Chancellor John Healey is expected to use his first Autumn Budget this week to protect nearly one million retirees from income tax by raising their tax-free allowance, a move a former pensions minister has described as "messy" and increasingly costly.
The Treasury's proposal aims to shield low-income pensioners who rely solely on the state guarantee from being dragged into the income tax net. The policy was first unveiled by then-Chancellor Rachel Reeves in last year's Budget and is expected to remain in place until the end of this Parliament.
State pension rise pushes retirees above threshold
Healey is set to confirm on Wednesday that the full state pension will increase by £489 to £13,036. That rise will push those who depend only on the state benefit above the £12,570 personal allowance threshold, leaving them facing a tax bill of nearly £500.
To prevent this, Healey is expected to announce an increase in the tax-free allowance for this group to £13,036. According to calculations by Steve Webb, a partner at pension consultant LCP who served as pensions minister during the Conservative-Liberal Democrat coalition government, the move will cost taxpayers £200m a year by 2030.
Growing gap and rising costs
"This scheme is being developed because the repeated freezing of the personal allowance has dragged more and more retirees into the tax net. But the proposed solution looks messy and increasingly expensive," said Webb.
"The gap between the new state pension and the tax threshold is set to grow every year, which will make the policy hard to switch off. But if it continues, the cost will grow and grow."
Despite the tax allowance being frozen for the remainder of this Parliament, the gap between the new state benefit and the tax threshold will continue to widen, even if it only increases by the 2.5 per cent minimum guarantee, according to Webb.
Projected costs in coming years
In the 2027/28 tax year, the state guarantee is projected to rise to £250.70 per week, placing it £466.40 above the threshold, meaning the scheme would effectively disregard £93.28 in tax at the 20 per cent basic rate. By the 2029/30 financial year, the pension is anticipated to climb to £263.35 per week, equivalent to £13,694 per year, surpassing the allowance by £1,124.20 and pushing the amount of tax disregarded up to £224.84.
Webb further noted that the new tax allowance is set to apply solely to those whose income matches the new state pension, meaning anyone with just £1 of taxable income above this level would forfeit the protection. Meanwhile, the Treasury has yet to clarify how the policy will affect those with a "modest" state pension who have built up small private pension pots.
He said: "At present, income tax would be collected through a PAYE tax code on the private pension. In future, would these individuals be taxed first and then have to claim back a tax rebate every year?"
"If the extra allowance is available only to those on a low income, there could be a growing 'cliff edge' problem where those with very small amounts of private income lose the whole allowance and end up worse off than those with nothing."
