Time for tax reform

The 8 July Budget may prove to be George Osborne’s best chance to bring in some much-needed reforms to our creaking and increasingly incoherent tax system. This Observation suggests some important directions for reform and calls for an improvement in the way policy is made. If this is to be a Budget for productivity, then both a better, and a more predictable, tax system should be an important part of it.

Unfortunately, the Conservative manifesto does not augur well for coherent reform. We have written elsewhere about some of the problems.

Manifesto commitments

The proposal to reduce annual limits on tax-relieved pension contributions for higher earners makes little sense, and may do more to discourage earning than the 50% income tax rate Mr Osborne says he disliked so much. The commitment to offer additional inheritance tax relief for owner-occupied housing will serve further to damage and distort an already broken system of housing taxation. It will do even more to lock older home owners into possibly inappropriate properties. Costly promises to increase the income tax personal allowance even further are supposed to be paid for by unspecified and highly uncertain anti-tax-avoidance and -evasion measures.

The Chancellor is further constrained by his promise to legislate to prevent himself from raising the headline rates of income tax, National Insurance Contributions (NICs) and VAT. Between them, these taxes account for more than two thirds of total revenues. In the case of income tax though, this is probably not much change to normal practice. Other than the introduction of the 50p rate in 2010, no headline rate of income tax has been increased since 1975. And for income tax and NICs, the pledge relates only to the main rates, not thresholds or the base on which they are charged, so there remains some room for manoeuvre.

Getting beyond these self-imposed political handcuffs, though, what ought the Chancellor to be thinking about? There are two sorts of things it would be good to see. The first is a commitment to a better and more coherent policymaking process, alongside recognition of some of the challenges that the tax system will need to address. The second is a set of specific changes to improve the current system.

Needed: A long-term plan

Our process for making overall tax policy is, and has been for a very long time, broken. No strategy is laid out by government. No long-term direction is signalled. Parliamentary scrutiny is inadequate. Businesses and individuals have little idea from one year to the next what will happen to their tax liabilities. Reduced rates of income tax are introduced and abolished. Limits on tax-relieved pension saving are cut and cut and cut again. A diverted profits tax is introduced before it has been fully thought through. The bank levy is increased every six months. Inflation indexation of rates of fuel duties is postponed, postponed and cancelled time and again. Chancellors cannot restrain themselves from layering complexity upon incoherence. 

So perhaps the most important thing Mr Osborne could do next week is simply to commit to telling us broadly what he wants to do with the tax system. One route to long-term reform is set out in the Mirrlees Review published by the IFS in 2011. There are other routes to reform. The Chancellor should lay out his own strategy.

He should tell us how he means to address the growing challenges created by increased dependence on a few very well off taxpayers, by international mobility of people and of profits, and by the growth of e-commerce. And he should give us some sense of where he wants to take the taxation of pensions, the taxation of profits, the taxation of earnings, the taxation of housing and the taxation of inheritances.

These issues are too important to be left to piecemeal Budget announcements and the detailed discussion of finance bills. Choices about tax policy have big effects on economic activity and inequality. If this is to be Mr Osborne’s Budget for productivity then one of the most helpful things he could do with the tax system is reduce the amount of uncertainty about the future.

As for reforms, here are just a few of the things that both ought to happen and have not been explicitly ruled out by manifesto commitments:

• Reintroduce a coherent system of inflation indexation into the tax system. Increasing indirect taxes in line with the retail price index and most direct tax thresholds in line with the consumer price index erodes confidence in the honesty of policymaking. To have introduced numerous elements into the income tax system which are fixed in cash terms – the £150,000 point at which the 45% tax rate is levied, the £100,000 point at which the personal allowance is tapered away, the £50,000 point at which child benefit starts to be withdrawn – is indefensible.
  
  
• Address the absurdity of having a 60% rate of income tax on incomes between £100,000 and £121,200.
  
  
• Set us on a course towards the real integration of income tax and NICs. The latter serves purely as an additional tax on earnings and exists only to attempt to fool the electorate into believing that they pay less tax than they do and into believing there is a meaningful link between what each individual pays in and what they get out. There is not.
  
  
• Put in place regular and frequent revaluation of properties for council tax such that tax liabilities are based on current values, not on the relative value of properties nearly a quarter of a century ago. At the same time reform the structure of council tax such that liabilities are proportional to property values rather than much less than proportional to property value.
  
  
• Reduce stamp duty land tax. The current system acts as a substantial barrier to mobility.
  
  
• Remove some of the badly targeted and expensive allowances and exemptions in both inheritance tax and capital gains tax which undermine the credibility of both taxes by allowing the very wealthy and well advised to pay less tax than the merely well off.
  
  
• Recognise that it is perfectly sensible to allow pension saving out of pre-tax income if tax is to be paid on withdrawal. But address the real subsidies to pension saving which come through the fact the employer contributions are entirely exempt from NICs and a lump sum of up to £250,000 can be withdrawn entirely free of income tax.
  
  
• Reform fuel duties. In the short run this might just mean having them adjust monthly and automatically in response to inflation. In the long run it might well mean replacing them with another tax altogether, ideally a national system of congestion charging, because the main harm caused by motoring is congestion and because the government is committed to reducing the use of road fuels massively in order to meet climate change targets.

There are of course many more changes, both big and small, that would improve our system of taxation. With £33 of every £100 generated in the UK taken by the government in tax, making improvements can really affect the welfare of its citizens. Next week’s Budget could be the best chance this new government will have to show that it understands that. It could make a start on a process of reform which could have substantial long-term pay-offs.