This article was commissioned and first published by the Tax Journal and has been reproduced here in full with permission.
I write this before knowing who will win the election on May 7. But this advice on what is needed for tax policy should be heeded by whoever wins.
The first five suggestions are very general, they are about the making of tax policy. Follow these and policy ought to get a lot better. The next six are about specific parts of the tax system. As you’ll see they won’t all be politically easy to implement – but if you decide not to implement them, be aware that there is a substantial economic and social cost involved.
Here are five pieces of general advice:
1. Develop a view about what you want to do with the tax system. Preferably make that public and consult on it: consultation can improve policy and a clearly articulated plan can provide taxpayers with some degree of certainty about a sense of direction. But even if you must keep it secret, develop a long-term plan. In doing that think about how the various bits of the tax system fit together and how they can be made to fit together better over time. That will help you avoid political problems and mistakes made by your predecessors, most obviously the damaging to-ing and fro-ing on things like Capital Gains Tax and the 10p starting rate of income tax under the last Labour government, and the "omnishambles" budget of 2012. By thinking about the long-term strategy for the system as a whole there is much more chance of getting coherent and efficient policy decisions.
Even if you ignore all the other pieces of advice below, please take this one. Every other element of government policy, and particularly spending, will have a strategy attached, a series of white papers, debates and consultations about the appropriate direction. Tax needs that too.
2. Remember how important the tax system is to the functioning of the economy. Continually reminding yourself of that should lead you take the first piece of advice. One pound in every three earned in the economy is taken in tax. It is obvious that the way in which this happens must matter for how the economy functions, how efficient the economy is, how people and companies behave, and what the ultimate distribution of income looks like. Getting it wrong can be incredibly costly – not always in ways which are immediately obvious, but in ways which in the long run will hinder economic growth and wellbeing.
The tax system is one of the most powerful, and dangerous, economic tools which any government can wield. Wield it with care. But recognise that there are without question changes that could be made to the system we have at the moment which would improve it and which would be good for economic growth and welfare.
3. Be courageous (up to a point). Tax reform is cursed by a tyranny of the status quo. It can be hard to make rational changes because they will generally leave some people worse off. They won’t like it. But remember it is possible to make change. Over a long period governments have been able to implement sensible reforms which have left people worse off – the gradual abolition of mortgage interest tax relief is perhaps the best example. So don’t believe those who say rational reform is politically impossible. Changes don’t need to happen all at once. With enough time and direction reform is genuinely possible.
4. Understand that in the end all tax is paid by people. There is no such thing as a victimless tax increase. It might catch the victims you are aiming at. But it might not. Corporation tax has, in the end, to be paid by the company’s shareholders (often pension funds and equities held by British voters), its employees or its customers. There isn’t anyone else.
Always try to understand where the incidence of a tax lies – who is ultimately made worse off by it. VAT is formally paid by businesses. In general we think the incidence is mostly on consumers. In the long run the incidence of employer National Insurance Contributions (NICs) is almost certainly the same as employee NICs or income tax. Stamp Duty is formally paid by the purchaser of the property, but the incidence is likely to be mainly on the seller through a reduced price. But also recognise that we will never fully understand the final incidence of many taxes – we certainly don’t really know who in the end is made worse off by the existence of corporation tax. We don’t know what would be the incidence of a financial transactions tax.
5. Worry about inequality to the extent that fits your political preference – but recognise that there are nearly always trade-offs to take into account. The more progressive a tax system the more effect it is likely to have on behaviour, whether that be work effort, effort put in to avoiding tax, or location decisions. Make policy with a clear understanding of these trade-offs. Don’t pretend they don’t exist.
And here are some more specific pieces of advice aimed at particular parts of the tax system. Many of them will look politically unattractive. But see the general advice above.
1. Finally take the plunge and merge NICs with income tax. There is no longer any measurable relationship between additional NI paid and additional entitlement to pensions or other benefits. The insurance principle is a costly myth largely maintained to fool the electorate into believing that when they pay NI they are doing something different to what they are doing when they pay income tax or other types of tax. They are not. As well as an exercise in deception, the current system involves maintaining two separate administrative structures and is costly to employers who have to deal with two systems of income tax, levied on slightly different definitions of income and over different time periods.
2. If you were feeling really radical, you could overhaul the taxation of capital income, aligning tax rates on earned income with the tax rates on capital income, taxing returns in full but with an allowance for the amount saved. This was one of the central recommendations of the IFS’s Mirrlees Review and in the end is probably the best route to achieving two core objectives for the tax system. First, tax different forms of income at similar rates so as to reduce distortions and obvious opportunities for avoidance. Second, by giving an allowance for the amount saved, ensure the tax system is not creating disincentives to saving and investment.
3. Sort out the taxation of housing; it is a mess at present. Despite modest improvements in its structure announced in the last Autumn Statement, Stamp Duty remains a damaging and distorting tax. It reduces transactions in the housing market below levels which would maximise welfare.
Meanwhile Council Tax continues to be based on relative property values from 1991 – which is obviously absurd. It is also probably the only tax deliberately designed to be regressive (in that the amount payable rises less than proportionally to the (1991) value of the property and is capped). The "Mansion Tax" proposed by Labour, Liberal Democrats and SNP is a very partial and complex response to this last point. But we don’t need a new tax. We just need a rational council tax system, based on up to date values and set at a rate proportional to values.
And don’t forget that owner occupation remains tax privileged relative to renting. At the very least don’t make that worse (by for example offering additional inheritance tax relief for principal residences).
4. Please, please don’t keep messing around with income tax relief for pension contributions. What we have traditionally had has broadly made sense – put money into a pension free of income tax, pay tax on withdrawal. Continuing to limit contributions and reduce relief for the higher paid moves away from this sensible ideal (and in the long run won’t raise as much money as appears in the short run as less taxable income is taken in retirement).
There are ways in which the system of pension taxation could be overhauled to yield more revenue. Employer contributions are treated absurdly generously by the NI system. It remains possible to withdraw a quarter of an accumulated pension free of income tax altogether. There are good reasons to change these features, not to change the income tax treatment of contributions.
5. Consider the case for extending the VAT base. That may not get you many votes, but recognise three things. First, having one of the world’s narrowest VAT bases, as we do, is inefficient and economically costly. Second, in cash terms the main beneficiaries of this narrow base are those who consume a lot – the rich. Third, it is possible to extend the VAT base and, on average, compensate low-income losers through adjustments to other parts of the tax and benefit system.
Perhaps more importantly – and unfortunately there are European rules getting in the way here – end the economically and administratively hugely costly systems of VAT exemption.
6. Set out a plan to move us from taxing road fuel to road use. Fuel duties raise over £25 billion a year. But it seems to have become politically very difficult to raise their level even in line with inflation, so real revenues are falling. If we are to get anywhere close to meeting legislated targets for greenhouse gas emissions, we will have to move away from reliance on petrol and diesel, so revenues will eventually fall drastically. And from an economic point of view fuel duties are very poor at targeting congestion, the main problem caused by road use. In the end we are likely to be forced into moving towards some form of road-user charging. Recognise that and prepare for it.
So there you have it Chancellor. I wouldn’t expect you to do all of that in one term. But if you were to make start on just some of it you would be a hero to public finance economists for decades to come. What other reward could any Chancellor desire!