As part of its deficit reduction programme, the coalition government has made tax changes whose direct impact is to reduce borrowing by an estimated £16.4 billion in 2015–16. This net figure belies much larger changes, with £64.3 billion of tax rises being partly offset by £48.0 billion of tax cuts. But all this activity has done little to improve the structure of the tax system. As we set out in a new IFS Election Briefing Note, with funding from the Nuffield Foundation, the reforms introduced by the coalition have for the most part involved simply changing rates and thresholds with little attempt to address the fundamental structural deficiencies of the tax system. Plenty of challenges remain for whoever wins the election in May.
The biggest tax increases were implemented early in the Parliament: a rise in the main rate of VAT from 17.5% to 20%, a sharp reduction in the amount that can be saved in tax-privileged pensions, and a 1 percentage point increase in all rates of National Insurance contributions (NICs) that had been announced by the previous Labour government.
All of these exacerbate unwelcome distortions in the tax system. The first has increased the distortions created by the VAT system since no real attempt has been made to broaden the VAT base and so the difference between the treatment of different goods and services has grown.
The second has reduced the coherence of the taxation of pensions. A system which allows saving out of income before income tax, has no income tax on returns on funds in the pension as they accrue, and charges income tax on withdrawal has many attractive features. Widespread proposals(including those from the Labour party) to take the Government’s changes further, and potentially to restrict the rate of tax relief available threaten to undermine the more coherent parts of the system. There are better ways to increase tax revenues from pension taxation by reducing the excessive tax privileges associated with the tax-free lump sum and the fact that NICs are never charged on employer contributions.
The third, a rise in all rates of NICs, increases the existing incentive to shift the form in which income is taken away from earnings and towards capital income (for example, through setting up a company and taking income as dividends rather than earnings).
There have also been three big tax cuts: an increase in the income tax-free personal allowance, cuts to the main rate of corporation tax, and real-terms reductions in fuel duties.
Corporation tax has been cut, making the UK’s rate more internationally competitive, but its base continues to discourage investment and to favour using debt to finance it.
The different treatment of the income tax allowance and corresponding NICs thresholds makes little economic sense. It is hard to think of a good economic reason for wanting to take the low-paid out of income tax but not NICs, and the emphasis on income tax and neglect of NICs highlights the absurdity of continuing to have two similar but separate taxes, given that National Insurance is not a true social insurance scheme. Despite some promising rhetoric, there has been virtually no progress on integrating the two.
The cuts to fuel duties will no doubt have been welcomed by motorists. But the way in which they have been delivered, continually delaying and then finally dispensing with planned increases provides little evidence of planned reform. The unsuitability of fuel duties for tackling congestion – the biggest harm associated with driving – has not been addressed. The relationship between fuel burned and congestion caused is weak, and improving fuel efficiency and new technologies are making it ever weaker.
But the coalition’s changes to the tax system go far beyond these, with a large number of smaller measures constituting the bulk of its activity. Across the full range of taxes, the coalition’s reforms have changed rates and thresholds but have failed to tackle the underlying weaknesses in the system.
- The additional rate of income tax has been reduced from 50% to 45%, yet nothing has been done to address the anomaly of the effective 60% income tax rate associated with the withdrawal of the personal allowance once income exceeds £100,000.
- Council tax has been cut but allowed to get ever more out of date: we now find ourselves in the absurd position that tax bills in England and Scotland are still based on relative property prices in 1991.
- Inheritance tax has been increased as the threshold has not kept pace with inflation, but no real attempt has been made to close the loopholes that allow many – particularly among the very wealthy – to sidestep the tax.
- Capital gains tax has been increased but with no clear strategy for dealing with the tension between minimising disincentives to save and minimising avoidance opportunities.
- Business rates have been cut but made more unstable and continue to discourage property-intensive production.
All in all the coalition’s changes represent a missed opportunity to improve the tax system. There have been some welcome structural reforms, but even there the job has often seemed incomplete. The jumps in stamp duty land tax (SDLT) liabilities at price thresholds have been removed for housing, but not for non-residential properties, and the more fundamental problem with SDLT has not been addressed: the effect of a transactions tax such as SDLT is to discourage mutually beneficial transactions, so that properties are not held by the people who value them most.
Meanwhile the use of the discredited retail prices index (RPI) to adjust the tax system for inflation has been ended for direct taxes, but not for indirect taxes. More problematically, an increasing number of thresholds in the tax system are not uprated at all. As income growth picks up, the number of people affected by the effective 60% income tax rate, the 45% income tax rate and the withdrawal of child benefit will increase rapidly. We estimate that this fiscal drag will lead to the number of families losing some of their child benefit doubling within a decade unless this lack of indexation is addressed.
One possible reason for optimism about the future is that the coalition has made some admirable improvements to the institutions of tax policy–making, enhancing transparency and allowing better scrutiny. That optimism should be tempered, though, by the way in which the coalition has announced tax policy itself. Some areas, such as fuel duties and business rates, have seen a stream of ad hoc, often temporary, announcements overtaking each other without a clear statement of principles or long-run intentions. Arguably, the ad hoc and inconsistent approach being taken to devolution of tax-setting powers to different parts of the UK creates similar uncertainty.
There is a better way to make tax policy. The corporate tax road map was a good start, setting out a direction of travel and providing an element of predictability. The next government would be well advised to apply this approach to more elements of the tax system, and indeed to the tax system as a whole. That would help taxpayers to plan, provide a benchmark for assessing the policies actually implemented, and facilitate debate on whether the strategy laid out is the right one. Taking the time to articulate a strategy might even lead to the adoption of better tax policy.