Unpleasant choices redux

As expected, the UK government did indeed announce the widely trailed rise in NICs that I looked at in my previous post. The package of measures represented a budget in all but name and will take the tax burden relative to GDP to its highest since 1950 (chart). If nothing else, this highlights that the era of low taxation is over. This is a reflection of the reality that the UK cannot continue to cut taxes whilst simultaneously meeting the electorate’s demand for better public services. It is also a reflection of demographic reality. The tax cuts of the 1980s were possible because the last of the baby boomers were still entering the workforce. But over the last four decades, the population share of those aged 65-plus has risen by four percentage points to 19% and is set to rise to 25% by 2050. Some thoughts on these issues below.

What was announced?

Dealing first with the package of measures, both employer and employee NIC rates will rise by 1.25 percentage points (a touch more than anticipated) from April 2022 and the rate of dividend taxation will rise by a similar amount. All told, this is expected to generate £12 billion pa of funds for health and social care (0.5% of GDP). From April 2023, underlying NICs rates will return to their previous level and a formal legal surcharge of 1.25% will be levied on wages which will be ringfenced only for health and social care purposes. Another important part of the package is that the government plans to introduce a cap of £86,000 on the amount that households (in England) will need to spend on personal care over their lifetime. This is designed to reduce the problem that individuals will be subject to high and unpredictable long-term care costs (an issue I looked at ahead of the 2017 election).

What is it likely to mean in practice?

The tax hikes come on top of the £25 billion (1.1% of GDP) of medium-term tax raising measures announced in March. It is notable that the UK is the one major developed economy to raise taxes in the wake of the pandemic – which, by the way, is not yet necessarily behind us. It may be that this will prove to be a tax hike too soon. Moreover, contrary to previous expectations, the funds raised by what the government calls a Health and Social Care Levy will be used largely to fund the NHS rather than fix the problems in the social care system. Over the next three years the social care programme will receive just £1.8bn in additional revenues (15% of the total raised by the Levy). The government has taken the (probably well-founded) view that voters are not going to be too exercised by whether the funds are used for the NHS or for social care – at least in the short-term. This might change if the government is forced to come back for more money in a few years’ time.

A deeper dive into the details

Although the government is using the Levy as a way to find sorely needed funds for the health system rather than primarily to fund social care, this is not necessarily unwelcome – after all, many of us have pointed out that the pressures on the NHS arising from demographic change meant that it has been underfunded over the last decade. But those of you with long memories might recall that the Brexit campaign, backed by Boris Johnson, promised that leaving the EU would generate savings of £350 million per week (£18.2 billion per year) which could be used to fund the NHS. That being the case, you may wonder why workers are being hit with additional taxes to do exactly that.

There is also some confusion regarding the impact of the lifetime social care spending cap. The £86,000 lifetime limit refers only to how much individuals pay for care. It does not include daily living costs which are incurred by living in a care home, such as food, energy bills and the accommodation itself. The average costs associated with living in an old age care home are currently £36k per person per year. Daily living costs are estimated to account for one-third of that. It would thus take the average person 3½ years to run up £86k of health costs (3.5*(36-12) = 84) – but 75% of those admitted to care homes do not live longer than three years, suggesting that the £86k limit is (a) not very generous and (b) still leaves residents having to use an additional £40k of their own money to cover daily living costs before they hit the limit.

The macroeconomics of the tax hike

Whilst there was much criticism about the generational aspects of the plan, some of this is to miss the point that there is always a transitional element in tax policy. Admittedly, today’s retirees do benefit at the expense of younger workers but assuming no changes to policy in future, today’s young workers can be expected to benefit from similar funding when they eventually retire. There is no doubt, however, that those in the early stages of their career and those on low to middle incomes will bear a considerable part of the load. At the younger end of the age spectrum graduates already face significant costs as a result of having to pay back their student debt. New graduates with an average debt of £47k and earning an average salary of £30k per year are subject to a debt repayment charge equivalent to 1% of gross income, and are now being asked to contribute an additional 1.25% to fund the health levy. As an inter-generational move, this is not a vote winner.

In any case, many were left wondering why there is any need to raise taxes at all in this fragile stage of the economic cycle. The UK is coming off its biggest peacetime recession in history and is responding by tightening the fiscal stance. It is unlikely that the impact on growth will be significant but on the basis that the government will almost certainly need to tap taxpayers for additional funds for social care, this tax hike may have political repercussions.

Nor has the government had any problem raising funds in the bond market. It could quite easily have kicked this can down the road for a year had it wished in order to assess the longer-term effects of the pandemic. Chancellor Rishi Sunak argued that to continue borrowing would be “irresponsible at a time when our national debt is already the highest it has been in peacetime.” But this is misleading. The BoE owns almost 40% of the debt – a significant proportion is thus held by the one institution that is not about to get cold feet and demand a higher risk premium.

What to make of it all?

We should not be overly critical of efforts to try and secure more funding for the NHS. However, we can be more critical of the way the government has gone about it with too much emphasis on taxing the incomes of working people (not to mention the additional costs to employers) whilst not enough of the burden falls on those who derive income from non-labour sources.

Two final thoughts spring to mind: First, the Chancellor has announced a spending envelope which is unchanged overall. Thus although health spending will rise and some areas of spending will be ringfenced (e.g. schools) this implies real spending cuts for unprotected departments. It also implies that future Covid-related spending will not be funded by borrowing (e.g. to cope with the effects of scarring) but must be met from taxation. This leads us to the second point: Over the past decade, spending on health has risen from 30% of total outlays to 38% today (even after taking out Covid effects). This squeeze is likely to continue as demographic pressures intensify, suggesting that if the state is to remain the primary provider of health and social care, more tax rises are likely before the decade is out. 

And to think that Boris Johnson wrote in the Conservative manifesto in 2019: “the Labour Party … would raise taxes so wantonly.” Life comes at you fast.

Unpleasant choices

Funds are needed to reform the social care system …

Fiscal strategies around the world have been blown off course by the pandemic which has forced governments to reconsider ways to pay for the demands on the public sector. Indeed, one consequence of the pandemic is that it has highlighted the need for a strong public sector to marshal the resources required to meet unprecedented circumstances. It has also highlighted the need to fund areas of public sector engagement which have been neglected for too long.

One such issue in the UK is the provision of social care. Scarcely a week goes by without news that one of yesteryear’s footballers has been diagnosed with some form of dementia – a particularly distressing condition which robs people of their identity – with the latest victim being former Liverpool and England footballer Terry McDermott. Whilst professional footballers appear particularly prone to the disease, due to the repeated application of blows to the head as a result of heading the ball, it affects many hundreds of thousands of people in the UK alone. According to the NHS, there are more than 850,000 sufferers, with 1 in 6 aged over 80 afflicted. Social services struggle to provide the requisite care for this and other conditions, and upon acceding to office in July 2019 Boris Johnson promised to “fix the crisis in social care once and for all with a clear plan we have prepared.”

It turns out that the “clear plan” did not exist. But the Conservatives did promise in their 2019 election manifesto to “build a cross-party consensus to bring forward an answer that solves the problem.” Unfortunately Covid blew the government off course but as we start to cautiously look ahead to the post-pandemic world it appears to be seriously considering how to tackle the issue. Media chatter in recent days has focused on the likelihood that the government will announce a rise in National Insurance Contributions (NICs) – a form of payroll tax – to fund it. It is being suggested that both employers and employees will pay an additional one percentage point, which it is estimated will generate an additional £10bn of revenue (around 0.5% of GDP). One problem with this policy prescription is that it flies in the face of the 2019 manifesto commitment that “we will not raise the rate of income tax, VAT or National Insurance.”

This was, as I noted 2019, “not good policymaking” because “taking these key levers out of the fiscal equation could severely limit the Chancellor’s room for manoeuvre” – a lesson amplified by the unexpected nature of the Covid pandemic. Nonetheless, whilst the plan to raise taxes has been widely criticised as a break with the manifesto commitment, there has been rather less acknowledgement of the fact that it is designed to fulfil another one. That there is a need to provide additional funding for the social care system is undeniable. As the Kings Fund has pointed out, the one percentage point rise in NICs back in 2003 to fund the NHS resulted in “a generational improvement in waiting lists, major investments in key causes of death such as cancer and heart disease, and improvements in mental health.” Providing the funds alone is not enough and significant reforms to the system are also required. Nonetheless it would represent a good start.

… but NICs are not the best way to raise them

The planned tax rise has also come in for significant criticism for a number of economic reasons. For one thing, it is a tax on those in employment whereas those of retirement age are the prime beneficiaries which strikes many people as unfair. It also comes at a time when the government is planning to phase out the temporary increase in Universal Credit to help low paid workers during the pandemic. According to one MP quoted by Sky News, “I'm very concerned about the fact we seem to be protecting the inheritances of those with means at the same time as stripping the £20 uplift [in Universal Credit].”

NICs are also regressive. All employee income between the lower earnings limit (£9,568 per year) and upper earnings limit (£50,270) is taxed at a 12% rate but any income exceeding the UEL is subject only to a 2% rate. This has the effect that the average rate of National Insurance Contributions falls the further incomes are above the UEL. Thus, whilst those earning £50k per annum pay an NIC rate of 9.7%, those earning gross income of £100k pay an average rate of 5.9%. Even more egregious is the fact that those earning half the average wage (around £15k per year) pay a higher NIC rate than those earning £200k. If the government is intent on raising NIC rates, it really ought to review the structure of the tax first. It could, for example, raise the tax rate applied above the UEL so that the average tax rate falls more slowly at higher earnings levels (see chart 1 demonstrating the impact of various options).

Another problem with hiking NICs is that the incidence will also fall on employers. The empirical evidence does not suggest that hikes in employer NICs will have a significant impact on employment but it may at the margin impact on firms’ willingness to create new jobs, particularly in the post-Covid environment where many service sector firms face uncertain revenue prospects.

It is not even clear why we need NICs at all. They were originally intended as a tax to fund the social welfare system but they have long since been subsumed into general taxation (only around 20% goes directly to the NHS). In effect, they are perceived as a form of income tax. Some years ago I performed some calculations which suggested that it would be possible to abolish NICs altogether and set higher rates of income tax whilst still giving a post-tax income boost to the lowest earners. In my view this would not be a bad place to start in order to reform the tax system – a subject to which I will undoubtedly return.

What are the alternatives?

One possibility is a rise in income taxes. As the IFS has pointed out an increase of 1.5 percentage points in the basic and higher rates of tax could generate the same revenue as the proposed rise in NICs. The incidence of the tax is also skewed more to older workers, with 14% of the revenue coming from pensioners versus 1% in the case of NICs – not a huge amount but it is an improvement. However, an increase in income taxes would also violate the manifesto commitment.

Unions have suggested that capital gains taxes be increased although according to the HMRC ready reckoner, each one percentage point increase across the board would only generate around £175 million. A rise in CGT rates would go a long way as a signal of intent to the low paid, but as a practical revenue raising measure it would not deliver much. Increases in stamp duty land taxes by one percentage point could generate around £1 billion. But this is only 10% of the yield generated by higher NICs, so here too, a significant hike would be required to make up the shortfall. It would thus appear that an alternative to hiking NICs would require a combination of tax increases across a variety of areas. For example, a two percentage point rise in stamp duty plus a five percentage point increase in CGT would yield £3 billion. Another £1 billion could be squeezed out of inheritance taxes whilst a 4 percentage point rise in the additional NIC rate (paid by those earning more than £50k) would yield £4.6 billion (chart 2).

However, it is unlikely that a Conservative government would be willing to sanction higher taxes on capital and the well-paid. Ultimately, however, they may have little choice in the long-run and I maintain that a discussion about some form of wealth tax is one which the electorate needs to have. Income taxes exist in part to address the problem of income inequality. But with official statistics suggesting that the richest 10% of UK households hold 44% of all wealth whilst the poorest 50% own just 9% it is a problem that, like it or not, our society needs to address.

Corporate health risks

Whilst the presentation of the government’s financial plans in many countries is often a dry affair focused on the impact of the fiscal measures on public finances, it is increasingly used as a showpiece political event in the UK as the government tries to put the rosiest possible spin on tax and spending measures. Not only does the UK budget generate a lot of commentary and analysis ahead of the event, but the sheer volume of the material released on Budget Day means that it often pays to avoid instant commentary as the full implications of the measures percolate through. The Office for Budget Responsibility’s Economic and Fiscal Outlook alone represented 222 pages of detailed analysis of the UK’s economic situation, covering everything you might want to know (and a lot that you don’t), and there is a lot more besides.

By general consent, Wednesday’s budget was a “spend now, tax later” affair in which the government plans to continue providing a significant amount of economic support in the near-term but intends to pursue a more aggressive fiscal tightening beyond 2023. Indeed, the fiscal expansion measures over the next two years are offset by a planned fiscal tightening over the following three years and by 2026 the ratio of tax revenue to GDP is projected to reach its highest since the late-1960s (chart 1). The fact that the majority of the fiscal tightening falls on tax increases rather than spending cuts is a recognition that it will be politically difficult to repeat the austerity measures that were implemented in the wake of the 2009-09 recession. Indeed, I have been pointing out for some years that planned cuts in corporate taxes were putting an unnecessary strain on the budget deficit.

The impact of raising corporate tax rates

The primary tax measure announced in the budget was a rise in corporate taxes from the current rate of 19% to 25% in 2023 which would leave it in the middle of the range of a group of 37 countries, rather than significantly below (chart 2). This flies in the face of the low tax orthodoxy espoused by successive Conservative governments over the past 40 years and represents the first increase since 1974, when it was raised from an already-high rate of 40% to an eye-watering 52%. This week’s announcement was driven by two factors. First, in its 2019 manifesto the Conservative party committed to not raising income tax, national insurance or VAT rates, leaving it with few alternatives. Second, there has been growing disquiet in recent years that efforts to slash corporate taxes meant that many companies were getting off lightly at a time when individuals were bearing the costs of austerity.

The OBR highlighted that although the tax rate has been slashed sharply over the years, the share of corporate tax receipts in GDP has fluctuated in a narrow range centred around 3%. This reflects the fact that the tax base has been widened over time, thus offsetting the revenue-dampening effects. In theory, applying higher tax rates to a wider base ought to significantly increase revenue. One concession applied to the latest package is that companies generating less than £50k per annum in profits will continue to pay a tax rate of 19% with a graduated scale applicable on profits above this limit, to a maximum of 25%. The government reckons that 70% of companies will continue to pay a rate of 19%. The fact that the remaining 30% will contribute an extra £20bn in taxes by 2026 compared to estimates made in November (an increase of 31%) suggests that larger companies will be hit hard. Fears expressed in EU circles that the UK would embark on a regime of tax competition to undercut companies in continental Europe appear to be unfounded.

But tax increases have consequences. In the first instance, companies that may be considering whether they need to continue operations in the UK after Brexit may use higher taxes as a reason to move elsewhere. In addition, curbs on corporate profitability may have adverse effects on job creation in the medium-term. Moreover, expectations of reduced future profitability will depress the capacity to pay out dividends, fund buybacks and pay down debt, not to mention reducing the net present value of corporate earnings. All of these factors might be expected to depress UK equity valuations relative to other markets. Raising taxes will, other things being equal, also reduce the capacity to fund capital investment.

Pros and cons of generous investment allowances

In order to offset the worst of the investment problem, the government unveiled a generous two-year temporary capital allowance covering the fiscal years 2021-22 and 2022-23, in which companies will be able to offset 130% of investment spending on eligible plant and machinery against profits. The evidence does suggest that such measures have a stimulatory impact on investment since they reduce the user cost of capital (the tax-adjusted marginal cost of capital). Moreover, tax incentives tend to have a bigger impact on long-lasting assets. At a time when the UK is keen to encourage the switch away from combustion-engine vehicles, which will require significant investment in the infrastructure to support the adoption of battery-powered vehicles, the tax breaks could give this particular project a big shot in the arm.

However, temporary tax breaks suffice only to shift the timing of investment projects rather than leading to a permanent increase. The OBR’s forecast indeed suggests that a big investment surge in 2022 will be followed by only a moderate increase thereafter. Between 2007 and 2016, business fixed investment increased at a paltry annual rate averaging just 1.6%. Between 2016 and 2019, in the wake of the Brexit referendum, it barely increased at all and despite the budget measures introduced last week the OBR’s projections point to growth of just 0.8% per annum between 2016 and 2025 (chart 3).

Moreover, there are particularly high levels of uncertainty at present which run the risk that efforts to stimulate investment may not have the desired effect. Incentive measures presuppose that there is a lot of investment waiting to be brought online. As MPC member Jonathan Haskel noted in a speech yesterday, “residual uncertainty and risk aversion over the recovery are likely to continue to weigh on investment,” particularly in the wake of Brexit. There is also a lot of spare capacity in the economy at present – my own estimates suggest that the output gap this year is likely to average -2.6%, narrowing to -0.7% in 2022. In addition, the tax incentives are only useful if companies generate a profit. In the post-pandemic recovery phase profitability may remain under pressure, although to mitigate this effect the government has extended the loss carry back rules which allow companies to offset past trading losses against profits.

Whilst efforts to boost investment are welcome, one of the drawbacks associated with the tax allowance is that it is aimed squarely at tangible assets but there is no incentive for investment in intangibles which is a problem in an increasingly digital economy. This may continue to act as a drag on multifactor productivity, which in the past decade has posted its slowest growth in a century, which will in turn hold back potential GDP growth. 

Last word

When asked last year whether I expected the Chancellor to announce fiscal consolidation measures in 2021, my response was “it is likely that some form of fiscal consolidation will be announced in 2021 though may not necessarily be immediately implemented.” This expectation has been borne out. It was inevitable that corporates would be asked to shoulder a bigger part of the fiscal repair bill and the government has tried to sweeten the pill by offering generous investment allowances. But the strategy does represent a risk to the health of UK PLC. Like many aspects of budgetary policy, however, we will only know the outcome many years from now.