Five big ways to fix Britain’s broken tax system
It is possible to encourage growth without crashing the economy. Here are the fatally flawed policies that need sorting now, says tax expert Dan Neidle
Former chancellor Kwasi Kwarteng’s “fiscal event” last September was widely perceived as a disaster, but at its heart was a kernel of undoubted truth: there are features of our tax system that discourage growth — and we should fix them. Some of our tax rules are contradictory and occasionally downright mystifying, often punishing people and businesses for being successful. Anyone completing their tax return this January may run into them - particularly if they earn between £50,000 and £60,000 or £100,000 and £120,000.
Stop income tax hitting the ‘comfortably off’ hardest
The boldest, and most criticised, element of the mini-budget was the decision of Kwarteng and Liz Truss to scrap the 45p top rate of income tax to “simplify taxes” and “incentivise growth”. The problem with this is that, even if you accept the premises of Kwarteng’s position, 45p is not even close to the highest marginal tax rate in the UK.
The marginal tax rate at any given income is the tax rate you pay on the next pound you earn. That’s crucially important, because it affects your incentive to earn that extra pound.
I’ve charted the marginal rate of income tax and employee national insurance for different incomes, and it looks like this:
This should immediately start ringing alarm bells. The comfortably off — people earning between £100,000 and £120,000 — pay a higher marginal rate of tax of 62 per cent. Why are they paying a bigger proportion than those on really high incomes? Because at this point the personal allowance starts to taper away — with every £1 of income earned above £100,000, the personal allowance reduces by 50p.
Correct the childcare trap
But we’re only getting started. What if you have three children all qualifying for child benefit? Well . . .
Child benefits starts to be withdrawn at £50,000, resulting in a marginal rate of 68 per cent between £50,000 and £60,000.
Unfortunately, we can make even that outcome look good if we throw in the effect of the government’s much-heralded “tax-free childcare” scheme. This entitles you to up to £2,000 per child. The catch is that it completely disappears if your earnings hit £100,000. In an astonishing flaw, a couple could each be earning £99,000 (a combined household total of £198,000) and they keep the benefit; but if one earns £100,000, even if the other earns nothing at all, they lose it.
What marginal tax rate is that? Well, if you’re claiming tax-free childcare for three children, and earn £99,999, your take-home pay is £69,884. If you earn £1 more, your take-home pay decreases to £63,942. That’s an infinite marginal tax rate, which is a slightly tricky concept to demonstrate in a chart. Instead, here’s a chart that depicts gross v net wages:
The dip at £100,000 demonstrates the drop in post-tax income, which isn’t recovered until you earn £120,000.
In practice, this means that people who can control their hours usually think very carefully before putting themselves willingly in the £50,000-£60,000 or the £100,000-£125,000 pay bracket. If they’re employed, they often make additional pension contributions, use salary sacrifice schemes, or find other ways to earn the money, but not pay tax on it. If they’re self-employed they often just stop working for the year. These are not good things for the UK economy.
And, worse still, all of these tapering effects are triggered, like the childcare flaw, by one person in a family’s income hitting the £50,000 or £100,000 thresholds. That means that the Smiths, for example, who each earn £60,000, are much better off than the Joneses, where Mrs Jones earns £120,000, and Mr Jones doesn’t work. The Smiths take home £93,000 after tax; the Joneses £75,000. There are many reasons why the Joneses may have decided that only one of them should work – it’s mystifying why the government should choose to slap an £18,000 penalty on their decision.
These inadvertent fallouts from the tax system are worth so much more than the deliberate tax policies that governments announce with much fanfare. The “marriage allowance” is worth a fairly pathetic £252 a year.
Why isn’t there outrage about this? I think in part it is because many people earning £50,000 or £100,000 feel it’s ungrateful or, worse, “un-British”, to complain about paying tax. Furthermore, people earning less don’t want to hear the complaints. But it’s not about whether people on high incomes should pay more tax — it’s about whether they should pay more tax in a fair and rational way, or in an unfair and irrational way.
Therefore, a truly reforming chancellor would declare war on marginal tax rates above 50 per cent. Jeremy Hunt can do this without giving a handout to people on high incomes as the cost can be recovered by slightly increasing the top rate of tax. The cost may be less than the Treasury historically thought, given that people are going out of their way to avoid paying these rates. And those on benefits also face ridiculously high marginal tax rates of up to 96 per cent as benefits are withdrawn, creating a perverse incentive not to work.
Here’s the challenge from a political standpoint: politicians on the right have to accept slightly higher taxes for some high earners, and politicians on the left have to accept slightly lower taxes for some others. Will they?
Stop VAT punishing small businesses for being successful
This chart should keep Jeremy Hunt up at night:
This piece of evidence shows, for a given pound of turnover/revenue, how many businesses there are in the UK at that level of turnover/revenue.
You’d expect a reasonably smooth curve, falling from a large number of small businesses on the left side to a smaller number of larger businesses on the right. However, we don’t see that at all — we observe a dramatic cliff edge right on the VAT registration threshold, which is now set at £85,000 a year (the graph shows the drop at the old cut off of £81,000). Businesses whose revenue hits the threshold suddenly have to charge VAT, meaning that — overnight — they must either raise prices or suffer a profit loss of up to 20 per cent.
This chart tells us that many businesses respond to this by suppressing their turnover so it never hits that £85,000 threshold. A cynic would say that they do this by taking cash under the table, and therefore not telling HM Revenue & Customs. But there’s recent academic evidence that the cynic is wrong: businesses are genuinely holding back their growth as they approach the £85,000 threshold. The data is compelling, but I hear plenty of first-hand stories too — plumbers going on holiday for the rest of the tax year; electricians not hiring an apprentice; coffee shops deciding not to open another branch.
As a result, there’s powerful evidence that the UK tax system has created a break on the growth of small companies, some of which might, in time, grow into large companies.
There are two uninviting possible fixes for this problem, and one acceptable but difficult one.
The first poor option is that we should increase the threshold. This would cost the Treasury a lot of income and doesn’t solve the problem, but simply moves it.
The second bad option is that, given that the UK has one of the highest VAT thresholds in the world, we should reduce it to the average, which is about £30,000. However, the sudden impact that this would have on tens of thousands of businesses would require a chancellor to be not just brave but politically suicidal.
The potentially positive — but difficult — answer is that we shouldn’t have this kind of cliff-edge threshold at all. It can be argued that the proliferation of apps and digitalisation mean that now we don’t need it. Instead of VAT suddenly coming in at 20 per cent at £85,000, what if it applied at 1 per cent at £30,000, and then slowly crept upwards, hitting 20 per cent at £140,000? We’d collect the same amount of tax, but without creating an incentive to halt growth.
Until recently, expecting anyone to operate a system like that would’ve been delusional, but the modern digital systems HMRC has put in place make it achievable. It would take years of planning, with HMRC having to provide free apps and compliance solutions to small businesses, but the challenge is less technical and more political — politicians have to sell, and voters have to accept, the idea that raising tax is necessary for growth.
Abolish council tax, business rates and stamp duty
We have three taxes on land in the UK: council tax, business rates and stamp duty, which come together to form three parts of a very broken puzzle.
Here’s a chart showing how much council tax is paid as a percentage of the value of a property:
The more expensive the property, the less significant council tax becomes. That’s not how any tax should work. And in England, council tax is based on valuations made in 1991 that bear little relation to the housing market today.
The equivalent tax for businesses is almost as bad as council tax. The most common criticism — that it’s not fair to tax retail businesses — is wrong. All the evidence shows that, in the long run, most of the economic burden of business rates falls on landlords (because rents are lower than they would be if business rates didn’t exist).
However, there are other big problems with the tax. It’s based on the “rentable value” of a property, but the rentable value is so infrequently updated that you can end up with a situation where rents have fallen and the business rates haven’t caught up (which is where we are now in many cases). A further problem is that business rates are taxed on the rental value of a property, taking into account whether it’s been improved. That’s a disincentive to invest in improving property.
The final broken piece of the puzzle is stamp duty. It’s a good rule of taxation that we shouldn’t be discouraging transactions. Yet, as everyone who buys a house knows, that’s exactly what stamp duty does. It distorts the housing market and, by punishing people for moving in search of work, distorts the labour market too.
How can we solve the land-tax puzzle? By scrapping all three broken taxes and replacing them with a land-value tax — an annual tax based on the unimproved value of land. Instead of acting as a brake on investment, it would encourage it. Moving house would become a tax-free event. The economic burden would fall on landlords, not tenants.
Land-value tax has political support from economists across the political spectrum. All we need are politicians with courage to sell the idea that if we want to repeal bad unpopular taxes, then we have to create new, better ones.
Make corporation tax simpler
From 1997 to 2017, according to the Office for National Statistics, the UK had the lowest level of investment as a proportion of GDP in the Organisation for Economic Co-operation and Development.
Is tax one of the reasons behind this?
It’s trite economics that businesses do things they’re incentivised to do. The problem is that UK tax relief for investment exhibits the two deadly sins of tax policy: it’s really complicated and it changes all the time. This means that you’d have to be brave or foolish to make long-term investment plans on the strength of today’s tax-relief rules — you can’t be sure you’ll qualify, and you certainly can’t be sure the rules will be the same when your investment actually comes to fruition. This is another way of saying that the tax relief rules fail to achieve their purpose of incentivising investment.
We need a radical solution. What if we didn’t have complicated rules governing what kinds of investments get tax relief, but just gave tax relief to all investment, paid for by increasing the rate of corporate tax, so the reform was tax-neutral overall and guaranteed to remain unchanged for the length of a parliament. This would be ideally made with cross-party agreement that gives reasonable assurance for the longer term. Suddenly we’d create a powerful incentive to invest, made all the greater by the increased tax rate.
This isn’t my invention — it’s called “full expensing” and it’s supported by the Confederation of British Industry and economists across the political spectrum. But, again, we’d need politicians and voters to accept the counterintuitive truth that, to encourage growth, sometimes taxes have to go up.
Dan Neidle was head of tax at a large global law firm and now runs Tax Policy Associates.
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