Time to rethink the tax system

Looking to next week …

Next week the Chancellor will present the annual UK budget in which he must strike a balance between providing support to the economy in these unprecedented times whilst suggesting that measures will need to be put in place to plug the fiscal gap. Unlike in times past when the purdah period ahead of the budget meant there was complete radio silence on the expected measures, this year the plans have been splashed all over the weekend newspapers. They highlight that the government is planning a “restart” grant scheme to provide funds to allow businesses to reopen after the Covid lockdown and an extension of the furlough scheme through June. In addition, the government is expected to announce measures to support house buying, including a time-limited extension to the stamp duty holiday and help for people hoping to get on the property ladder.

Any message that the government is trying to convey via the media should be taken with a huge pinch of salt. Whilst it is giving the impression that it remains committed to providing support, a £5bn restart fund is chickenfeed in fiscal terms (0.2% of GDP) – as one below-the-line contributor to the FT story sardonically commented, “why not just send a card?” I have noted on previous occasions that the media representation of fiscal aggregates is akin to a form of money illusion if measures are simply reported in absolute terms without giving any form of context. A £5bn fund sounds big to the average punter but it will only deliver a payout of up to £18,000 for the biggest firms. Small businesses will obviously get less and the payout may not even cover the fixed costs of running a business during the lockdown. This is not to say that support is unwelcome but it highlights that the state’s generosity is more limited than ministers would have us believe. Nor is it clear that measures to further inflate the housing market will do much to tackle the UK’s economic woes. Inflating the price of non-productive assets may make voters feel good but it is of questionable economic benefit.

Naturally politicians want to deliver only good news whilst hiding the bad and there has been less discussion of any fiscal tightening measures. However, Chancellor Sunak has promised to “level with people” over the “enormous strains” in Britain’s public finances and warns that the bill will fall due at some point. Matters have been made more complicated by the foolish commitment in the 2019 election manifesto to rule out increases in income tax, national insurance and VAT rates though whether that is adhered to in the long run remains to be seen. One of the measures likely next week is a freeze in income tax thresholds which will push people into higher tax bands as their income rises, although the fiscal effect of this will be limited, yielding less than £1bn in FY 2022-23. There has been some chatter about whether corporate taxes will rise. Whilst this may be postponed to the future as there are genuine questions as to whether this is the right time to be talking about fiscal tightening, it is a measure likely to come onto the agenda sooner or later.

… And beyond

Much of the discussion around fiscal tightening centres around tinkering with existing taxes. But looking ahead, now would be as good a time as any to open up a discussion about the future shape of the tax system. After all the current system largely grew out of a twentieth century economy but given the impact of the pandemic on the structure of the economy and the need to reshape fiscal policy in its wake, it would now seem to be a good time to announce a long-term public consultation on the scope of tax reform. This would build on the excellent body of work conducted by the Mirrlees Review in 2010 and 2011 which was motivated by the fact that the tax system has grown in an ad hoc way and “remains the product of often incoherent piecemeal changes rather than strategic design.”

Although the British system is fairly efficient in an international context, offering relatively few loopholes and opportunities for avoidance, and is on the whole non-intrusive, it is far from perfect. We can broadly categorise measures into easy fixes and ones which require a much deeper level of consideration. In terms of the former category, I repeat my call for a reduction in the benefits taper rate (the rate at which in-work benefits are withdrawn as people take on paid employment) which would eliminate the burden on some of the least well-off in society whilst also increasing their work incentives.

Other relatively easy fixes include increasing capital gains tax to align it with income taxes, as recommended by the Office of Tax Simplification, to ensure equal tax treatment of labour income and wealth income. Another fix would be to limit the rate of pension tax relief to 20%, thus reducing the regressive treatment of pension contributions which currently favour higher rate taxpayers, whilst abolishing the double taxation of interest income would be a welcome vote winner. Finally in terms of easy fixes, there is a case for abolishing the distinction between national insurance contributions (NICs) and income taxes as a way of simplifying the tax system. In fairness this was considered in the 1980s but the then-Chancellor concluded that “the benefits of a combined charge would be unlikely to justify the ensuing upheaval.”

There are a number of more complex questions to be asked of the tax system which require a lot more thought. To the extent that income tax, VAT and national insurance contributions together account for around 60% of revenues there is a case for thinking about ways to widen the tax base. One option would be to consider the possibility of a wealth tax. I did look at this issue three years ago and concluded that there are many practical objections which means it may be more trouble than it is worth. But there are some attractive features, especially in the wake of the pandemic in which young asset-poor people have been forced to make sacrifices to shield older asset-rich people.

Another area ripe for reform is corporate taxation. The standard belief is that there is a case for raising the tax rate which is relatively low in an international context. There is some merit to this but there is a lot more to the issue than simply tax rates. For example, a recent OECD symposium looked at ways to levy tax based on the location of customers rather than legal domicile and there is a big debate around the taxation of digital services which is very much in its infancy. A related issue in the corporate taxation debate is the extent to which debt finance receives more favourable treatment than equity finance. By allowing the tax deductibility of debt interest payments against profits, the base against which corporate taxes are levied is artificially reduced.There is scope to look more closely at this anomaly.

Last word

There are numerous other areas ripe for reform (local authority financing being one of them and I will come back to that another time). As Stuart Adam and Helen Miller noted in a recent IFS 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 … The tax treatment of returns to investment is a mess … And this is just the start; the list of problems is long.” These are very strong arguments in favour of rethinking the tax system to make it more applicable to the economy of the 21^st century. Just as we need a debate about what we want the state to provide following the pandemic, we need a debate about how to pay for it.

Not so much a poverty problem but a benefits problem

The context

This is a true story. Some years ago a Polish builder working in the UK suffered an accident at work in which his right hand was severely injured. Although he is perfectly capable of working with his left hand, prospective employers took one look at his injury and determined that he was unfit for work. Deprived of his ability to make a living, the man quickly burned through his savings, and came to rely on the £72 per week provided by Employment and Support Allowance (ESA). Not surprisingly he was unable to continue to pay for his accommodation and was soon reduced to living in a shed.

Last week, our builder showed up at a job centre in a well-to-do part of southern England to try and get some help with his circumstances. After having told his story, the first question he was asked by the officer dealing with his case was whether he had any health issues. Assuming that the question referred to supplementary issues other than his hand, he replied that he suffered from anaemia. The officer was about to press the enter button on the keyboard to finalise the data entry when another official who was observing the interview reminded them that the man had a serious hand injury.

It was then explained to our builder that he was eligible for housing benefit. Wonderful – some help at last. Except that in the Kafkaesque system employed in the UK, the recipient first has to find a place to live and only then are they entitled to support. Due to the shortage of social housing, those seeking somewhere to live are forced to rely on the private rental sector. Assuming you can find someone willing to rent their property, the landlord will ask for a deposit of 2-3 months’ rent. If you are living in a shed and surviving on £72 per week, the chances of saving up around £1,000 for a deposit are slim to none. To recap, this is a skilled workman who paid his taxes whilst he was working and by an unfortunate sequence of circumstances found himself living in a shed, in the middle of winter in what prides itself as being a rich civilised country. Furthermore, he cannot claim his housing benefit because he has nowhere to live.

I must admit to being shocked by this story and it is an eye-opener to realise that people are living in such circumstances in a so-called rich economy in the 21^st century. It would be easy at this point to say that Jeremy Corbyn was right after all, and that the electorate has mistakenly given a mandate to a Conservative government which is putting increased pressure on the poor. But I am not sure that this is the whole story.

The problem 

On a long-term basis, the evidence suggests that there was a sharp rise in relative poverty, but it occurred in the second half of the 1980s, during the second and third term Thatcher governments (as measured on an income basis, see p18 of this House of Commons Briefing Paper). It has been exacerbated by a sharp rise in housing costs, which means that income after housing costs has not recovered to the same extent as before-housing cost income where relative poverty levels have fallen moderately since the 1990s. The Social Metrics Commission, an independent group of experts which is working to understand and measure poverty in the UK, reckons that the proportion of people living in poverty (which takes into account factors such as income and housing costs) has fallen slightly since the middle of the last decade (chart) with a larger decline for pensioners than for other groups. Overall numbers have gone up, of course, but more slowly than growth in the total population.

I do not wish to suggest that poverty is not a problem, because it clearly is for a lot of people. But a far bigger problem appears to be issues with the benefit system itself. In summer 2018 the National Audit Office released a damning report on the rollout of Universal Credit (UC). UC was introduced in 2012 and was intended to simplify the benefits system by combining six benefits into one and to raise work incentives by promoting a system of benefit-tapering as people moved into work rather than ending state support altogether. However, as the NAO pointed out, the system did not initially work as intended and underwent several changes – one of the biggest was the 2015 decision by George Osborne to reduce the UC budget, which limited its effectiveness. 

One of the biggest failings of the system compared to previous benefits was the decision to pay out in arrears. Claimants do not receive any payment until five weeks after their first claim whereas under the previous system they were eligible for payment straight away. The well-documented rise in food bank use appears to be highly correlated with the introduction of UC, with the Trussell Trust reporting a 67% increase in the distribution of food parcels over the past five years, as claimants simply do not have sufficient funds to buy food. 

A (partial) solution 

I have no political axe to grind, not being a member of any political party. But as an economist with an interest in social justice issues, the first thing I would recommend to the new Conservative government is to take action to resolve the flaws in the UC system. This would go a long way towards helping those voters in those areas who “loaned” their votes to the Tories in exchange for “getting Brexit done.” An obvious fix would be to reduce the waiting time before benefits are paid out. Another possibility would be to reduce the UC taper rate. At present, the taper rate is set at 63% which means that for every £1 earned above the Work Allowance, benefit is reduced by 63p. According to the HMRC tax ready-reckoner, each £100 increase in Working Tax Credit costs the Exchequer £260 million versus a cost of £605 million for each £100 rise in the personal tax allowance, so altering the taper rate is a cheaper way of helping the truly low paid.

If the Conservative Party is serious about renewing its contract with the electorate, small fixes such as this could go much further than the big headline-grabbing proposals espoused by the main parties during their election campaigns. They will be cheaper too.

As more evidence comes to light ...

Nigel Farage likes to claim that he is speaking for the ordinary citizen and has argued strongly against immigration, suggesting that the studies which show the benefits of immigration to be flawed because they fail to account for the cost of in-work benefits such as tax credits. But right-wing politicians are not the only ones to be concerned about free movement within the EU: One of Jeremy Corbyn’s key union supporters, Unite’s Len McCluskey, suggested this week that Labour should also take a tough line on free movement of workers. But the evidence clearly shows that both are ignoring the economic benefits of free movement to the UK and their opposition to immigration is based on a false premise.

Three months ago HMRC published data which showed the revenue and expenditure contribution of EU citizens to the UK’s tax and benefit system for fiscal 2016-17 which paints a very different picture to many of the claims made during the  EU referendum campaign. The figures show that EU and EEA citizens received around £3.2 billion in child benefit and tax credits. But they paid in £21.3 billion, meaning that they made a net contribution to the UK Exchequer of £18.1 billion. Although this figure does not include all tax and revenue streams, it is a safe bet that this these figures are a fair reflection of the overall fiscal contribution of EU citizens. To put it into context, a figure of £18.1bn is more than the current budget surplus for FY 2016-17 (£17.4bn). Without the fiscal contribution of EU and EEA nationals, the current balance on public finances would have been in deficit. 

Citizens of all EU countries made a positive exchequer contribution, with the largest net sums being paid by French (£2.9bn) and Irish (£2.2bn) nationals, with the Poles chipping in a net £2.1bn. On a per capita basis, the biggest contributors were Danish nationals, who paid an average of £25,090 followed by the French (£24,090, chart). The average European per capita contribution was £7,260 with the overall figure being depressed by the relatively low contributions made by central and eastern European nationals. The figures tell us two things: Most obviously European nationals come to the UK to work, not claim benefit as has often been claimed in the recent past. Second, the distribution of per capita contributions highlights the fact that western European nationals tend to be highly skilled and are therefore high earners whilst those from newer EU member states tend to be lower paid.

Even before the end of free movement, the UK is no longer an attractive destination

For all the fact that EU nationals make a significant contribution to the UK economy, there is clear evidence that fewer of them are entering the UK than was the case three years ago. Although the UK immigration data are subject to significant methodological flaws, they are all we have at present and they show that in the year to March 2019, a net 226k foreign nationals entered the UK compared to 311k in the year to June 2016. The net inflow of EU nationals has slowed to 59k versus 189k in the year prior to the referendum, with net outflows of EU8 citizens as many of the huge wave of migrants from Poland begin to return home. But the real kicker is that in the year to March, a net 219k non-EU nationals entered the UK compared to 171k in the year to June 2016. Recall that this is the part of immigration that the UK government can actually control, so if the electorate really does have a problem with immigration they are going to be mighty dumbfounded by the government’s current policy.

It has long been recognised that there are substantial costs associated with pulling up the drawbridge and the government appears to have quietly dropped its unrealistic pledge to reduce the net number of immigrants below 100k. But it might be too late: Large sections of the UK public sector rely on foreign labour input and there has been a 70% fall in the number of EU citizens coming to the UK to work. In the absence of a sudden surge in Brits willing and able to take on the tasks, these positions will have to be recruited from outside the EU, which may explain why the numbers arriving from outside the EU have increased.

Moreover, one of the flaws with the data is that it includes those coming to the UK to study and who make a net overall contribution to university coffers. Prior to the EU referendum roughly one-sixth of the net immigration figures was attributable to students – there has been a reduction of around 20k in new student numbers over the past three years with anecdotal evidence suggesting that many have been put off by the more hostile climate. This is certainly not a desirable outcome for universities which are seeking to expand their footprint in an increasingly competitive global education market.

Whatever one’s views on immigration, it is clear that a policy of restricting the flow of EU citizens into the UK will have economic consequences. This may only be evident initially at the margin. But it remains one of the potential underrated consequences, whose full effects will only become evident in the fullness of time.

Is that a B'Stard I see before me?

A crowded field but where is the quality?

They say that fact is stranger than fiction and nowhere is this more true than in British politics right now. Thirty years ago, the TV scriptwriters Laurence Marks and Maurice Gran satirised the Conservative Party of the 1980s in the TV sitcom The New Statesman. It was based around the fictional hard-right Tory MP, Alan B’Stard, who was portrayed as an unscrupulous, amoral individual who would stop at nothing to fulfil his ambitions. It is difficult to watch this clip and avoid the impression that many of the current candidates for the Tory leadership are aping B’Stard’s fictional rhetoric.

Nominations for the Conservative Party leadership closed today, with 10 candidates on the ballot paper and with the first round of voting due to take place on Thursday. Just as a reminder of what is at stake, 314 Tory MPs are due to choose two candidates to succeed Theresa May who will then face a ballot of all Party members. What this means is that 124,000 people will choose the person who will attempt to negotiate the UK’s departure from the EU. Or, to put it another way, this choice will be made by 0.27% of the total electorate. Moreover, if only one candidate emerges from the parliamentary process, as happened in 2016, the new PM will be chose by less than 0.01% of all eligible voters[1]. To highlight the New Statesman-like surrealism of the debate, three of the candidates (Rory Stewart, Andrea Leadsom and Michael Gove) have all admitted to past drugs misdemeanours. Two of the hardline Brexiteer candidates (Dominic Raab and Esther McVey) have suggested suspending parliament to ensure that it cannot block Brexit on 31 October. And this is before we get to Boris Johnson whose strained relationship with the truth is legendary. Welcome to democracy in 21st century Britain.

Reviewing the fiscal options

But for all the lack of quality on display to inherit the office held by substantial politicians such as Winston Churchill and Margaret Thatcher, the economic issue of interest concerns the fiscal policy options suggested by the candidates. Let’s start with Boris Johnson. He has already threatened to withhold the £39 billion payment for incurred liabilities unless the EU gives the UK better exit terms. But assuming this is paid over a period of 3 years, it only amounts to around 10% of the EU’s annual budget revenues (or 0.1% of EU GDP). Not only is it a trifling sum in the grand scheme of things but lawyers suggest that such a move is probably illegal. It would also be the first time since the UK came into existence following the Act of Union in 1707 that it has defaulted on its credit obligations. The EU simply will not be threatened in this way and it would cost the UK far more than it gains. Whilst such a policy may play well with the Tory faithful, it would be an act of monumental economic stupidity.

Various leadership candidates have also promised tax cuts in the event they accede to 10 Downing Street. Johnson has promised to raise the threshold for the higher rate of income tax (40%) from a starting salary of £50,000 to £80,000, at an estimated cost of £10 bn (around 0.5% of GDP). Johnson claims that this can be funded from the £26.6 bn set aside by the Treasury as an insurance fund against a no-deal Brexit. But since Johnson has threatened that the UK would be prepared to walk away from the EU without a deal, he is surely going to need the emergency fund. Johnson’s team counter that the policy would be part funded by raising the upper limit on national insurance contributions. However, the Institute for Fiscal Studies has pointed out that this would benefit richer pensioners who do not pay NICs – which, oddly enough, maps onto the Conservative Party membership demographic.

Meanwhile, Brexiteer Dominic Raab has suggested reducing the basic rate of income tax by 5 percentage points over a period of five years. A rough rule of thumb based on Treasury calculations suggests that this will reduce revenues by more than 1% of GDP on a five-year horizon with no suggestion of how this will be funded. Foreign Secretary Jeremy Hunt, who is also in the running, has called for a huge increase in defence spending to “support our great ally, the United States.” Currently, the UK spends around 2% of GDP on defence – each one percentage point increase will raise outlays by £20 bn. Maybe former Health Secretary Hunt thinks he can find more for defence by taking something away from the health budget or perhaps in contrast to his rivals, he believes taxes should be raised. But like his rivals, he has failed to set out how his plans will be funded.

We should also not forget Michael Gove’s plan to abolish VAT and replace it with a lower, simpler sales tax. Interesting theory but a bad policy. For one thing, it is one of the government’s biggest revenue generators, delivering £138 bn per year to the Exchequer (6.3% of GDP). Moreover it is a general tax involving the production and distribution of goods and the provision of services, and whilst it is borne by the final consumer it is more than simply a sales tax. VAT is also efficient, in contrast to Purchase Tax which it replaced and which was levied on a range of goods at differing rates. It was certainly not efficient. If Gove’s proposed tax is “simple” it will have to be applied to a wide range of goods in order to generate the kind of revenue that VAT does currently, which raises questions of whether items such as food will remain exempt.

Then there is the question of how it impacts on the supply chain. If it is levied at every stage of the process, a “simple” 5% rate on a chain with five links results in a 27% tax rate compared to the current VAT rate of 20%. Moreover, if an exporter is the final link in the chain they will not be able to recoup the tax paid without raising their international selling price, which would render their product uncompetitive. In short, switching away from VAT would involve far more complexity than Gove believes. A simpler tax which is revenue neutral would require a lot of thought and would almost certainly prove impossible to implement before the next election. There is a reason why 166 of 213 UN members have adopted VAT and why India has just rolled it out. It is simple and more efficient than the alternatives.

The fact that the Tory front-runners have made taxation such a big part of their leadership bids reflects the lack of new ideas coming from the political right. Reducing direct taxes worked in the 1980s because previous levels of tax were too high so there were some incentive effects derived from cuts. In addition, there was a large rise in female labour force participation which helped swell income tax coffers. However, the UK did not face the problem of an ageing society which it does today. As a consequence the UK does not have the same scope to cut taxes without major consequences for future public liabilities. Having endured nine years of austerity to bring public finances back into line, it would be fiscally irresponsible to waste all the hard work on unfunded tax cuts which benefit particular interest groups simply to win the race for Number 10.

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[1] Admittedly, voters do not vote for the PM directly since they only get to choose their local representative. But there is no doubt that their local choices are determined by national level issues.