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A distorted tax system makes us all worse off

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We spend much more time talking about the specific ways in which the government spends money than about how revenues are raised in the first place. This is somewhat surprising given that annual tax revenues are around £740bn—that’s 35 per cent of national income.

As pressures continue to grow on public services, including as a result of an ageing population that demands more and more expensive health and social care, we may see more discussion about the size of the state. But how we raise tax can be just an important as how much we raise. Governments use the structure of taxes to redistribute incomes and to manipulate behaviours, thereby shaping the kind of economy and society we have.

The majority of tax revenue (63 per cent) comes from just three taxes: income tax, National Insurance Contributions and VAT. This has been true for decades, is true across most developed economies and will likely remain true in future. But even considering the source of revenue can mask many important choices about which people and activities are actually being taxed. For example, while income tax provides the same share of revenues today as in 1990, the share paid by the top 1 per cent of income taxpayers has almost doubled (from 15 per cent to 28 per cent). This resulted largely from growing inequality (which changes the tax base), and is despite cuts in the top rate of income tax.

Considering the details of tax design is necessary for evaluating whether various political goals are being achieved. It also reveals that our tax system distorts choices by much more than is necessary to achieve political objectives. Poor tax design is a problem for efficiency—the costs imposed by taxes are significantly higher than they need to be—and equity.

For example, a job generating £40,000 of income will attract over £3,500 less in tax each year if the job is done by a self-employed person rather than an employee; taxes are even lower if the person operates through their own company. More broadly, people working for their own business get large tax breaks relative to employees that are based purely on the legal form in which work is undertaken—they do not reflect differences in access to government benefits. It is hard to argue this is fair. Lower taxes are often justified as ways to boost entrepreneurship and business owners have been the fastest growing part of the UK labour market since the early 2000s. But many businesses are operating with very low productivity and generating low incomes. There are now 25 per cent more self-employed sole traders than in 2007 but, remarkably, the aggregate turnover for this group has fallen by 19 per cent. The tax breaks, which cost over £11bn annually, can make people worse off by skewing the structure of work towards what minimises tax rather than by what makes the most commercial sense.

To take another example, we place very different tax rates on different types of capital income (i.e. interest, dividends, capital gains) and lower rates on capital income than labour income. This inefficiently skews choices towards less productive but lower taxed investments. It also creates unfairness when people with the same overall income have different tax bills depending on the source of income. There are currently particular concerns around intergenerational fairness because the baby boom generation were in the right place at the right time to amass large capital gains on housing (most of which attracts zero tax) and to accrue large private pension pots (pension income is taxed at much lower rates than labour income). Younger generations look set to be much less wealthy and to get more of their income from (more highly taxed) earnings.

How we tax property and housing—which together account for 80 per cent of UK households’ total net wealth—and, more broadly, how we tax capital incomes matters today and may become more important in future. The economist Thomas Piketty popularised the concern that returns to capital will grow faster than wages in future, thereby driving growing inequality. Others worry that robots will become more important, meaning higher capital incomes for those who invest in robots. Economists do not agree on whether returns to capital will be more important in future, but fixing the design of capital taxes today would make any of those futures less concerning.

We know how to fix tax design. It requires fixing tax bases—the definition of which income is taxed—as well as changing rates in order to remove distortions, including to savings and investment incentives, and to ensure new distortions aren’t added. And it would raise objections, especially when it involved removing preferential treatment and thereby creating losers. But it is possible, at least technically, to have a tax system that is more sensibly designed. Sticking with poor tax design makes us all worse off. Whatever political choices we make about the size of the state and how progressive taxes should be, how we design the taxes to implement those choices seems like something worth talking about.

This article was originally published in Prospect Magazine and is reproduced here with full permission. Helen Miller is Deputy Director of the IFS. Follow her on @HelenMiller_IFS.