Rachel Reeves will be urged to raid the pension savings of up to 6m middle-class workers in plans presented by Treasury officials ahead of her first Budget.
The Chancellor is expected to consider a proposal for a flat 30pc rate of pension tax relief – meaning that higher rate payers will pay an effective 10pc tax charge on their retirement contributions for the first time.
The plan would affect up to 6m higher and additional rate taxpayers, costing the wealthiest savers around £2,600.
Ms Reeves has spoken in favour of restricting relief on pensions but has since distanced herself from the proposals, insisting she has “no plans” to change the current regime.
Pension contributions are tax deductible. This means that basic rate payers get a relief equal to 20pc of their payments to cancel out the income tax that would otherwise be due. Higher rate payers – those earning more than £50,270 – get relief of 40pc, and most additional rate payers earning more than £125,140 get 45pc.
These rules cost the Exchequer more than £50bn each year through income tax relief, corporation tax relief, zero tax on the growth in pensions and the fact that employers do not have to pay National Insurance on employer pension contributions.
The Treasury has long wanted to tax pension savings and has a detailed plan drawn up for a raid that has been presented to successive chancellors since the coalition government took power in 2010.
Proposals on the table include flat rates of 20pc and 30pc. Sources suggested a 30pc rate would be more politically acceptable because it could be presented as a giveaway to millions of basic rate taxpayers, effectively meaning their pensions are topped up by the Government.
However, this would leave higher and additional rate payers facing an effective 10pc or 15pc charge.
Any change would trigger outrage in the pensions industry and lead to concerns that many savers would stop paying in. It would also mean the highest earners could end up being taxed twice on the same income, because withdrawals after retirement are also liable for income tax.
A 30pc flat rate would be the equivalent of a £2.7bn increase in tax, the Institute for Fiscal Studies (IFS) has said. The policy would save the bottom 80pc of earners around £230 per year, while the top 10pc would see an average tax increase of just under £2,600 a year.
Limiting income tax relief to the basic rate would represent a £15.1bn tax rise, the IFS has said – roughly the same as a 2p rise in the basic rate of income tax.
The think tank said this “substantial increase” in tax would be shouldered almost exclusively by the top 20pc of earners, with the top 10pc facing an average hit of £4,300. The bottom 80pc, who largely receive basic income tax relief on pension contributions, would experience little to no change, the IFS said.
Sources familiar with the plans said moving to a flat 30pc rate of upfront relief could help to “level up” the savings landscape with more generous support for the majority of workers who would benefit by hundreds of pounds every year.
In 2018, when Ms Reeves was chairman of the business select committee, she wrote a 66-page document outlining a string of tax reforms, including limiting relief on pensions. She said: “Forty per cent of UK wealth is held in private pension funds. To combat this inequality, higher rate pensions contribution reliefs could be restricted.”
Two years earlier, in 2016, she proposed setting the relief at a flat rate of 33pc. The IFS has said a rate of 32pc would be roughly revenue neutral, although a freeze in the personal allowance is expected to drag millions of people into higher tax bands in the coming years.
Experts said a 30pc tax rate would force the Treasury to restrict salary sacrifice pension schemes, which currently provide a tax-efficient way for employers and employees to pay into a workplace pension.
The Treasury has also done detailed work on this proposal, which could raise up to £3bn a year. It has also conducted analysis on restricting relief on employee and employer National Insurance contributions.
However, Sir Steve Webb, a former pensions minister and partner at pension consultants LCP, said it would serve as a disincentive for employers to “do the right thing by penalising employers who contribute generously to workplace pensions”.
Research by the London School of Economics has also shown that the generosity of employer contributions for workplace pension schemes was the single biggest incentive for people to save, increasing the chance that someone will save into a pension by 71pc.
Sir Steve added that extending the restrictions to defined benefit schemes – which offer a guaranteed retirement income based on career earnings – would be hugely complex.
This is because most of the contributions to these schemes are made by the employer. Restricting relief to the basic rate, for example, would be the equivalent of a taxable benefit going to higher rate taxpayers. This could result in huge tax charges or reduced pensions in the event of an immediate tax charge.
Sir Steve said: “Giving everyone the same rate of tax relief on their pension contributions might seem fair, but it would be extremely complex to implement for the millions of workers in traditional salary-related pension schemes.
“The bulk of contributions in such schemes comes from employers and are made without any deduction of tax. If higher earners lost higher rate tax relief they would potentially face a tax surcharge not just on their personal contributions but also on the contributions their employer makes directly to the scheme. This bill could run into thousands of pounds a year in some cases.”
A Treasury spokesman said: “We have set out the need for economic stability and we have begun fixing the foundations so we can grow our economy and keep taxes, inflation and mortgages as low as possible.”
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