Labour have abolished one of the few remaining reliefs available for Britain's most productive people

Rachel Reeves' changes to salary sacrifice arrangements prove that she does not care about either growth or basic fairness

Last Wednesday, Rachel Reeves delivered the Autumn Budget which — as expected — saw a large increase in the overall tax burden in order to pay for increased welfare spending. Much of this increase was by stealth: the most significant change from a fiscal point of view was the decision to freeze personal allowance and income tax thresholds for three years, raising an estimated £23 billion in total by 2030/31. But perhaps the second most significant change, also by stealth (as it left headline rates similarly unchanged), was the decision to charge both employer and employee national insurance contributions on salary sacrificed pension contributions over a £2,000 annual cap from April 2029. The OBR expect that this will raise £4.7 billion in its first year in operation, before falling to £2.6 billion in its second year in operation.

At present, salary sacrifice arrangements allow employees to shift some of their pay into their pension before it is hit by national insurance and income tax. Effectively, employees enter into an agreement with their employer to forgo a certain proportion of their salary, and the employer will then instead pay this as a pension contribution. Currently, outside of salary sacrifice arrangements, employee pension contributions are subject to both national insurance and income tax. From 2029/30, any salary sacrifice contributions in excess of the £2,000 annual cap will be subject to national insurance (though they will still be exempt from income tax).

This change, while bad in itself, would be of far less significance were it not for the extremely high marginal tax rates (and, not infrequently, effective marginal tax rates that are over one hundred percent, i.e., earning more means you take home less money) for those who cross the £100,000 salary threshold. Outwardly, it appears that nothing is wrong once your income tips over from £99,999 to £100,000: people will continue to pay the higher (40%) rate of income tax, and will only pay the additional (45%) rate from £125,140. Nor is there any change in national insurance contributions, which remain at 2%.

However, in 2009 the Labour Government introduced the personal allowance taper (i.e., personal allowance gets gradually withdrawn from £100,000 onwards), which today means that people earning between £100,000 and £125,140 are hit with a marginal rate of 62%, compared to 42% for those earning £99,999 and 47% for those earning above £125,140 (with student loan repayments, this would be even higher). This existing distortion was, incidentally, substantially increased by the rapid increase in the actual value of the personal allowance under the Coalition Government; more people have also been pulled into this income bracket thanks to fiscal drag. All of this would be bad enough, but this serious disincentive to work was compounded further still by the childcare subsidy schemes of the previous Conservative Government. These schemes can be worth as much as £10,000 per child in London, but disappear immediately, with no taper, for those earning even one pound more than £99,999 — resulting in astronomical effective marginal rates of thousands of percent in some cases. Even if it is fair to say that this absurd system was not of this Government’s creation, predictably, Reeves has done absolutely nothing to fix any of this mess.

The result has been to greatly increase the appeal of salary sacrifice schemes which, although already a tax-efficient and often a very sensible use of money, can become virtually a necessity for some high-earning employees. These changes mean that one of the few remaining reliefs available to these people, who (we are told) have ‘the broadest shoulders’, has been partially removed. As an example of the practical effect of this change, take an employee earning £100,000 making a 10% contribution (i.e., a £10,000 contribution) via salary sacrifice. The tax imposed on the £8,000 of this contribution that will no longer be exempt from 2029/30 will be £160 in additional national insurance contributions (2%) for the employee, and £1,200 in additional national insurance contributions (15%) for the employer.

But beyond the obvious impact of even further increasing the tax burden on those earning around £100,000 — both in terms of the undesirable, dogmatic egalitarianism it entails, and in terms of the big hit to incentives (and thus growth) — the change creates a number of other problems. It is likely to have a net effect of reducing the general provision of private retirement savings in Britain, exacerbating existing unfairness, and will most likely not actually yield that much in the medium-term:

i. Less saving. With the tax incentives to save for retirement reduced, many will simply pay less into their private pensions. This will see the average private pension pot shrink over time and, once we consider compounding these contributions for investment returns, many people will potentially see a sizeable reduction in their final pension pots. (This is especially important for high-earning thirty-somethings, who will not see these contributions for decades, allowing them to compound very substantially.)

Private pensions are something that successive governments have chosen to ignore. This is not surprising: the challenges created by inadequate savings will only present themselves in the long term, far beyond the time horizons of most politicians. There is already a big pension savings gap; subsidising pension savings is a sensible way to help overcome our inbuilt myopia. It is estimated that around 43% of working-age individuals are already not saving enough, and this figure is only likely to increase with the partial withdrawal of behavioural incentives for individuals to save. It should go without saying that many of the costs from this systematic undersaving will eventually be picked up by the state.

ii. An indication of more change to come. It is widely expected that the government’s medium-term intention is to abolish the scheme altogether, with the new £2,000 annual cap — which is very low in the context of some people sacrificing tens of thousands of pounds annually — mostly there to provide short-term appeasement and a claim that they are standing up for ‘working people’ (as those on lower incomes, who will therefore be making relatively small contributions, can still use the scheme without seeing much difference).

iii. Potential productivity loss. This has already been discussed above, but with those on £100,000-£125,000 paying extremely high marginal rates, one impact of removing salary sacrifice — which has hitherto been used to mitigate this — may just be that people reduce their working hours to four days a week, decline promotions, move into less demanding roles or, in some cases, be that final push for someone to move abroad. Individuals in this pay range tend to be amongst Britain’s most productive people, and disincentivising them to work is, needless to say, very damaging. No one should be deluded: people will be determined not to pay rates that they consider to be both penal and fundamentally unfair.

Rachel Reeves has repeatedly claimed that Labour’s first priority is growth and yet, as a number of those previously more sympathetic to Labour have observed, their second budget contained virtually nothing on growth whatsoever. To be clear, taxing people more to pay for more state-directed ‘investment’ — the core of Labour’s original economic agenda — is already erroneous. But even less defensible is the promotion of actively growth-destroying measures like this in order to pay for more people not to work.

iv. Employer reaction. Whilst the focus has (understandably) been on the impact on employees, it is somewhat overlooked that it is employers who will bear the brunt of the increased costs from this policy change. Employers’ national insurance contribution rates are already much in excess of what employees pay: a flat 15% rate for employers, versus the 2% marginal rate for employees earning over £50,270 per year (and 8% on any earnings below this). When faced with these additional costs, rational employers will simply reduce any planned pay rises for employees and/or reduce the employer pension contribution rates (as the exemption from employers’ national insurance was often recycled into higher pension contributions).

Many employees take for granted the cumulative impact of what these employer contribution rates have over the long-term, meaning more people will not be saving adequately for their retirement. The OBR estimates that they expect employers will seek to pass three-quarters of the increased costs to employees (via smaller salary increases, bonuses, or lower contributions as noted above).

v. Low yields from the policy. This change isn’t coming in until April 2029, giving employees and employers ample time to react and reduce the impact. By the OBR’s own estimates, in the second year of the policy (2030/31) the yield falls to just £2.6 billion, and it is plausible to believe that, given behavioural changes (which are inherently difficult to model), the £4.7 billion it is expected to raise in the first year is a significant overestimate. People are not just going to bovinely continue doing what they were doing before regardless of how much tax they get hit with, even if we accept that it will be difficult for some to avoid the tax altogether in practice.

vi. Further compounding existing (and increasing) inequality between public sector and private sector pensions. Compare this ungenerous treatment of private sector pensions (almost universally defined contribution schemes) to public sector pensions (universally defined benefit schemes, almost all unfunded except LGPS). The latter, being virtually risk-free and (usually) superior in financial terms as well, is almost without exception preferable to the former, and one of the few advantages of the former in practice — that unused pension funds in defined contribution schemes can be passed on to children (something that is not generally possible with defined benefit schemes) — was partially revoked in last year’s budget by making these assets liable to inheritance tax in most circumstances from April 2027. Because of the difficult politics of a Labour Government changing any aspect of public sector defined benefit schemes, they have largely been left alone in both budgets. While we could claim that these exemptions are only technical and incidental — though this is implausible — it is undeniable that the general approach is completely unfair even according to Labour’s own (bogus) egalitarian logic.

What explains this consistent pattern of behaviour? We could say that this was a tax change devised by a group of people — civil servants and politicians — who will be almost completely unaffected by it. We could also say that this is yet another instance of Labour politicians protecting their public sector client voters — who, as it happens, have also been showered with generous pay deals since Labour’s victory in 2024 (something that itself undermines much of the justification given for generous public sector pension provision) — while hammering the productive workers in the private sector who have to pay for all of Labour’s welfare and public sector pay increases. Although it is true that some within the public sector will indeed make contributions to defined contribution pension pots to supplement defined benefit pension schemes, this will usually only be a relatively small part of their retirement planning, given how generous public sector defined benefit pensions usually are; as such, it is still mostly fair to say that public sector workers are in practice exempted from these changes, for the basic reason that they are not reliant upon the schemes that are affected as their defined benefit schemes already guarantee them a comfortable income at retirement.

Defined benefit pensions within the public sector tend to have much higher (notional) employer contributions by default, given that they are required to meet ever-increasing, ‘gold-plated’, index-linked pensions which accrue over time. For unfunded public sector pension schemes (i.e., schemes in which current member contributions and employer contributions largely pay for retirees’ pensions), contributions are usually well over 20%. This compares to figures that can, legally speaking, be as low as 3% for employers’ contributions to private sector defined contribution schemes, and even very good schemes will usually still be less than 10% (some employers, especially energy companies, can be much more generous — but they are the exception that proves the rule). One particularly egregious example of defined benefit employer contributions in the public sector is the Police Pension Scheme, which currently sees a notional employer contribution of 36.2% (note that this is a notional, actuarial figure, not a true ‘contribution’ in the sense of a defined contribution scheme, meaning it has no interaction with the tax system either before or after these changes except when it is being paid out).

So what’s the inevitable net effect of this policy? Lower employee savings, lower employer contributions, lower wages, lower growth, an increased disparity with public sector pensions — and all for what is likely to be only a few billion per year in increased revenues once the policy comes into place.

A final aside…

Beyond the main Budget headlines, there was an interesting section contained within the OBR’s analysis with regards to the makeup of UK gilt investors: domestic demand for gilts continues to fall due to a mixture of quantitative tightening and maturing defined-benefit pension schemes. The result of this over time, if the trend continues, is that gilts will be subject to greater volatility (i.e., the ‘bond vigilantes’ we have heard so much about), given foreign ownership. These sorts of investors will demand certain fiscal standards and ‘rules’ are followed, however arbitrary they may be; any deviation from the orthodoxy will see a spike in yields. We are also likely to see systematically higher gilt yields as a result of this change over the long term.

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This article was written by an anonymous Pimlico Journal contributor who works in pensions investment. Have a pitch? Send it to submissions@pimlicojournal.co.uk.

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