Tax choices are political as well as economic decisions. In
many ways the government created a rod for its own back prior to the 2024
election by pledging not to “increase National Insurance, the basic, higher,
or additional rates of Income Tax, or VAT.” History suggests it is very
unwise to make such commitments when economic circumstances can change very
quickly (think the GFC, Covid or the impact of the Russia-Ukraine war on oil
prices). The pledge was thus an unwise political choice that is set to be reversed.
Any tax-raising decisions later this month thus have to be viewed through the
lens of politics, as well as economics.
The economic choices are clear enough: Raise as much revenue
as possible while inflicting the least amount of damage to economic growth. The
political choices are more difficult to navigate: Where should the burden of
tax increases fall without damaging political support? Politicians would like
to shift the burden of tax onto businesses wherever possible – after all, they
do not vote (although they may be substantial political donors). However,
having raised payroll taxes in the form of higher employer National Insurance
Contributions and hiked the minimum wage in April 2025, scope for asking
businesses to bear even higher costs is limited. Raising minimum wages has
contributed to higher inflation in recent months, and there is evidence to
suggest the labour market is losing momentum.
While
voters clearly do not relish the prospect of higher taxes, they are the
ultimate consumers of public services and will be required to pay in some form.
In any case, much of the deterioration in public finances over the last five
years can be attributed to government support during the Covid crisis and the
subsequent energy price spike. As I
pointed out in March 2020: “A question which has been put to me by
non-economists is who is going to pay for all this largesse. In truth, we are –
maybe not immediately, but in the longer run … Under normal circumstances, bond
yields would be expected to rise sharply in anticipation of big increases in
national debt, which would in turn imply a rising proportion of tax revenue
being used to service debt. Governments would thus be expected to respond with
fiscal tightening.”
What options are available to the Chancellor?
The Chancellor has two problems: In the short-term, she
needs to raise additional revenue, but in the longer-term the tax system needs
an overhaul – a topic which I have touched upon on numerous occasions in the
past (here,
for example). But the political cycle being what it is, the Chancellor will
have to act to plug holes in the public finances sooner rather than later. In
the last fiscal year, almost 79% of central government revenues were derived
from just four tax heads – incomes (31%), VAT (20%), social contributions (18%)
and corporates (10%). As a matter of expediency, it is these four areas which
are most likely to be raised in order to generate significant sums.
It is unlikely that all of the fiscal shortfall will be covered
by income taxes alone. My NIESR colleagues calculate that in order that the
government achieve its goal of balancing the current budget by fiscal year
2029-30, while ensuring an adequate buffer against unforeseen shocks, a fiscal
tightening of at least £50bn will be required. According to the HMRC’s Ready
Reckoner, achieving this solely through income tax hikes would require an
increase of almost 5 percentage points in the basic and higher rates of income
tax (currently 20% and 40% respectively) which would seem to be a political
non-starter. A more balanced package comprising a 1pp rise in income taxes,
employee NICs and inheritance duties, together with increases in various
duties, could raise around £20bn. In other words, we can get almost half way
there by pulling on some of the more obvious levers but this would still leave
us a long way short. It is notable that while the
Resolution Foundation’s creative proposal to increase income taxes by 2pp while
compensating with a 2pp cut in employee NICs may dilute much of the
political anger, it would offset much of the fiscal effect, rendering it less
useful.
Of course the other option open to the Chancellor is
spending cuts. But having set out a Comprehensive Spending Review as recently
as June, it is difficult to imagine that the Chancellor will want to rip up her
carefully crafted spending plans (though some cuts at the margin may be a
possibility).
More radical options for tax reform
Among the areas open to scrutiny is the taxation of
pensions. Currently, employee pension contributions receive income tax relief
at the highest marginal rate which means that higher-rate taxpayers receive 40%
relief, whereas basic-rate taxpayers receive only 20%. It is often suggested
that this creates a series of perverse incentives, whereby those who are
already better off gain the greatest benefit, while lower earners receive
comparatively little encouragement to save for retirement. Reforming pension tax
relief – such as moving to a single flat rate of relief – has long been
proposed as a way to improve fairness and potentially raise revenue. Indeed the
IFS estimates that limiting relief to a flat rate of 20% would generate an
additional £22bn by 2029-30.
However, the IFS also points out that it would be unfair to
give relief at 20% but impose a marginal tax of 40% on those whose retirement
income pushes them into the higher tax bracket. Instead, it suggests that
around £6 billion per year could be raised by introducing NICs on employer
pension contributions, which are currently exempt. An alternative would be to align
the tax treatment of contributions and withdrawals (e.g. pension income is
taxed at 20%), or introduce a tapered system that balances fairness with fiscal
sustainability (e.g. tapering tax relief at rates between 20% and 30% depending
on incomes).
But such measures would serve only to introduce
additional complexity into an already complicated tax system. Prior to the 2024
general election I suggested that one thing the
incoming government might consider was a Royal Commission on tax reform to assess
the proposals made in the 2010 Mirrlees
Review. The main conclusions of the Review were that the tax system should
raise revenue efficiently, minimising distortions to work, saving and
investment decisions by avoiding piecemeal changes that create inconsistencies.
Currently, it is quite the opposite: as Martin
Wolf pointed out in the Financial Times recently, “the tax system is a
mess”. But it may still not be too late to implement a reform plan, perhaps
in conjunction with the modest tax hikes set out above. Indeed, it might be
possible to sell a need for temporary tax hikes which will be at least
partially reversed when the suggestions from a Royal Commission are implemented
(admittedly, that would be a tough sell).
Last word
This is not the place to go into a detailed review of some
of the areas that are ripe for reform, but a coherent look at property and
inheritance taxes are clearly required. Motoring taxes and carbon emissions
taxes are other areas of the system where an overhaul is necessary; it has
always seemed inconsistent that motoring fuel duties have been frozen since
2011 at a time when governments have expressed their commitment to net zero. As
the IFS has noted, if fuel duties had been uprated in line with RPI inflation
since 2011, it would have an additional £17.4bn of revenues to play with.
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