Unravelling the Chaos: Evaluating the UK Tax Regime

Ethan Ilzetzki and Suryaansh Jain

Wednesday, October 11, 2023

Summary

The September 2023 CfM survey asked the members of its UK panel to assess the effect of tax reform on the UK’s growth over a 5-year horizon. The panel was also asked to identify which tax was in the greatest need for reform. Most panellists think tax reform will positively impact growth in the UK in the near future, with only a small fraction believing that it is unlikely to affect growth significantly. Almost all of the panel believes that all taxes are in dire need of reform, with some panel members highlighting the need to reform personal income taxes in particular.

Background

The September 2023 CfM-CEPR survey asked the members of its panel to evaluate the effect of tax reform on the UK’s growth over a 5-year horizon and identify the tax in the greatest need of reform.

An Overview of the UK Tax System

Productivity in the UK has grown by only 0.9% per year since 2008, raising concerns about the state of the UK economy and its future. The May 2022 CfM survey revealed that most economists believe the UK will continue to suffer from low growth in the upcoming decade due to UK-specific structural challenges. Among these structural issues is its tax system, which has been characterized to be “complicated, inefficient and beset with perverse incentives that do little to raise revenue” (Tetlow & Marshall, 2019a). The UK tax system is a patchwork of policies enacted by successive governments, rather than a carefully designed system (Tetlow & Marshall, 2019b). Delestre (2023) provides a useful summary of the state of the UK tax system.

UK tax revenue (32% of GDP) is also slightly below the average of the G7 (36%) and the OECD (34%), and considerably lower than other western European countries (average tax revenue amongst the EU14 was 39% of GDP) (IFS TaxLab, 2023). With an ageing population, there is likely to be increased demand for healthcare, adult social care and pensions, which would put additional strain on public finances and further stretch the tax system (Tetlow & Marshall, 2019a).

One of the biggest criticisms of the current tax system is its complexity, particularly regarding income taxes. With separate systems of income tax and National Insurance Contributions (NICs) along with various rules and exemptions, the current income tax system is inefficiently organised. A common example of this complexity is the ‘hidden’ 60% effective marginal tax rate that people must pay if their annual income falls between £100,000 and £125,140 due to the loss of personal allowance, despite a statutory income tax of 40%. Similarly, employees face different effective marginal tax rates depending on how their income is structured. For instance, the effective marginal tax rates for employees in the top income bracket (earning more than £125,140) can vary significantly, peaking at 53.4% when employer NICs are included or 54.5% paid on income from dividends, falling to 47% paid on self-employment income, 45% on rental income, 28% on gains from property, and as little as 0% if an employee keep their income in a company and then emigrates (Resolution Foundation, 2023). Broome et al. (2023) suggest equalising tax rates on different kinds of income and removing very high marginal rates, through higher dividend and Capital Gains taxes and higher top National Insurance rates for the self-employed, offset by indexing capital gains to inflation, a cut in employer National Insurance, reinstating the Personal Allowance above £100,000 and abolishing the High Income Child Benefit Charge.

Politicians frequently rely on NICs to raise taxes,  even though these are regressive and aren’t earmarked for social spending purposes. Economists therefore view NICs are as merely another tax on labour (but not capital) and not part of a system of social insurance (Mirrlees et al., 2018).

Another major criticism of the current taxation system is the extensive possibilities for tax avoidance. Advani and Summers (2020) find that individuals in the highest tax bracket (earning more than £125,140) pay far less than the 45% marginal income tax implied by their statutory rate.  Individuals receiving £10 million have effectively paid just a 21 per cent tax rate on average. This is due to the much lower tax rates on dividends and capital gains, as well as various deductions and reliefs offered under the current system. Advani and Summers (2020) suggest that up to £20 billion could be raised if all taxable income and gains were taxed at the existing headline rates applicable to earnings. An alternative could also be replacing the current income tax system with an Alternative Minimum Tax of 35 per cent on remuneration (income and gains) above £100,000, which would raise around £11 billion.

Property tax is another aspect of the UK tax system that needs overhaul. Council tax bands in England are still based on property values in April 1991. As a result, properties are in increasingly arbitrary tax bands that may bear little relation to current reality. Adam et al. (2020) find that the most valuable properties in 1991 (Band H) attract just three times as much tax as the least valuable properties (Band A), despite being worth at least eight times as much in 1991 and typically even more now, since prices have risen most in areas where they were already highest. As such, council tax is extremely outdated and highly regressive with respect to property value. One suggestion for reform is to replace the tax with an annual proportional property value tax based on up-to-date house valuations with tax rates chosen such that each authority raises the same amount as it did with council tax (The Editorial Board , 2023).

Stamp duty is another example of a UK tax that is considered to be a ‘bad tax’ by economists. See Best and Kleven’s (2017) analysis in this regard. Economic theory suggests that transactions taxes are inefficient and Scanlon et al. (2017) find that stamp duty reduces household mobility. This harms mobility and thus an efficient allocation of labour. A number of think tanks and politicians have called for the scrapping of stamp duty.

Economists have also pointed out the need to re-evaluate certain aspects of corporation tax in the UK. While the UK has the lowest corporation tax rate (25%) among the G7, its permanent investment allowances are among the least generous across advanced economies, and they also create distortions that hinder its economic performance (The Editorial Board, 2023). One solution to this issue includes making “full expensing” – which allows businesses to deduct 100 per cent of plant and machinery investment expenses from their taxable profits – permanent. Broadening the scope of full expensing would also increase business investment (The Editorial Board, 2023).

Under the current tax regime, debt interest payments can be deducted from taxable corporate income, whereas equity financing receives no such treatment. This has resulted in a bias in the corporation tax system towards debt, leading to businesses loading up on debt (The Editorial Board, 2023). Higher corporate indebtedness leads to lower investment and innovation, and greater economic volatility (Lopez-Garcia et al., 2023). Curbing the amount of interest that can be deducted from taxable corporate income could be one way of addressing this issue (The Editorial Board, 2023).

The final aspect of the UK tax regime that needs to be addressed is the Value Added Tax (VAT). The UK raises a similar amount of revenue from VAT vis-à-vis the OECD average. However, unlike other countries, zero VAT rates and exemptions are applied to an unusually wide array of goods and services in the UK (Mirrlees et al., 2018). Consequently, the headline VAT rate in the UK is much higher than other OECD countries, amplifying its distortionary effect. Moreover, the VAT exemptions in the UK can give rise to a number of bizarre anomalies. For instance, cakes and biscuits are normally zero rated, but a chocolate-covered biscuit is subject to standard rate VAT at 20 percent. As a result, a gingerbread man with chocolate eyes is zero rated, but if he has chocolate trousers he is subject to VAT at 20 percent (Clougherty et al., 2020).

Broadening the VAT base could lead to much higher tax revenues, reduced complexity and much lower market distortion. Mirrlees et al. (2018) suggest that if almost all zero and reduced rates of VAT in the UK were removed, the government could (in principle) compensate every household to leave them as well off as they were before and still have about £3 billion of revenue left over.

The September CfM survey contained two questions. The first asked the panellists whether a well-designed tax reform had the potential to boost UK economic growth over a 5-year horizon. The second asked them which aspect of the UK tax system they would prioritize.

Question 1: How would a major, well-designed, tax reform, affect economic growth in the UK over a 5-year horizon, relative to its current trajectory?

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