Opinion: What do Charity tax and higher rate pension relief have in common?

We have seen much furore over the effects that a restriction on the level of higher rate tax relief for charitable deductions may have on philanthropy. Nine out of ten charities are opposed to such a move and warn that large donations could reduce by as much as 20%. In the Lib Dem 2010 manifesto, we proposed reforming gift aid to operate at a single rate of 23%, giving more money to charity while closing down a loophole for higher rate taxpayers.

The 2010 manifesto also proposed giving tax relief on pensions only at the basic rate, so that everyone gets the same tax relief on their pension contributions. Higher earners typically benefit from relief at 40% or 45% on pension contributions. The majority benefit from a tax-free lump sum withdrawal from their pension fund and pay only basic rate tax of 20% on their pension annuity income.

Gift aid works by grossing up the amount of your charitable contribution by the basic rate of tax. If you make a charitable donation of £100, then the charity can claim an additional £25 back from HMRC, making your total contribution £125. The effect is the same as if you had made a gross donation of £125 and claimed tax relief yourself at the basic rate of tax of 20%. The charity would have received £125 and your net contribution would still be £100.

If you are a higher rate tax payer making the same donation, the charity receives the same amount, but you are able to claim back a tax refund equivalent to the higher rate you pay – less the amount of basic rate tax HMRC pays to the charity. In the above example a higher rate taxpayer could directly reduce his tax bill by £25 to £31.25.

Tax relief on personal pension contributions operate in a similar manner. Your contributions to a personal pension fund are supplemented by an amount equivalent to basic tax relief. Higher rate taxpayers can claim additional relief as a reduction against their tax bill.

The tax relief is the reason why personal pension fund contributions and charitable donations are favoured by higher rate taxpayers.

What if everyone got the same relief for charitable or pension contributions at 32% i.e. the rate that would apply, if basic rate income tax and national insurance were combined?

Firstly, the income of charities is less likely to decline and may increase, as all of the tax relief for both basic rate and higher rate taxpayers goes directly to the charity. The exchequer would be paying more to charities for donations from basic rate taxpayers, while paying out less for donations from higher rate taxpayers – a broadly neutral position.

Similarly, the level of savings in pension funds is unlikely to decline for the same reason. As a consequence, all taxpayers would get the same level of relief that they ultimately pay on their pension income.

* Joe Bourke is an accountant and university lecturer, Chair of ALTER, and Chair of Hounslow Liberal Democrats.

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  • Politically it might not be easy. For most HRT the problem would be not on their contributions but on their employer’s, which would suddenly attract tax. So it would mean a hefty tax increase. It

  • Richard Dean 19th Apr '12 - 9:08am

    But why give tax relief on charitable donations at all? In effect, the general taxpayer either ends up paying more tax to make up the shortfall in the government’s income, or some government services have to be cut . These effects do not seem consistent with a liberal or democratic approach.

  • @Henry

    You got your maths mixed up! See my comment on your blog.

    The reason for HMRC retaining a slice of tax on the Higher Rate taxpayers donation was to fund the simplifications to the GiftAid scheme introduced by New Labour, making them largely revenue neutral to the Treasury. The simplifications? these made it much easier for charities to get tax relief (at the Lower rate) on all donations by UK taxpayers, thereby dramatically increasing their value, especially those from Lower and Basic Rate tax payers (who in general didn’t fill out tax returns and hence may or may not actually paid sufficient tax to cover their donation).

    HMRC don’t retain a slice of tax on Pension contributions as these are treated in a different way in the tax calculation.

    I would be interested in seeing the Treasury’s analysis of the proposal for combined NI and Income tax, because I suspect that it will result in a vastly reduced take by the Treasury, particularly when compared to what the government is trying to achieve with the capping of reliefs…

  • Matthew,

    not sure I follow you there. Employer pension contributions to a personal pension are not supplemented by a tax credit uplift. It is not proposed that this would change – employer paid NI would would not be credited on pension payments.

  • Richard,

    without the social support that charities provide in the UK, I would expect the general taxpayer would very soon be paying out a lot more than the cost of the tax relief given, to fill the gap left in the provision of essential services. Think of the work undertaken by charities such as Shelter and the Citizens advice bureau among others.

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