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Home Publications We need to reform the tax system as national debt rises — and here’s how

We need to reform the tax system as national debt rises — and here’s how

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The national debt has topped 100 per cent of national income, and the annual deficit looks likely to stay well above £100 billion a year for the foreseeable future. That’s not a recipe for fiscal sustainability. Another bout of spending cuts looks neither desirable nor plausible. Hence warnings from several quarters that tax rises look likely — not this year or next but before very long.

The warnings are surely right. We were due some tax rises just to cope with population ageing in any case. So we could be looking at an historic change. Pre-pandemic tax revenues were already at the highest sustained level relative to national income that they have ever been, if only by a smidgeon. Raising them by another couple of percentage points of national income — surely the minimum that will be required — will take the UK into new territory.

I could find you a dozen ways of raising that odd £40 billion. But if we are going to be in the business of increasing taxes to record levels then we ought to start by sorting out some of the problems in the way the tax system works. The problems create complexity, inequity and the kinds of invitations to tax avoidance which politicians spend so much time bemoaning and so little time actually fixing. The more we raise taxes the more costly these sorts of problems are likely to be. I’m afraid this is all a bit less exciting than just calling for wealth taxes or a soaking of the rich. But please bear with me.

Lots of the problems arise because we tax similar activities differently. There are dozens of examples of where we do this. Perhaps the most important relates to the way in which earned income is taxed depending on whether it is earned by an employee, by a self-employed person, or by someone who has set themselves up as a company. For a job generating £40,000, tax is £3,300 higher if the job is completed through an employment contract rather than by someone who is self-employed, and £4,300 higher than if they work through their own company. This is mostly because employees’ salaries are subject to employers’ national insurance contributions whereas other incomes are not. This isn’t just inefficient it is blatantly unfair; and it is increasingly costly for the exchequer.

There are now five million people getting income from self-employment and about two million company owner-managers. That’s one in five of the UK’s workforce working through their own business representing a rise of 40 per cent over the past 20 years. The tax differential has played its role in that growth. It’s one of the reasons platform companies such as Uber are so keen to ensure that those they pay are classed as self-employed and not as employees.

For some people the tax differences can be even greater because we continue to levy much lower tax rates on capital gains than on earned income. That difference overwhelmingly benefits the wealthiest. Almost two thirds of taxable capital gains realised annually accrue to people realising gains of more than £1 million that year.

The obvious answer would seem to be to raise tax rates on the self-employed, on company owner managers, and on capital gains. That doesn’t quite work though. And not just for the obvious political reasons.

Given the current tax base, higher rates would deter investment and risk taking. Indeed, they are to some extent deterred at the moment despite low tax rates. That’s because, for example, not all investment can be fully offset against tax, and losses can’t be offset against future earnings other than from the same business.

The biggest beneficiaries from the current system are those who make big profits off the back of small investments. Big investing risk-takers can find themselves penalised. The fact that gains that are purely inflationary are taxed by the capital gains tax (CGT) system also militates against simply raising the rate of CGT.

As my colleagues Stuart Adam and Helen Miller set out in a report last week, there is a way to square this circle. As well as increasing tax rates on business incomes, we need to change the tax base — the definition of what is taxed — to give full deductions for amounts saved or invested and allow losses to be offset against as broad a set of income as possible. That would allow tax rates to be equalised while improving incentives to invest.

While that would represent a big change, there are plenty of steps along the way that the chancellor could take. For example, he could increase tax rates on dividends and capital gains to standard income tax rates while giving tax relief on the purchase of shares in a company. This would remove disincentives to invest in a company while also ensuring tax is paid at full income tax rates on returns to that investment.

He could increase tax rates on self-employment income while allowing self-employed people who make a loss to deduct the loss from income from their next job or business venture. This would align tax rates more closely while reducing disincentives for risky entrepreneurial activity. He could increase tax rates on capital gains while reintroducing indexation for inflation so that only above-inflation gains were taxed. This would both reduce avoidance incentives and reduce disincentives to save and invest.

Remember, every time someone calls for more money for the NHS, or social care, or universal credit, as it seems just about everyone is nowadays, they are also implicitly calling for higher taxes in the long run. That’s a less exciting thing to call for. And these issues of tax design may be particularly unexciting. But bigger spending without better taxes will cost us much dearer than it should.

There will be objections to any reforms, of course. But choosing to keep the current system is also objectionable.

This article was first published in The Times and is reproduced here with kind permission.

More on this topic

External publication
Aligning tax rates between employees and the self-employed would reduce inequity while encouraging entrepreneurial risk-taking, says Stuart Adam, senior research economist at the Institute for Fiscal Studies.
Report
The parts of the UK tax system that dictate how different forms of income are taxed are of central importance and are not fit for purpose.
Press release
A new report by IFS researchers, funded by the Nuffield Foundation, argues that the parts of the UK tax system that dictate how different forms of income are taxed are not fit for purpose. The report offers both a long-term solution to these problems and practical steps towards achieving a fairer ...