Friday, April 14, 2006

£5billion raid on pensions - it achieves what?

The more you look at this measure, the less economic sense it makes. My analysis of how it impacts tax revenues shows that it doesn't really raise any money - but instead produces a massive distortion in the market between debt and equity.

Removing tax credits has given people smaller pension funds.

1. People put more into their pension funds to compensate for the loss of the credit. They then get tax relief on those amounts. The bulk of the relief is at 40% as most of its goes to higher rate taxpayers. For basic rate taxpayers they get back 22%. Therefore of the £5bn hit, at least £1bn goes back to taxpayers as tax relief - but more likely about £1.5 billion.

2. People don't put more into their pension funds and simply have less pension. When this is taken out in the annuity form, the marginal income gets lost and hence is not collected through PAYE at the taxpayer's highest marginal rate. A key point given that personal allowances have gone up by only inflation and not by higher investment returns.

3. State run pension funds, which are substantial will have deficits. Which need to be funded - by the taxpayer. This means that ending Pension Tax Credits achieved the incredible feat of raising taxes in a way, that means there will have to be more tax increases at a later date.

4. Taxing pension funds on corporate profits they earn but not debt has caused a huge market distortion. This has led to a huge reduction in the proportion of UK equities held by Pension Funds from 36.5% to 29%. This distortion has meant that its more commerical to be a private equity owned, highly leveraged business than a quoted company - and the tax relief on that debt has caused corporate tax revenues to be lower than they would otherwise be.

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