It looks like it is going to be a pretty noisy run in to the budget given the amount of press comment in the last few days.  There is still over a month to go to a Budget which has been expected to be relatively uneventful by most tax commentators.  The reason for this is that there is simply not much money for the government to play with and therefore it is difficult to see that there will be dramatic changes.                                       

Personal Allowance

Much of the noise so far has been on the issue of personal allowances for income tax and a proposal being pushed by the Liberal Democrats to increase the personal allowance as soon as possible.  Under the terms of the Coalition Agreement the personal allowance should be increased to £10,000 over the lifetime of the current Parliament which is for a fixed term and will end in 2015.

The Liberal Democrats have decided that the best way to help those struggling in the economic climate is to increase the personal allowance earlier.  This is an interesting view, given that most previous governments have decided that dramatically increasing the personal allowance was not an effective way to help poor families.  This is for a number of reasons:-

1. As the personal allowance is increased there will then be a number of people that earn less than the personal allowance so not getting the full benefit.
2. Many high income families will benefit from the increase in the personal allowance rather than the benefit being felt by the poor.  For those with incomes over £100,000 the personal allowance is withdrawn.  But where you have a dual income household with incomes below this level then the full benefit of the personal allowance will flow through.  Similarly there may be households with other adult members working in them. 
3. Non-working spouses and children still all have a personal allowance.  Therefore the greatest beneficiary of any change will be the trust funds as the amount that can be distributed to beneficiaries tax free will increase.  It will make paying for school fees much easier for many people.

The upshot of the above is that the outcome of increasing personal allowances is not as obvious as it first seems.   It is a very expensive thing to do and it depends what assumptions the Treasury makes as to what impact it has on tax planning and taxable behaviour.  Certainly this is likely to prompt far greater activity in transferring income to non-working spouses which again raises the issue of “income shifting” which the Treasury and H M Revenue & Customs have put on the back burner for now as being too difficult to try and deal with.

A further factor is that increases in the personal allowance so far during this government have been paid for by reducing the higher rate taxable threshold.  Given what I have said above about the way the greatest benefit of the personal allowance increase will flow through to relatively high income dual households, then it is likely that there will be an effort to counter this by dragging more taxpayers into 40% tax. 

Beyond the psychological changes of this, this does have implications for the workings of the tax system as it has been a fundamental tenet of the system that there is an assumption of a very wide basic rate tax band and the deduction of tax at source by banks and building societies and in particular, the operation of dividend taxation assumes that this wide tax band exists.  This wide tax band has already been squeezed somewhat in the last couple of years and if the personal allowance increase follows through in the same way then it is likely to be squeezed further.  The knock on implications of this for the workings of the self-assessment tax system are not that easy to predict at this point and again, could actually lead to further changes in the way the tax system operates in the next few years.

Pensions

The question then is how to pay for any increase in the personal allowance. In the last few days the papers have been full of talk about the implications for pension tax relief and so it is worth thinking further about that.

The idea of abolishing higher rate (40%) and additional rate (50%) tax relief is very difficult to see being implemented.  Any change to the self-assessment tax system is very easy to deal with in terms of the self-employed or other employees that are within a money purchase pension scheme.  The problem is how to deal with the defined benefit schemes and in particular, the final salary schemes within the public sector.  The implications of abolishing higher rate tax relief work very badly for non-contributory pension schemes such as that operated in the civil service (the people that are likely to be deciding on any such policy) where large tax charges would arise every year on many employees who would have no funds from which to pay them because the monies would be within the pension scheme.

Apart from this being a well known issue, Alistair Darling did try to attack the pension scheme tax relief in his final years as Chancellor and the Coalition had to unravel it because it was simply unworkable.  The result was a system whereby there is an annual allowance of £50,000 and it was felt that at this level it was manageable to deal with any of the tax issues.  Even then we are already seeing tax charges arising on members of final salary pension schemes in this context where the benefit exceeds the annual allowance.

One possibility is that the government could reduce this £50,000 limit but it is difficult to see it coming down much.  As far as most taxpayers are concerned outside the final salary schemes then a limit of £20,000 or £30,000 would be more than sufficient even before one starts to take into account the carried forward capability.  The other thing is that it just looks inconsistent to drop the limit one year and then mess about with it another year and I think George Osborne will try to resist this.  So it is possible, but my personal expectation is that the £50,000 limit will be here for a few years and will simply not be indexed upwards.  The result will be that it will be eroded by inflation and will drag further employees into the tax net over time.  I could be wrong but that seems the reasonable best guess at the moment.

So what does that leave?  Well, it leaves the tax free cash.

The justification for the tax free cash originally was that because the pension fund had to be used to purchase an annuity that it was reasonable to give the pensioner a tax free cash lump sum up front to compensate for the risk of early death and to go some way to making the pension arrangement more attractive.  However, two things have happened since then:-

1. Life expectancy has increased substantially; and
2. There is no longer any obligation to take an annuity.

As a result, the tax free cash looks an anachronism and looks exposed.  A further consideration is that there is a general public mood against fat cat payoffs and large tax free cash lump sums from pension schemes have tended to be part of this in the past.

Possibilities include taxing the tax free cash lump sum, restricting the right to take a lump sum or a combination of the two.  For my money, a monetary cap on the tax free cash lump sum looks the most likely.  The issue here is the average pension fund in the country is actually very low and so by sticking with 25% tax cash free but with a monetary financial limit, it is possible to leave most pension funds unaffected.  It would appear to deal with the issue whilst still being relatively simply to implement.  Perhaps a limit on tax free cash of £50,000 might be applied.

I think there is likely to be a delay of at least a year before any such changes are introduced and this will be likely to lead to a rush to take lump sum benefits.  Longer term I certainly think it is unwise for contributors to pension funds to bank on the tax free cash being available.