The Liberal Democrats have a problem. They have staked their colours clearly to the mast when it comes to raising the minimum threshold for income tax to £10,000. Most expect it to be done by the end of the parliament, if not by 2014.
The problem is, this will cost money – £4bn if it’s done by 2015, £5.5bn if it’s done by 2014 – and there isn’t much of it floating around. Lib Dems will tell you they are keen on two options to pay for this: one is to clamp down on tax avoidance; the other is to tax the pension contributions made by higher earners.
Both options are likely to make some kind of appearance in the Budget in March. But it is the latter that raises the serious money, and carries potentially serious risks for the coalition.
The Lib Dems have long argued that the best way to go about taxing pension contributions is to lower the tax relief higher earners enjoy from 40 per cent (and in some cases, even 50 per cent) to the basic income tax rate of 20 per cent. This would mean that for every £1 put into a pension, the government will top it up with an extra 20p, rather than the 40p they currently do.
The problem is, the 40 per cent rate kicks when you earn £40,000. Given that dropping the relief will feel exactly like a sudden tax hike, this will end up looking like a tax rise for people who sit roughly in the middle of the income spectrum.
That calculation is why the Conservatives have opposed such a move, but there is a compromise that both sides are close to agreeing on. As I revealed this morning, instead of dropping the tax relief rate, George Osborne could lower the overall cap on the amount that can be put into a pension in a single year while still enjoying tax relief.
The chancellor has already done this once, bringing the cap down from £250,000 to £50,000. If you are putting 5 per cent of your income a year into a pension, this means you still have to earn over £1m to feel the effect of this policy.
Lowering the cap further would replicate the effects of a bankers’ tax. Bringing it down to, say, £25,000 (the actual figure has not yet been agreed, this is merely a supposition) would mean those affected are probably earning between £500,000 and £1m a year.
That calculation is why both sides of the coalition would be happy with such a move: a tax increase for the richest to pay for the poorest to be taken out of tax makes good political sense.
The problem is that the people affected will be mainly middle-aged (older workers pay more into their pensions as a general rule) higher-earners. These are people who often support the Tories, and most importantly, actually turn out to vote for them. With the City already feeling under siege from Westminster, expect a lot of lobbying from some of the Conservatives’ most influential backers before this proposal becomes law.