergenerational issue.

The idea that money can be conjured up seemingly from thin air without it having an impact further down the line goes against common sense. It whiffs of alchemy. But then, isn’t rearranging cash flows to make organisations more efficient precisely what accountancy firms are for?

The question is, does a pension Isa steal revenue from future chancellors, or does it free up for the public good cash that is currently lying dead in the system, serving no purpose other than making pension incentives look bigger than they really are and boosting funds under management, administration and advice?

For the purposes of finding out let’s assume tax relief is £35bn a year on the way in and £14bn is recouped on the way back out. These numbers are purely theoretical – the aim is to see whether rearranging the incentives can conjure money from nowhere, without impacting future generations.

Osborne can win big by moving to a pension Isa. He does so by not giving away that £35bn each year, and replacing it with an incentive at a fraction of that price – let’s say £20bn. That gives him an extra £15bn a year to play with – which is a serious amount of money. And he still gets to keep his £14bn income tax on decumulation, as that money is already in the system.

But, say critics, future chancellors won’t have that £14bn a year to rely on as EET pots deplete, so he is not being fair to future taxpayers – he is robbing the future to pay for the follies of today.

But, goes the theory propounded by Michael Johnson at the Centre for Policy Studies, future chancellors won’t have to pay out the £35bn a year tax relief either. They too will be paying out £15bn less, offsetting the £14bn a year they get in.

To get a clearer picture let’s narrow the issues and talk about people who pay basic rate tax both in employment and retirement, and let’s assume for simplicity their up-front tax relief costs £10bn. Of this £10bn, £7.5bn is going to be taken back at some point decades into the future. How can it be rational for the Treasury to pay £7.5bn a year into tens of millions of pension pots, leave it there for several decades subject to numerous tiers of known and unknown charges and other frictional costs, and then get HMRC to recover it from the pensioners whose pension accounts it is in. This is dead money. Isn’t the Chancellor simply talking about freeing it up?

Johnson’s argument has always been that a switch to TEE is a once-only move. Like Phileas Fogg getting an extra day by travelling eastwards in Around the World in 80 Days, this is a gain you can only win once. And if you are the current incumbent in Number 11, you are probably going to want to do it before someone else does.

My purely theoretical examples make the hefty assumption that the economy will continue to be the same for many more decades. It ignores what are genuine issues with regard to an ageing population. The reality is, we will have a growing retired population for the foreseeable future, even if the Government takes robust steps to make state pension age grow in proportion with longevity. So putting more money aside for the future makes sense.

But it would be a very, very long time before demographic changes mean the income tax on pension withdrawals is higher than the tax relief going in. And as pension Isa supporters point out, increased tax relief for auto-enrolment is going to more than offset any lost income tax on pensions in payment. And with Labour pushing for a consensus on a near doubling of pension contributions, the current EET system will cause even more fiscal strain.

Even if it is the case that, net net, there is some intergenerational transfer caused by demographic changes at some point, that does not mean the Chancellor does not have a duty to liberate dead money wherever he can. And if the Government wants to invest for future generations there are, with no disrespect to the industry, better ways to do it than putting it in millions of tiny pots, most of which are investing in default funds with holdings all over the world.

Both flat rate and pension Isa have their merits. I have no particular view as to which will work better. We have not had a proper debate on all the issues – it is a shame that such momentous changes have only really been looked at in anything approaching any detail in a very small number of publications by a relatively small number of people. I am yet to see a detailed macro analysis of the financial impacts of a pension Isa structure. The closest was the note from the Morgan Stanley note published last September that suggested a £115bn windfall for the Treasury was possible.

Both approaches have their merits and the risks of failure are high. So, macroeconomists, come forward and give us the real picture.