Reality check: Fixing the UK's tax systemMarch 2010
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So far the debate on the deficit crisis has focused on public spending. But tax matters too. Tax policy has been just as short-term and just as subject to political whim as spending policy. The right tax decisions now can both rescue the public finances and help to set the conditions for stronger economic growth in the future.
The main political parties are right to propose policies to increase revenue as part of their plans to ease the deficit. But their plans place too much emphasis on tax rises rather than spending reductions. Most importantly, their plans would cause the maximum economic damage by raising taxes on employment and income rather than consumption, and by increasing the burden on a small group of wealth generators rather than widening the number of taxpayers. The current plans will hinder investment, employment and growth.
Economic opinion is united that a credible plan is needed to eliminate the deficit over a number of years. That plan must involve some additional taxation. In one sense this is simple realism; increasing revenues can reduce the deficit in the short term before the full effects of spending reform take place. But in another it is necessary to remind the electorate that spending has to be paid for. UK political parties have given the impression that ever increasing welfare benefits and public services can be made available to them at little or no cost. The consequence is unsustainable levels of public spending. The link between public spending and taxes needs to be restored.
The great majority of the deficit reduction should come from spending cuts and efficiency due to the poor quality of spending on public services and the benefits system, as set out in previous Reform research. A good rule of thumb would be the balance that Canada struck when rescuing their public finances in the 1995 Budget. This would see about one pound of the deficit in every eight dealt with through tax changes. That is a lower proportion of tax rises that each of the major parties is currently offering. Labour propose that one pound in three would be raised in higher taxes; the Conservatives, one pound in five; the Liberal Democrats, one pound in six.
That leaves the question of the right tax policy to deliver the revenue increases. The wrong way is to continue the kaleidoscope of conflicting and unpredictable initiatives into which tax policy has descended in recent years. Each of the major parties has proposed tax policy changes that are little more than gimmicks and have no basis in principle, from freezes in council tax to mansion taxes to a bankers' bonus tax. Basing tax policy on principles will itself go a long way to restore businesses and investors. Reform proposes the following as a new set of principles for UK tax policy:
Economic efficiency. This means increasing the tax base rather than damaging increases in tax rates. It means a tax system which is attractive for investors, businesses and individuals, who in a mobile global economy can often choose to locate wherever they wish.
Consistency. Income from different sources should be taxed in an equivalent way and tax should be tied to the individual. An efficient and fair system cannot exist if the tax burden is allocated on an arbitrary basis.
Transparency. The tax system and tax policy process should be free from political whim and consistent with principle. This means an open process of consultation and robust scrutiny of policies.
Fairness. Taxes should be applied in an even handed way and people should pay their fair share, in all parts of the income scale.
Given the weakness of the economy and the need to encourage growth, the tax rises should be levied in the least economically damaging way possible. Unfortunately all three major parties are committed to the most economically damaging tax rises - those on income and employment. Labour has proposed increases on income via the new 50p top rate and withdrawal of the personal allowance for incomes over £100,000, and on employment via an increase in National Insurance contributions. Both Opposition
parties have said that they will not repeal the changes in the foreseeable future.
While these changes are yet to come into effect, their proposal is already forcing major companies to consider leaving the UK and dissuading talented people from moving to and investing in the UK. The 50p income tax rate is seen by business leaders as a tipping point for the UK business environment. Taken together with the withdrawal of personal allowances and the restriction on higher rate relief for pensions contributions, the balance of fairness has tilted too far against a small group of wealth generators. Repeal of these measures would be a more important boost to business than a reduction in the corporation tax rate, funded by elimination of reliefs, that the Opposition proposes.
The Opposition has said that it cannot repeal the income tax and NICs increases because of the need to reduce the deficit. That is not true because there is a much better candidate for increasing revenue - indirect taxation on consumption. Eliminating the exemptions on VAT, with protection for the poorest third of households, would make VAT a less complex tax and bring the UK in line with other nations. The UK is one of only four EU countries to apply a zero rate to food and one of only three to apply a zero or reduced rate to children's clothes. Replacing personal allowances with a zero rate threshold of an equivalent amount (£6,475) would also raise extra revenue, while making the income tax system simpler and fairer by capping the benefit at the basic rate.
Taken together, these measures would raise extra revenue of £8.3 billion in 2011-12 and £8.4 billion in 2012-13, compared to the Government's plans which would raise £11.1 billion in 2011-12 and £14.3 billion in 2012-13. These figures only relate to the major tax changes affecting income tax, National Insurance contributions and VAT.
Under the Reform package, households with incomes of less than £17,000 would, on average, see a tax reduction (from lower NICs and protection from the broadening of VAT). Households with incomes of over £17,000 would, on average, see a tax increase due to the broadening of VAT and, for higher rate taxpayers, replacement of personal allowances with a zero rate threshold. Individuals earning above £105,000 would see a tax reduction.
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Excel model that allows individuals to act as the Chancellor of the Exchequer and design their own systems of income tax and National Insurance Contributions.
Media release explaining the operation of the calculator and the need to treat the fiscal estimates as indicative only.
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