Chancellor John Healey’s proposal to exempt the poorest pensioners from income tax could cost the government up to £500 million annually within the next decade, according to economists and former ministers. The plan aims to prevent approximately one million retirees from becoming liable for income tax as a result of state pension increases.

The move follows the expected confirmation in Mr. Healey’s upcoming Budget that the full state pension will rise by £489, or 3.9%, to £13,036, reflecting average earnings growth. However, the personal allowance—the income level at which tax becomes payable—has been frozen at £12,570 until early in the next decade. This freeze effectively pushes nearly a million pensioners over the threshold, causing them to face income tax for the first time.

To address this issue, Mr. Healey is reportedly preparing to introduce a new tax allowance for low-income pensioners, aligning it with the increased state pension figure of £13,036. Government sources have indicated that the Treasury will seek an “administrative fix” from HM Revenue and Customs (HMRC) that would essentially waive small tax bills, projecting a cost of around £200 million by the end of the decade.

While the proposal is expected to provide relief to lower-income pensioners, concerns have been raised about its financial implications. Sir Steve Webb, former pensions minister and current partner at consultancy LCP, warned that the annual cost of the exemption could escalate to £500 million by 2035. He described the situation as “embarrassing” for the government, noting that the prolonged freeze on the personal allowance means that the state pension will exceed the tax threshold for the first time next year. As the state pension continues to increase with average earnings, the discrepancy between the pension amount and the frozen tax allowance—and consequently the cost of the exemption—is likely to widen.

Additionally, Sir Steve highlighted a potential unintended consequence of the measure: pensioners with modest private pension savings might opt to cash them in early to benefit from the tax break, potentially reducing their long-term retirement income. He cautioned that “a short-term fix” could pose a “long-term headache for the Government.”

Martin Beck, director at WPI Strategy, questioned the fairness of the policy, asking why a pensioner receiving £13,036 annually would avoid income tax while a worker earning the same amount would still be liable. The debate underscores the delicate balance policymakers face in addressing the impact of frozen tax thresholds on pensioners amid rising state pension payments.