The Treasury’s plans to shield low-income pensioners from income tax could lead to a “messy” cliff edge and a ballooning bill for future governments, a former pensions minister has warned.

Chancellor John Healey will use his maiden Autumn Budget this week to protect nearly one million retirees who are dependent on the state guarantee by announcing they will not pay income tax.

The plans to shield them from income tax was first announced by then chancellor Rachel Reeves in last year’s Budget and the policy is expected to run until the end of this Parliament.

Healey is anticipated to confirm that the full state pension will rise by £489 to £13,036 on Wednesday, but the rise will push those who rely solely on the state benefit above the £12,570 personal allowance threshold, meaning they will be dragged into the income tax net.

Pulling them down

This could leave them paying tax on nearly £500. To prevent them from paying, Healey is expected to announce a hike in the tax-free allowance for this group to £13,036.

But this will cost taxpayers £200m a year by 2030, according to calculations by Steve Webb, a partner at pension consultant LCP who served as pensions minister during the Conservative-Liberal Democrat coalition government.

“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 tax threshold will continue to grow, even if it only rises by the 2.5 per cent minimum guarantee, according to Webb.

In the 2027/28 tax year, the state guarantee is expected to rise to £250.70 per week, leaving it £466.40 above the threshold, meaning the scheme would have to ignore £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, equal to £13,694 per year, exceeding the allowance by £1,124.20. This pushes the tax ignored up to £224.84.

Webb added that the new tax allowance is set to apply only to those whose income matches the new state pension, meaning those who find themselves with just £1 of taxable income above this level would lose the protection.

Meanwhile, the Treasury is yet to clarify how the policy will affect those with a “modest” state pension who have accumulated small private 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”.