Tax policy is drenched in politics. Failures in tax policy can have devastating political consequences. Understanding the interaction between tax and politics can provide useful insights into the development and evolution of future policy. The political desire to maintain low income tax rates has constrained the conduct of effective fiscal policy for more than 30 years. The ‘spend now, pay later’ announcements in Budget 2021 were probably made with an eye to an early general election. Public spending will probably be much lower than planned, and there will be scope for tax cuts before the end of the current parliament.
Tax policy is drenched in politics. Decisions about who should bear taxes, and when and in what amount, are among the most important decisions made by any government. Tax policy failures have contributed to key episodes of history, including the Boston Tea Party, which triggered off the American war of independence. The riots that followed the introduction of the community charge in England and Wales in 1990 contributed to the fall of Mrs Thatcher, the most formidable British prime minister since the end of the Second World War.
Studying past episodes and themes in tax policy can provide useful insights into the origin and the direction of future policy. For example, the most powerful thread running through the tax policies adopted by different governments in the last thirty years has been the maintenance of low personal income tax rates. Governments of different persuasions have, for political reasons, voluntarily limited their ability to conduct effective fiscal policies. They have publicly committed that they won’t increase the rates of the taxes that provide their principal sources of revenue, whilst maintaining or increasing public spending.
Income tax
Letting people keep more of their own money and enabling them to decide for themselves how to spend it was at the heart of the radical tax policies introduced by the Conservative governments led by Mrs. Thatcher. She reversed the seemingly inexorable postwar increase in the level of income tax that had funded the growth of government expenditures on health, welfare and education. Her governments reduced the basic rate of income tax from 33% to 25%, and the higher rate from 83% to 40%.
Mrs Thatcher’s policy of maintaining low income tax rates had a powerful electoral appeal. So much so, that in the run-up to the 1997 general election, the New Labour Party led by Tony Blair promised that it would maintain the Conservative government’s tax policies, and its spending plans. It did so to project its own sense of financial responsibility. It wanted to avoid being dubbed as ‘the Party of high taxation’. The label was supposed to have contributed to the Labour Party’s defeat at the previous three general elections.
As the longest-serving Labour chancellor Gordon Brown noted in his memoir (2017), ‘As long as the basic rate [of income tax] was…. not 20p, the tax issue remained a potent weapon in our opponents’ hands. Indeed, I believed that sooner or later – probably sooner – the Conservatives would fight an election on cutting the basic rate to 20p’. The Labour Party succeeded in reducing the basic rate to 20p (as described below), albeit at a huge political cost.
Stealth taxation
Governments that box themselves in by their promises not to increase taxation can find themselves resorting to the introduction of ‘stealth taxes’ to fund public expenditure. That is, taxes collected in ways that are not always obvious to those who are paying them. For example, in its first two budgets, Tony Blair’s government made a number of technical changes to the corporation tax regime. The most controversial aspect of these changes was the withdrawal of dividend tax rebates of £5bn a year from pension funds. It was subsequently claimed that the change undermined the viability of final salary pension schemes by denuding them of up to £100bn in tax rebates.
Tax locks
The Conservative government elected in 2015 introduced legislation to freeze the rates of income tax and class 1 NICs, and the standard rate of VAT for the duration of the Parliament in its first Budget. The government voluntarily gave up its ability to increase the tax rates of its three biggest sources of public revenue. To fund its promise to increase the personal tax allowance, the government reduced public expenditure and introduced the bank levy; it also increased stamp duty, insurance premium tax, and the effective rate of income tax on dividends.
The tensions created by the tax lock became visible in 2017, when the government attempted to increase the rate of class 4 NICs payable by self-employed taxpayers. Most expert commentators agreed that the proposed reform of the national insurance contributions paid by the self-employed was overdue. But the government abandoned the policy a few days after it was proposed in the face of overwhelming opposition within the Conservative Party. The tax lock legislation did not mention class 4 NICs. But the government acknowledged that the measure would have breached the spirit of the tax lock. The current chancellor has noted that it is hard to justify why the self-employed pay less NICs than employees. But it remains to be seen if it is politically possible for him to reintroduce the reform.
The legislative tax lock expired at the end of the 2015–2017 Parliament. The Conservative Party manifesto for the 2017 election promised to keep taxes as low as possible. The Institute for Fiscal Studies (IFS) has noted that the Conservative Party’s manifesto for the 2019 election was ‘virtually devoid of proposals for tax changes … [but that] they may come to regret their guarantee not to increase rates of income tax, NICs or VAT’.
Lop-sided tax system
The Coalition Government that came into power in 2010 implemented a policy of progressively increasing the income tax personal allowance from £6,475 in 2010/11 to £10,000 a year. Until then, governments had tended to increase the personal allowance by relatively modest amounts. The largest previous increase until then had been that introduced in the wake of the 10p crisis in 2008 to compensate those who had lost out from the abolition of the 10p-starting rate of income tax (see below).
The Liberal Democrats had originally proposed the policy of increasing the personal allowance, but the Conservative Party, the senior partner in the coalition, enthusiastically adopted the policy. The Conservatives went into the 2015 general election promising to increase the personal allowance to £12,500 and the income tax higher rate threshold to £50,000.
The policy of increasing the income tax personal allowance, whilst leaving tax rates unchanged, has made the tax system increasingly lop-sided. Over 40% of those who receive taxable income don’t pay any income tax, while the top 1% of earners pays an estimated 30% of all income tax. The IFS’s analysis suggests that 50% of the households with the largest incomes pay nearly four-fifths of income tax, NICs, VAT, excise duties, and council tax (see chart 5 from IFS briefing note Tax revenues: where does the money come from and what are the next government’s challenges? (Helen Miller & Barra Roantree),1 May 2017).
The ‘disconnection’ of so many economically active voters from the income tax system makes them prey to voting for those who advocate irresponsibly expensive policies, safe in the knowledge that they wouldn’t have to contribute a fair share to their cost. It would be politically difficult for a government to reduce the personal allowance. But it can choose, instead, to let inflation erode its real value by freezing it at its current level, or by increasing it by less than the rate of inflation.
To 10p or not to 10p
Governments ignore the cross-distributional impacts of proposed changes to taxation at their electoral peril. In Budget 2007, chancellor Gordon Brown announced the abolition of the 10p-starting rate of income tax that he had himself introduced in 1999. He did so in order to fund a surprise reduction in the basic rate of income tax from 22p to 20p in the pound. Mr. Brown disregarded explicit advice from officials about the distributional impact of the proposed measure on those on very low incomes who were liable to income tax. His final Budget as chancellor was supposed to gild his path to succeed Tony Blair as leader of the Labour Party and prime minister. But his decision led to questions about his political judgment.
The IFS had described the 10p rate as ‘pointless’ and as a ‘gimmick’ when it was introduced, but the losers started complaining to their members of parliament about their loss of up to £230 a year. Gordon Brown, who was by then the prime minister, vehemently denied that there were any losers from the change. There was a media controversy and a parliamentary rebellion in the Labour Party. In the face of a potentially ‘catastrophic Commons defeat on the wrong side of a debate about helping the poor, a contortion that was utterly perverse given his lifelong passion for the subject’ (Richards, 2010), Gordon Brown was forced to compensate the losers.
The main losers from the abolition of the 10p rate were very low-paid workers who didn’t qualify for working tax credits, and pensioners on low-incomes who didn’t receive the higher pensioner tax allowance. But it was administratively impossible for HMRC to identify and compensate the individual losers. The government was forced to introduce an expensive untargeted increase in the personal allowance for all taxpayers to defuse the crisis. It cost the Treasury more than three times the amount saved by the abolition of the 10p rate.
Windfall tax
Opinion polls suggest that a majority of the public support the introduction of a windfall tax on the companies that have thrived during the coronavirus crisis. It has been claimed that they have benefited while other firms have been closed down; and that they have cashed in on the crisis whilst receiving the financial support provided by the government to businesses. Windfall taxes are typically imposed on a one-off basis. For example, the New Labour Party campaigned at the 1997 general election on the platform that it would seek to recover ‘the excess profits of the privatised utilities‘ by introducing a one-off windfall tax.
Labour had argued since 1992 that the nationalised industries, particularly the public utilities British Gas and British Telecom, had been sold (‘privatised’) at undervalue; and that their sale had deprived the exchequer of funds that should have been used to improve public services. It claimed that the shares had been sold cheaply to ensure the success of Conservative Party’s policy of privatisation. They cited as evidence the fact that the shares had risen sharply in value immediately after they were issued. The windfall tax was introduced shortly after the New Labour Party won the 1997 election with a large majority.
The tax was imposed on the companies that were supposed to have been sold at undervalue, rather than on those who had personally benefitted by acquiring the shares at less than they were worth. It would have been impracticable and electorally unpopular to tax the large numbers of the new owners of the shares. There had been claims that the windfall tax would be challenged in the courts, but the companies affected decided to acquiesce to the new tax. (The proceeds of £5.2bn from the tax were used to fund a welfare-to-work programme.)
Wealth tax
The recent publication of the LSE/Warwick Wealth Tax Commission’s report attracted media interest. It prompted speculation about whether the government would implement a one-off wealth tax to repay the public deficit. It was argued that those who could afford it should shoulder a greater part of the burden to pay for public services. A wealth tax would complement the existing taxes on wealth, namely capital gains tax and inheritance tax. The introduction of an annual wealth tax would help to alleviate the economic, social and political risks posed by the growth in wealth inequality. The current government has shown no interest in the proposal. It is highly improbable that a Conservative government would ever introduce a tax so contrary to its traditional credo and aspirational values.
The Labour Party had attempted to implement a wealth tax when it was unexpectedly returned to power in 1974. The then chancellor, Denis Healey abandoned the policy in 1976 in the face of intense opposition to the measure. He said that he ‘found it impossible to draft one which would yield enough revenue to be worth the administrative cost and political hassle’ (Healey, 1989). Gordon Brown considered whether the New Labour Party should introduce a wealth tax shortly before he was appointed as chancellor following its victory in the 1997 general election.
It formed part of a review of the tax system codenamed ‘Cascade’ (Peston, 2005). Cascade proposed the introduction of an annual tax on personal wealth. It was envisaged as a replacement for inheritance tax, which was regarded as ineffective. Mr. Brown and his aides discussed the proposal with officials from the (then) Inland Revenue and the Treasury in their traditional confidential pre-election contacts with the main opposition parties before a general election. He abandoned the idea. He concluded that ‘the benefit might not be worth the political cost’. The present Labour shadow chancellor has ignored the proposals of the Wealth Tax Commission; the Labour Party has backed away from the radical economic policies of its former leader.
Capital gains tax
The publication of the Office of Tax Simplification’s (OTS) report on capital gains tax (CGT) in November 2020 fuelled speculation that there would be changes to the tax regime. The report suggested that if the current tax-free allowance was reduced from £12,300 to £2,000 a year and the rate of CGT was aligned with the taxpayer’s marginal rate of income tax, the yield from the tax would rise to £14bn. (CGT yielded £9.5bn in the tax year 2018/19.) The estimated yield was based on the heroic assumption that the changes would not result in countervailing behavioural changes, such as avoidance and the sale of assets before the introduction of the changes.
Aligning the CGT rate on chargeable gains with income tax isn’t a novel idea; it is how CGT was charged for 20 years until 2007/8. The rationale for the change reflects what the Labour chancellor James Callaghan told parliament when he introduced CGT in 1965, ‘Gains confer much the same kind of benefit on the recipient as taxed earnings.’ The OTS’s recommendations attracted criticism from Conservative members of parliament and right-wing commentators. The chancellor’s allies were quick to remind the media that he had not adopted the OTS’s previous recommendations on inheritance tax and income tax. And that the current rates of CGT were set at a level that ministers were advised would maximise the yield from the tax.
Rhetoric versus reality
Successive British governments have sought to support small businesses to promote enterprise and employment (and to cultivate the electoral support of the millions who own and work in small businesses). They have boasted about creating a level playing field free from the distorting influence of tax, and stressed that individual businesses are free to decide whether to operate as sole traders, partnerships or through companies. But they have also encouraged the growth of small companies by charging them a lower rate of tax than that levied on individuals. They have made it cheaper and easier to incorporate or acquire new companies, even though small companies continue to be used to avoid income tax and national insurance.
Lack of consistency
The tax system has, at times, departed to an egregious extent from the principle of applying similar tax treatment to the same sort of income. For example, the Labour government introduced a 0% rate of corporation tax on the first £10,000 of taxable small company profits for the tax years 2002/03 and 2003/04. The government introduced the policy in response to pressure from the small business lobby bodies for a tax relief to encourage them to retain profits to finance future growth. Ministers decided the policy without consulting officials about the likely behavioural impact of the policy. (Officials had consistently advised against granting any relief for retained profits on the grounds that it would be ‘dead weight’.)
Ministers did not grant any analogous relief to those conducting their small businesses as sole traders or partnerships. There was predictably a large and swift spike in tax-motivated incorporations to take advantage of this bonanza. The exchequer started hemorrhaging massive losses of tax. To staunch the loss of tax, the government first restricted the 0% rate of corporation tax band to undistributed profits, and then reversed its policy.
The politics of tax avoidance
Party politics is one of the reasons why there has been an inexorable growth in the volume and severity of anti-avoidance legislation despite the steady decline in the tax gap to its lowest level to date. Combatting tax avoidance is one of the rare issues on which there is now a consensus among the major political parties. But it wasn’t always so; until about 15 years ago, the Labour Party was in the vanguard in warning about the dangers to the public purse of tax avoidance.
Public anger about tax avoidance by large companies and celebrities caused the Conservative Party, traditionally the ‘Party of big business’, to realise the political risks it faced. Fearful of being accused of being ‘soft’ on tax avoidance, it toughened up its policy on countering tax avoidance. In 2013, David Cameron, the leader of Conservative Party and prime minister of the Coalition Government, famously warned multi-national firms that if they were involved in tax avoidance they weren’t welcome in the UK and to ‘wake up and smell the coffee’.
The readiness of governments to introduce new powers to curb tax avoidance has, on occasion, resulted in new provisions that were so broadly focused that they extended beyond their original target. A House of Lords Committee warned in a report (2020) that there was ‘a pattern of new HMRC powers being disproportionate, poorly targeted and without sufficient safeguards’. In February 2021, HMRC published a report evaluating how powers, obligations and safeguards, introduced since 2012 had worked. It made a number of commitments to improve the experience for taxpayers.
Budget 2021
The March 2021 Budget was announced against the backdrop of worst pandemic since the Great Plague, and the largest public sector deficit since the Second World War. Chancellor Sunak said that the restoration of public finances would require work by ‘many governments’. To begin repairing public finances, he announced an extra £25bn in taxes. They are due to come into effect from 2023. He announced that the corporation tax rate (CT) would be increased from 19% to 25% in 2023. He also froze the income tax personal allowance; and the tax allowances for pensions relief, capital gains tax, and inheritance tax. The cumulative impact of the tax changes will increase the UK’s tax burden to its highest level since the late 1960s (according the ONS and OBR data; see chart 2 of the OBR’s Overview of the March 2021 economic and fiscal outlook report dated 3 March 2021).
‘Spend now, pay later’
The chancellor’s announcements were dubbed as the ‘spend now, pay later’ Budget because he was forced to allocate another £59bn for the continuation of fiscal support for those suffering from the economic impact of the covid-19 lockdown restrictions. (The government’s total coronavirus-related expenditure will amount to £407bn by the end of the next financial year.) The IFS has described the government’s spending plans as ‘implausible’. It has suggested that it would have to increase taxes in the future because of the likely increase in covid-19 related expenditures on health care, and to implement its campaign promises.
The politics of the Budget
Jeremy Corbyn, the former leader of the Labour Party, mocked the government for proposing almost the same increase in CT that his party had advocated in its manifesto for the 2019 election. He reminded it of how the Conservative Party had derided his Party’s proposal just over a year ago. Paul Johnson, the director of the IFS, has described the planned increase in CT as ‘a screeching U-turn in Conservative policy over the past decade’. Right-wing commentators have accused the chancellor’s decisions as a ‘bonfire’ of the verities of low taxation and tight control of public spending that have been Conservative policy since Mrs Thatcher’s time.
Political electoral cycle
Governments tend to increase taxes and reduce spending soon after winning an election. It enables them to cut taxes and to expand public expenditures in the run-up to the next election. It is a policy predicated on the assumption that voters have short memories. The Labour Party never forgave its chancellor Roy Jenkins for his inopportune fiscal rectitude. He increased income tax in the run-up to the 1970 election, which the Party then unexpectedly lost to the Conservatives. Budget 2021 will increase the tax burden to 35% of the gross national product, the highest level since Jenkins was the chancellor, by the time of the next election.
The forthcoming repeal of the Fixed Term Parliaments Act 2011 would allow the current government to declare its fiscal prudence a pre-mature success, and to reverse part of the announced tax changes before calling an early general election. The government has renewed its generous support for Covid-19 relief measures until October 2021. But the full amount of the funding allocated for it may not all need to be spent. The success of the vaccination programme is expected to allow a return to normal life by the end of June. It will usher in a strong economic recovery and increase tax revenues that would enable the government to introduce pre-election tax cuts.
Levelling up
The government had promised to redress the disparity between the deprived areas, whose voters in the so-called ‘red wall’ seats helped the government secure a large majority during the 2019 general election, and the more prosperous London and the South East. But there was little in the Budget about addressing regional disparities in growth and employment. That is, beyond the modest announcements about the creation of regional ‘free ports’, the relocation of some Treasury staff to Darlington, and the selection of Leeds as the home of the new Infrastructure Bank.
The recent amendment to Treasury’s ‘green book’ guidance to government departments about appraising investment decisions will arguably have a greater impact on government expenditure in the regions than the Budget announcements. The guidance now enjoins departments that are appraising government projects to take account of the impact on levelling up regional imbalances, not simply the maximisation of benefits.
Other gaps in the Budget
The Budget was silent about the government’s plans for reforming social care. Nor was there much reference to the government’s earlier rhetoric about investing for growth or improving public infrastructure. The Budget added little to the government’s earlier announcements about investing in green technology. The government could have introduced higher taxes to reduce the consumption of fossil fuels. It chose, instead, to leave fuel duty unchanged for the tenth year in succession. But the chancellor has instructed the Bank of England to take account of the government’s climate change policy goals. The Bank was instructed to ensure that the financial system was ‘resilient to the physical and transition risks that climate change presents’. The chancellor’s only sop to resolving the UK’s chronic low productivity was the announcement of a temporary new ‘super-deduction’ for investment allowances and a review of the research and development tax credit (see below).
Corporation tax
The chancellor increased CT in one fell swoop to 25% from 2023, the first such increase since 1974. He reversed the progressive cuts in the rate from 28 to 19% made by a previous Conservative administration. It had widely been expected that any increase would be modest and phased in over two or three years. The impact of the increased CT rate will be mitigated by the retention of the existing rate of 19% for companies that earn profits below £50,000. Companies will be able to claim a super-deduction worth some £24bn for capital spending during the two years before the new rate kicks in.
The increase in CT is forecast to raise an extra £17.2bn a year by 2025/26 (£50bn over the next five years). The increase in CT probably won’t raise the amount estimated by the government. The reduction in the post-tax return on capital employed by companies will discourage them from investing as much as they might otherwise have done; this will reduce their future profits and tax liabilities. The planned increase in the CT rate will also reduce direct foreign investment into the UK. Domestic and foreign investment had already been dented by the UK’s decision to leave the European Union and the uncertainty surrounding the agreement of its trade deal with the EU, and the pandemic.
The chancellor has suggested that the headline rate of CT will remain below that in most of the G7 countries. But, once deductions and other allowances there are taken into account, the UK will in fact have a higher effective rate of company taxation. The Office of Budget Responsibility (OBR) has warned about the uncertainty surrounding the behavioural response to the increase in the rate of CT. It might increase the incentive for UK companies to relocate to jurisdictions where there is a lower rate of company taxation, or to incorporate new business ventures abroad rather than in the UK. It might also increase the incentive for tax avoidance.
Whether the super-deduction will boost productivity
The super-deduction of 130% for expenditure on plant and machinery will have the effect of front-loading the level of capital investment already planned by businesses. It is unlikely to encourage any significant increase in investment. Companies will be able to get back 25 pence in lower corporation tax for every £1 they spend on plant and machinery. The availability of the super-deduction may also encourage companies to make investments that might previously have been commercially unviable.
Low investment is the prime cause of Britain’s stagnant productivity. The UK had the lowest rate of gross fixed investment in the G7 between 2010 and 2018. The government could have chosen instead to increase both, the rate of CT and the permanent level of capital allowances and R&D tax credits by spreading out the planned expenditure on the super-deduction. The new deduction won’t provide any relief for investment in intangible capital, such as a new website, that is currently deductible over the life of the asset. Nor is it likely to provide much benefit to businesses operating in the services sector that accounts for about 80% of all economic activity.
Resolving the ‘productivity puzzle’
The UK’s productivity growth had averaged about 2%–2.5% annually in the 1980s and 1990s. But it has languished since the financial crisis in 2007/08. Until then, governments could rely on economic growth to deliver automatic increases in tax revenues by boosting employment and profits. Productivity growth in the US and the UK’s European rivals had also suffered during the financial crisis. But their productivity bounced back to its former levels shortly afterwards. The OBR has warned that the UK economy will be permanently scarred by the pandemic.
The OBR’s ‘central case’ forecast is that the economy will permanently be 3% poorer than it might otherwise have been because the Budget changes will reduce economic growth (according to ONS and OBR data, see chart 1.5 see chart 2 of the OBR’s Overview of the March 2021 economic and fiscal outlook report, 3 March 2021). ‘The increase in the corporation tax rate will increase the cost of capital, lowering the desired capital stock and business investment in the medium term’. Reducing investment will hurt economic growth and jobs; it will impede the innovation that spurs increases in productivity. The OBR has forecast that productivity growth from 2023 is likely to remain stuck at about 1.7% a year.
The government can stimulate economic growth by encouraging increased investment and research and development. Economic growth is the best way to reduce the debt burden and increase employment. The government’s short-sighted commitment to encouraging growth is evident from its decision to abolish the Industrial Strategy Council; it appears to mark the end of its strategic approach to promoting economic growth.
The UK’s productivity challenge is to improve the performance of the short tail of the best companies and sectors of the economy. The longer tail of mainly smaller companies are likely to survive the pandemic restrictions thanks to the job furlough scheme and government-backed loans. But they will continue to remain unproductive. The decline in foreign direct investment and the associated import of new management and business techniques, and the exodus of skilled migrant EU workers will impede the growth of productivity.
Review of R&D tax credits
The chancellor has announced a review of the R&D tax credits regime. It is expected to widen the scope of the relief to include innovative approaches to managing data and cloud computing. The R&D tax credits regime is crucial to addressing the crisis in the UK’s innovation and growth crisis. The relief was originally introduced by the Labour government in 2000, and has been burnished by subsequent governments. There is a strong case for widening the terms of reference of the Treasury review to encourage increased spending on research and development.
Freezing income tax and other allowances
The chancellor’s decision to freeze the income tax allowances from 2022 is a stealthy tax raid. It will erode their real value and increase the yield from income tax through ‘fiscal drag’. It will result in 1.3m more people paying income tax and drag a million more into the higher tax net by 2025/26. Analysis suggests that the chancellor’s decision not to index the salary levels at which parents begin to lose child benefit (£50,000) or cease to receive it (£60,000) could cause thousands of families to lose some or all of their child benefit. Freezing the inheritance tax threshold, the annual exemption for capital gains tax and the pensions tax allowance limits are expected to raise some £2bn.
Chancellor Sunak’s comment that taxpayers would not be left worse off by his decision to freeze the personal allowance echoes the Labour prime minister Harold Wilson’s infamous remark that the ‘pound in your pocket’ would be unaffected by his government’s decision to devalue the pound in 1967. (Their comments are only true about the nominal amounts.)
Dangers to public finances
There is a risk that excess demand and loose monetary conditions could ignite domestic inflation, leading to pressure for an increase in interest rates. The government has been able to borrow billions to fund its response to the coronavirus crisis relatively cheaply because of historically low interest rates. The OBR has warned of the risks posed by increased interest rates on public finances. With public sector net debt currently at over £2 trillion, a 1% rise in interest rates would result in an increase of £25bn in the cost of servicing public debt; it would wipe out the tax increases announced in the Budget.
Short and long-term interest rates and the yields on government bonds are already beginning to rise because of the widespread expectation of future inflation. The US fiscal stimulus is likely to push up global interest rates, which the Bank of England will have to mirror to prevent capital outflows. If the increase in interest rates is caused by rapid economic growth, then the adverse effects of higher debt interest could be offset by the increase in tax revenues. But the increase in interest payments would outweigh the growth in tax revenues if economic conditions result in a sustained increase in the price level. The economy is expected to grow by over 7% next year, the largest increase since the post-war period.
There is huge pent-up consumer demand in the economy because the lockdown restrictions have constrained retail spending. The Bank of England has estimated that households have saved more than £170bn during the pandemic. The British Business Bank has reported that many SMEs have used their low-interest, government-backed loans to create cash reserves. They are likely to use these savings to re-stock and to take their staff off furlough when the economy recovers.
Households will wish to spend their savings when the lockdown restrictions are lifted. Even if households resist the temptation to go on a spending spree, the savings spent on domestic goods and services would add considerable additional stimulus to an economy that is already expected to recover rapidly. Andy Haldane, the chief economist of the Bank of England, has described the economy as ‘a coiled spring’, poised to spring back when the pandemic is over.
The confluence of increased consumer expenditures, the bringing forward of capital spending because of the super-deduction, and the increased demand for exports resulting from the US fiscal stimulus, is likely to result in an incipient excess demand for goods and services. It could stoke up inflationary pressures in the economy.
As the economy begins to reach full capacity, there is likely to be competition between employers for skilled labour. It would result in demands for higher wages. Unrest in the labour market would exacerbate the inflationary pressures created by excess demand. Businesses that concede wage claims would seek to put up their prices to protect their profits. Higher prices are likely to be followed by demands for even higher wages. Inflation would increase the cost of servicing the burden of public debt. It would also automatically trigger off higher public spending on the government’s indexed obligations, such as the state pension.
‘Tax day’
The Treasury deferred a number of announcements and consultations about future tax policies, which are normally made on Budget day, for three weeks until ‘tax day’. The government said the innovation of a tax day was intended to allow ‘more transparency and scrutiny’, and to strengthen policy-making. None of the new measures announced will be included in Finance Bill 2021, nor have any immediate impact on the government’s finances.
Understanding tax policy
It is helpful for those involved in developing tax policy or seeking to understand its future evolution to have some knowledge of tax history, and of the interaction between tax and politics.
Tax policy is drenched in politics. Failures in tax policy can have devastating political consequences. Understanding the interaction between tax and politics can provide useful insights into the development and evolution of future policy. The political desire to maintain low income tax rates has constrained the conduct of effective fiscal policy for more than 30 years. The ‘spend now, pay later’ announcements in Budget 2021 were probably made with an eye to an early general election. Public spending will probably be much lower than planned, and there will be scope for tax cuts before the end of the current parliament.
Tax policy is drenched in politics. Decisions about who should bear taxes, and when and in what amount, are among the most important decisions made by any government. Tax policy failures have contributed to key episodes of history, including the Boston Tea Party, which triggered off the American war of independence. The riots that followed the introduction of the community charge in England and Wales in 1990 contributed to the fall of Mrs Thatcher, the most formidable British prime minister since the end of the Second World War.
Studying past episodes and themes in tax policy can provide useful insights into the origin and the direction of future policy. For example, the most powerful thread running through the tax policies adopted by different governments in the last thirty years has been the maintenance of low personal income tax rates. Governments of different persuasions have, for political reasons, voluntarily limited their ability to conduct effective fiscal policies. They have publicly committed that they won’t increase the rates of the taxes that provide their principal sources of revenue, whilst maintaining or increasing public spending.
Income tax
Letting people keep more of their own money and enabling them to decide for themselves how to spend it was at the heart of the radical tax policies introduced by the Conservative governments led by Mrs. Thatcher. She reversed the seemingly inexorable postwar increase in the level of income tax that had funded the growth of government expenditures on health, welfare and education. Her governments reduced the basic rate of income tax from 33% to 25%, and the higher rate from 83% to 40%.
Mrs Thatcher’s policy of maintaining low income tax rates had a powerful electoral appeal. So much so, that in the run-up to the 1997 general election, the New Labour Party led by Tony Blair promised that it would maintain the Conservative government’s tax policies, and its spending plans. It did so to project its own sense of financial responsibility. It wanted to avoid being dubbed as ‘the Party of high taxation’. The label was supposed to have contributed to the Labour Party’s defeat at the previous three general elections.
As the longest-serving Labour chancellor Gordon Brown noted in his memoir (2017), ‘As long as the basic rate [of income tax] was…. not 20p, the tax issue remained a potent weapon in our opponents’ hands. Indeed, I believed that sooner or later – probably sooner – the Conservatives would fight an election on cutting the basic rate to 20p’. The Labour Party succeeded in reducing the basic rate to 20p (as described below), albeit at a huge political cost.
Stealth taxation
Governments that box themselves in by their promises not to increase taxation can find themselves resorting to the introduction of ‘stealth taxes’ to fund public expenditure. That is, taxes collected in ways that are not always obvious to those who are paying them. For example, in its first two budgets, Tony Blair’s government made a number of technical changes to the corporation tax regime. The most controversial aspect of these changes was the withdrawal of dividend tax rebates of £5bn a year from pension funds. It was subsequently claimed that the change undermined the viability of final salary pension schemes by denuding them of up to £100bn in tax rebates.
Tax locks
The Conservative government elected in 2015 introduced legislation to freeze the rates of income tax and class 1 NICs, and the standard rate of VAT for the duration of the Parliament in its first Budget. The government voluntarily gave up its ability to increase the tax rates of its three biggest sources of public revenue. To fund its promise to increase the personal tax allowance, the government reduced public expenditure and introduced the bank levy; it also increased stamp duty, insurance premium tax, and the effective rate of income tax on dividends.
The tensions created by the tax lock became visible in 2017, when the government attempted to increase the rate of class 4 NICs payable by self-employed taxpayers. Most expert commentators agreed that the proposed reform of the national insurance contributions paid by the self-employed was overdue. But the government abandoned the policy a few days after it was proposed in the face of overwhelming opposition within the Conservative Party. The tax lock legislation did not mention class 4 NICs. But the government acknowledged that the measure would have breached the spirit of the tax lock. The current chancellor has noted that it is hard to justify why the self-employed pay less NICs than employees. But it remains to be seen if it is politically possible for him to reintroduce the reform.
The legislative tax lock expired at the end of the 2015–2017 Parliament. The Conservative Party manifesto for the 2017 election promised to keep taxes as low as possible. The Institute for Fiscal Studies (IFS) has noted that the Conservative Party’s manifesto for the 2019 election was ‘virtually devoid of proposals for tax changes … [but that] they may come to regret their guarantee not to increase rates of income tax, NICs or VAT’.
Lop-sided tax system
The Coalition Government that came into power in 2010 implemented a policy of progressively increasing the income tax personal allowance from £6,475 in 2010/11 to £10,000 a year. Until then, governments had tended to increase the personal allowance by relatively modest amounts. The largest previous increase until then had been that introduced in the wake of the 10p crisis in 2008 to compensate those who had lost out from the abolition of the 10p-starting rate of income tax (see below).
The Liberal Democrats had originally proposed the policy of increasing the personal allowance, but the Conservative Party, the senior partner in the coalition, enthusiastically adopted the policy. The Conservatives went into the 2015 general election promising to increase the personal allowance to £12,500 and the income tax higher rate threshold to £50,000.
The policy of increasing the income tax personal allowance, whilst leaving tax rates unchanged, has made the tax system increasingly lop-sided. Over 40% of those who receive taxable income don’t pay any income tax, while the top 1% of earners pays an estimated 30% of all income tax. The IFS’s analysis suggests that 50% of the households with the largest incomes pay nearly four-fifths of income tax, NICs, VAT, excise duties, and council tax (see chart 5 from IFS briefing note Tax revenues: where does the money come from and what are the next government’s challenges? (Helen Miller & Barra Roantree),1 May 2017).
The ‘disconnection’ of so many economically active voters from the income tax system makes them prey to voting for those who advocate irresponsibly expensive policies, safe in the knowledge that they wouldn’t have to contribute a fair share to their cost. It would be politically difficult for a government to reduce the personal allowance. But it can choose, instead, to let inflation erode its real value by freezing it at its current level, or by increasing it by less than the rate of inflation.
To 10p or not to 10p
Governments ignore the cross-distributional impacts of proposed changes to taxation at their electoral peril. In Budget 2007, chancellor Gordon Brown announced the abolition of the 10p-starting rate of income tax that he had himself introduced in 1999. He did so in order to fund a surprise reduction in the basic rate of income tax from 22p to 20p in the pound. Mr. Brown disregarded explicit advice from officials about the distributional impact of the proposed measure on those on very low incomes who were liable to income tax. His final Budget as chancellor was supposed to gild his path to succeed Tony Blair as leader of the Labour Party and prime minister. But his decision led to questions about his political judgment.
The IFS had described the 10p rate as ‘pointless’ and as a ‘gimmick’ when it was introduced, but the losers started complaining to their members of parliament about their loss of up to £230 a year. Gordon Brown, who was by then the prime minister, vehemently denied that there were any losers from the change. There was a media controversy and a parliamentary rebellion in the Labour Party. In the face of a potentially ‘catastrophic Commons defeat on the wrong side of a debate about helping the poor, a contortion that was utterly perverse given his lifelong passion for the subject’ (Richards, 2010), Gordon Brown was forced to compensate the losers.
The main losers from the abolition of the 10p rate were very low-paid workers who didn’t qualify for working tax credits, and pensioners on low-incomes who didn’t receive the higher pensioner tax allowance. But it was administratively impossible for HMRC to identify and compensate the individual losers. The government was forced to introduce an expensive untargeted increase in the personal allowance for all taxpayers to defuse the crisis. It cost the Treasury more than three times the amount saved by the abolition of the 10p rate.
Windfall tax
Opinion polls suggest that a majority of the public support the introduction of a windfall tax on the companies that have thrived during the coronavirus crisis. It has been claimed that they have benefited while other firms have been closed down; and that they have cashed in on the crisis whilst receiving the financial support provided by the government to businesses. Windfall taxes are typically imposed on a one-off basis. For example, the New Labour Party campaigned at the 1997 general election on the platform that it would seek to recover ‘the excess profits of the privatised utilities‘ by introducing a one-off windfall tax.
Labour had argued since 1992 that the nationalised industries, particularly the public utilities British Gas and British Telecom, had been sold (‘privatised’) at undervalue; and that their sale had deprived the exchequer of funds that should have been used to improve public services. It claimed that the shares had been sold cheaply to ensure the success of Conservative Party’s policy of privatisation. They cited as evidence the fact that the shares had risen sharply in value immediately after they were issued. The windfall tax was introduced shortly after the New Labour Party won the 1997 election with a large majority.
The tax was imposed on the companies that were supposed to have been sold at undervalue, rather than on those who had personally benefitted by acquiring the shares at less than they were worth. It would have been impracticable and electorally unpopular to tax the large numbers of the new owners of the shares. There had been claims that the windfall tax would be challenged in the courts, but the companies affected decided to acquiesce to the new tax. (The proceeds of £5.2bn from the tax were used to fund a welfare-to-work programme.)
Wealth tax
The recent publication of the LSE/Warwick Wealth Tax Commission’s report attracted media interest. It prompted speculation about whether the government would implement a one-off wealth tax to repay the public deficit. It was argued that those who could afford it should shoulder a greater part of the burden to pay for public services. A wealth tax would complement the existing taxes on wealth, namely capital gains tax and inheritance tax. The introduction of an annual wealth tax would help to alleviate the economic, social and political risks posed by the growth in wealth inequality. The current government has shown no interest in the proposal. It is highly improbable that a Conservative government would ever introduce a tax so contrary to its traditional credo and aspirational values.
The Labour Party had attempted to implement a wealth tax when it was unexpectedly returned to power in 1974. The then chancellor, Denis Healey abandoned the policy in 1976 in the face of intense opposition to the measure. He said that he ‘found it impossible to draft one which would yield enough revenue to be worth the administrative cost and political hassle’ (Healey, 1989). Gordon Brown considered whether the New Labour Party should introduce a wealth tax shortly before he was appointed as chancellor following its victory in the 1997 general election.
It formed part of a review of the tax system codenamed ‘Cascade’ (Peston, 2005). Cascade proposed the introduction of an annual tax on personal wealth. It was envisaged as a replacement for inheritance tax, which was regarded as ineffective. Mr. Brown and his aides discussed the proposal with officials from the (then) Inland Revenue and the Treasury in their traditional confidential pre-election contacts with the main opposition parties before a general election. He abandoned the idea. He concluded that ‘the benefit might not be worth the political cost’. The present Labour shadow chancellor has ignored the proposals of the Wealth Tax Commission; the Labour Party has backed away from the radical economic policies of its former leader.
Capital gains tax
The publication of the Office of Tax Simplification’s (OTS) report on capital gains tax (CGT) in November 2020 fuelled speculation that there would be changes to the tax regime. The report suggested that if the current tax-free allowance was reduced from £12,300 to £2,000 a year and the rate of CGT was aligned with the taxpayer’s marginal rate of income tax, the yield from the tax would rise to £14bn. (CGT yielded £9.5bn in the tax year 2018/19.) The estimated yield was based on the heroic assumption that the changes would not result in countervailing behavioural changes, such as avoidance and the sale of assets before the introduction of the changes.
Aligning the CGT rate on chargeable gains with income tax isn’t a novel idea; it is how CGT was charged for 20 years until 2007/8. The rationale for the change reflects what the Labour chancellor James Callaghan told parliament when he introduced CGT in 1965, ‘Gains confer much the same kind of benefit on the recipient as taxed earnings.’ The OTS’s recommendations attracted criticism from Conservative members of parliament and right-wing commentators. The chancellor’s allies were quick to remind the media that he had not adopted the OTS’s previous recommendations on inheritance tax and income tax. And that the current rates of CGT were set at a level that ministers were advised would maximise the yield from the tax.
Rhetoric versus reality
Successive British governments have sought to support small businesses to promote enterprise and employment (and to cultivate the electoral support of the millions who own and work in small businesses). They have boasted about creating a level playing field free from the distorting influence of tax, and stressed that individual businesses are free to decide whether to operate as sole traders, partnerships or through companies. But they have also encouraged the growth of small companies by charging them a lower rate of tax than that levied on individuals. They have made it cheaper and easier to incorporate or acquire new companies, even though small companies continue to be used to avoid income tax and national insurance.
Lack of consistency
The tax system has, at times, departed to an egregious extent from the principle of applying similar tax treatment to the same sort of income. For example, the Labour government introduced a 0% rate of corporation tax on the first £10,000 of taxable small company profits for the tax years 2002/03 and 2003/04. The government introduced the policy in response to pressure from the small business lobby bodies for a tax relief to encourage them to retain profits to finance future growth. Ministers decided the policy without consulting officials about the likely behavioural impact of the policy. (Officials had consistently advised against granting any relief for retained profits on the grounds that it would be ‘dead weight’.)
Ministers did not grant any analogous relief to those conducting their small businesses as sole traders or partnerships. There was predictably a large and swift spike in tax-motivated incorporations to take advantage of this bonanza. The exchequer started hemorrhaging massive losses of tax. To staunch the loss of tax, the government first restricted the 0% rate of corporation tax band to undistributed profits, and then reversed its policy.
The politics of tax avoidance
Party politics is one of the reasons why there has been an inexorable growth in the volume and severity of anti-avoidance legislation despite the steady decline in the tax gap to its lowest level to date. Combatting tax avoidance is one of the rare issues on which there is now a consensus among the major political parties. But it wasn’t always so; until about 15 years ago, the Labour Party was in the vanguard in warning about the dangers to the public purse of tax avoidance.
Public anger about tax avoidance by large companies and celebrities caused the Conservative Party, traditionally the ‘Party of big business’, to realise the political risks it faced. Fearful of being accused of being ‘soft’ on tax avoidance, it toughened up its policy on countering tax avoidance. In 2013, David Cameron, the leader of Conservative Party and prime minister of the Coalition Government, famously warned multi-national firms that if they were involved in tax avoidance they weren’t welcome in the UK and to ‘wake up and smell the coffee’.
The readiness of governments to introduce new powers to curb tax avoidance has, on occasion, resulted in new provisions that were so broadly focused that they extended beyond their original target. A House of Lords Committee warned in a report (2020) that there was ‘a pattern of new HMRC powers being disproportionate, poorly targeted and without sufficient safeguards’. In February 2021, HMRC published a report evaluating how powers, obligations and safeguards, introduced since 2012 had worked. It made a number of commitments to improve the experience for taxpayers.
Budget 2021
The March 2021 Budget was announced against the backdrop of worst pandemic since the Great Plague, and the largest public sector deficit since the Second World War. Chancellor Sunak said that the restoration of public finances would require work by ‘many governments’. To begin repairing public finances, he announced an extra £25bn in taxes. They are due to come into effect from 2023. He announced that the corporation tax rate (CT) would be increased from 19% to 25% in 2023. He also froze the income tax personal allowance; and the tax allowances for pensions relief, capital gains tax, and inheritance tax. The cumulative impact of the tax changes will increase the UK’s tax burden to its highest level since the late 1960s (according the ONS and OBR data; see chart 2 of the OBR’s Overview of the March 2021 economic and fiscal outlook report dated 3 March 2021).
‘Spend now, pay later’
The chancellor’s announcements were dubbed as the ‘spend now, pay later’ Budget because he was forced to allocate another £59bn for the continuation of fiscal support for those suffering from the economic impact of the covid-19 lockdown restrictions. (The government’s total coronavirus-related expenditure will amount to £407bn by the end of the next financial year.) The IFS has described the government’s spending plans as ‘implausible’. It has suggested that it would have to increase taxes in the future because of the likely increase in covid-19 related expenditures on health care, and to implement its campaign promises.
The politics of the Budget
Jeremy Corbyn, the former leader of the Labour Party, mocked the government for proposing almost the same increase in CT that his party had advocated in its manifesto for the 2019 election. He reminded it of how the Conservative Party had derided his Party’s proposal just over a year ago. Paul Johnson, the director of the IFS, has described the planned increase in CT as ‘a screeching U-turn in Conservative policy over the past decade’. Right-wing commentators have accused the chancellor’s decisions as a ‘bonfire’ of the verities of low taxation and tight control of public spending that have been Conservative policy since Mrs Thatcher’s time.
Political electoral cycle
Governments tend to increase taxes and reduce spending soon after winning an election. It enables them to cut taxes and to expand public expenditures in the run-up to the next election. It is a policy predicated on the assumption that voters have short memories. The Labour Party never forgave its chancellor Roy Jenkins for his inopportune fiscal rectitude. He increased income tax in the run-up to the 1970 election, which the Party then unexpectedly lost to the Conservatives. Budget 2021 will increase the tax burden to 35% of the gross national product, the highest level since Jenkins was the chancellor, by the time of the next election.
The forthcoming repeal of the Fixed Term Parliaments Act 2011 would allow the current government to declare its fiscal prudence a pre-mature success, and to reverse part of the announced tax changes before calling an early general election. The government has renewed its generous support for Covid-19 relief measures until October 2021. But the full amount of the funding allocated for it may not all need to be spent. The success of the vaccination programme is expected to allow a return to normal life by the end of June. It will usher in a strong economic recovery and increase tax revenues that would enable the government to introduce pre-election tax cuts.
Levelling up
The government had promised to redress the disparity between the deprived areas, whose voters in the so-called ‘red wall’ seats helped the government secure a large majority during the 2019 general election, and the more prosperous London and the South East. But there was little in the Budget about addressing regional disparities in growth and employment. That is, beyond the modest announcements about the creation of regional ‘free ports’, the relocation of some Treasury staff to Darlington, and the selection of Leeds as the home of the new Infrastructure Bank.
The recent amendment to Treasury’s ‘green book’ guidance to government departments about appraising investment decisions will arguably have a greater impact on government expenditure in the regions than the Budget announcements. The guidance now enjoins departments that are appraising government projects to take account of the impact on levelling up regional imbalances, not simply the maximisation of benefits.
Other gaps in the Budget
The Budget was silent about the government’s plans for reforming social care. Nor was there much reference to the government’s earlier rhetoric about investing for growth or improving public infrastructure. The Budget added little to the government’s earlier announcements about investing in green technology. The government could have introduced higher taxes to reduce the consumption of fossil fuels. It chose, instead, to leave fuel duty unchanged for the tenth year in succession. But the chancellor has instructed the Bank of England to take account of the government’s climate change policy goals. The Bank was instructed to ensure that the financial system was ‘resilient to the physical and transition risks that climate change presents’. The chancellor’s only sop to resolving the UK’s chronic low productivity was the announcement of a temporary new ‘super-deduction’ for investment allowances and a review of the research and development tax credit (see below).
Corporation tax
The chancellor increased CT in one fell swoop to 25% from 2023, the first such increase since 1974. He reversed the progressive cuts in the rate from 28 to 19% made by a previous Conservative administration. It had widely been expected that any increase would be modest and phased in over two or three years. The impact of the increased CT rate will be mitigated by the retention of the existing rate of 19% for companies that earn profits below £50,000. Companies will be able to claim a super-deduction worth some £24bn for capital spending during the two years before the new rate kicks in.
The increase in CT is forecast to raise an extra £17.2bn a year by 2025/26 (£50bn over the next five years). The increase in CT probably won’t raise the amount estimated by the government. The reduction in the post-tax return on capital employed by companies will discourage them from investing as much as they might otherwise have done; this will reduce their future profits and tax liabilities. The planned increase in the CT rate will also reduce direct foreign investment into the UK. Domestic and foreign investment had already been dented by the UK’s decision to leave the European Union and the uncertainty surrounding the agreement of its trade deal with the EU, and the pandemic.
The chancellor has suggested that the headline rate of CT will remain below that in most of the G7 countries. But, once deductions and other allowances there are taken into account, the UK will in fact have a higher effective rate of company taxation. The Office of Budget Responsibility (OBR) has warned about the uncertainty surrounding the behavioural response to the increase in the rate of CT. It might increase the incentive for UK companies to relocate to jurisdictions where there is a lower rate of company taxation, or to incorporate new business ventures abroad rather than in the UK. It might also increase the incentive for tax avoidance.
Whether the super-deduction will boost productivity
The super-deduction of 130% for expenditure on plant and machinery will have the effect of front-loading the level of capital investment already planned by businesses. It is unlikely to encourage any significant increase in investment. Companies will be able to get back 25 pence in lower corporation tax for every £1 they spend on plant and machinery. The availability of the super-deduction may also encourage companies to make investments that might previously have been commercially unviable.
Low investment is the prime cause of Britain’s stagnant productivity. The UK had the lowest rate of gross fixed investment in the G7 between 2010 and 2018. The government could have chosen instead to increase both, the rate of CT and the permanent level of capital allowances and R&D tax credits by spreading out the planned expenditure on the super-deduction. The new deduction won’t provide any relief for investment in intangible capital, such as a new website, that is currently deductible over the life of the asset. Nor is it likely to provide much benefit to businesses operating in the services sector that accounts for about 80% of all economic activity.
Resolving the ‘productivity puzzle’
The UK’s productivity growth had averaged about 2%–2.5% annually in the 1980s and 1990s. But it has languished since the financial crisis in 2007/08. Until then, governments could rely on economic growth to deliver automatic increases in tax revenues by boosting employment and profits. Productivity growth in the US and the UK’s European rivals had also suffered during the financial crisis. But their productivity bounced back to its former levels shortly afterwards. The OBR has warned that the UK economy will be permanently scarred by the pandemic.
The OBR’s ‘central case’ forecast is that the economy will permanently be 3% poorer than it might otherwise have been because the Budget changes will reduce economic growth (according to ONS and OBR data, see chart 1.5 see chart 2 of the OBR’s Overview of the March 2021 economic and fiscal outlook report, 3 March 2021). ‘The increase in the corporation tax rate will increase the cost of capital, lowering the desired capital stock and business investment in the medium term’. Reducing investment will hurt economic growth and jobs; it will impede the innovation that spurs increases in productivity. The OBR has forecast that productivity growth from 2023 is likely to remain stuck at about 1.7% a year.
The government can stimulate economic growth by encouraging increased investment and research and development. Economic growth is the best way to reduce the debt burden and increase employment. The government’s short-sighted commitment to encouraging growth is evident from its decision to abolish the Industrial Strategy Council; it appears to mark the end of its strategic approach to promoting economic growth.
The UK’s productivity challenge is to improve the performance of the short tail of the best companies and sectors of the economy. The longer tail of mainly smaller companies are likely to survive the pandemic restrictions thanks to the job furlough scheme and government-backed loans. But they will continue to remain unproductive. The decline in foreign direct investment and the associated import of new management and business techniques, and the exodus of skilled migrant EU workers will impede the growth of productivity.
Review of R&D tax credits
The chancellor has announced a review of the R&D tax credits regime. It is expected to widen the scope of the relief to include innovative approaches to managing data and cloud computing. The R&D tax credits regime is crucial to addressing the crisis in the UK’s innovation and growth crisis. The relief was originally introduced by the Labour government in 2000, and has been burnished by subsequent governments. There is a strong case for widening the terms of reference of the Treasury review to encourage increased spending on research and development.
Freezing income tax and other allowances
The chancellor’s decision to freeze the income tax allowances from 2022 is a stealthy tax raid. It will erode their real value and increase the yield from income tax through ‘fiscal drag’. It will result in 1.3m more people paying income tax and drag a million more into the higher tax net by 2025/26. Analysis suggests that the chancellor’s decision not to index the salary levels at which parents begin to lose child benefit (£50,000) or cease to receive it (£60,000) could cause thousands of families to lose some or all of their child benefit. Freezing the inheritance tax threshold, the annual exemption for capital gains tax and the pensions tax allowance limits are expected to raise some £2bn.
Chancellor Sunak’s comment that taxpayers would not be left worse off by his decision to freeze the personal allowance echoes the Labour prime minister Harold Wilson’s infamous remark that the ‘pound in your pocket’ would be unaffected by his government’s decision to devalue the pound in 1967. (Their comments are only true about the nominal amounts.)
Dangers to public finances
There is a risk that excess demand and loose monetary conditions could ignite domestic inflation, leading to pressure for an increase in interest rates. The government has been able to borrow billions to fund its response to the coronavirus crisis relatively cheaply because of historically low interest rates. The OBR has warned of the risks posed by increased interest rates on public finances. With public sector net debt currently at over £2 trillion, a 1% rise in interest rates would result in an increase of £25bn in the cost of servicing public debt; it would wipe out the tax increases announced in the Budget.
Short and long-term interest rates and the yields on government bonds are already beginning to rise because of the widespread expectation of future inflation. The US fiscal stimulus is likely to push up global interest rates, which the Bank of England will have to mirror to prevent capital outflows. If the increase in interest rates is caused by rapid economic growth, then the adverse effects of higher debt interest could be offset by the increase in tax revenues. But the increase in interest payments would outweigh the growth in tax revenues if economic conditions result in a sustained increase in the price level. The economy is expected to grow by over 7% next year, the largest increase since the post-war period.
There is huge pent-up consumer demand in the economy because the lockdown restrictions have constrained retail spending. The Bank of England has estimated that households have saved more than £170bn during the pandemic. The British Business Bank has reported that many SMEs have used their low-interest, government-backed loans to create cash reserves. They are likely to use these savings to re-stock and to take their staff off furlough when the economy recovers.
Households will wish to spend their savings when the lockdown restrictions are lifted. Even if households resist the temptation to go on a spending spree, the savings spent on domestic goods and services would add considerable additional stimulus to an economy that is already expected to recover rapidly. Andy Haldane, the chief economist of the Bank of England, has described the economy as ‘a coiled spring’, poised to spring back when the pandemic is over.
The confluence of increased consumer expenditures, the bringing forward of capital spending because of the super-deduction, and the increased demand for exports resulting from the US fiscal stimulus, is likely to result in an incipient excess demand for goods and services. It could stoke up inflationary pressures in the economy.
As the economy begins to reach full capacity, there is likely to be competition between employers for skilled labour. It would result in demands for higher wages. Unrest in the labour market would exacerbate the inflationary pressures created by excess demand. Businesses that concede wage claims would seek to put up their prices to protect their profits. Higher prices are likely to be followed by demands for even higher wages. Inflation would increase the cost of servicing the burden of public debt. It would also automatically trigger off higher public spending on the government’s indexed obligations, such as the state pension.
‘Tax day’
The Treasury deferred a number of announcements and consultations about future tax policies, which are normally made on Budget day, for three weeks until ‘tax day’. The government said the innovation of a tax day was intended to allow ‘more transparency and scrutiny’, and to strengthen policy-making. None of the new measures announced will be included in Finance Bill 2021, nor have any immediate impact on the government’s finances.
Understanding tax policy
It is helpful for those involved in developing tax policy or seeking to understand its future evolution to have some knowledge of tax history, and of the interaction between tax and politics.
Tax policy is drenched in politics. Failures in tax policy can have devastating political consequences. Understanding the interaction between tax and politics can provide useful insights into the development and evolution of future policy. The political desire to maintain low income tax rates has constrained the conduct of effective fiscal policy for more than 30 years. The ‘spend now, pay later’ announcements in Budget 2021 were probably made with an eye to an early general election. Public spending will probably be much lower than planned, and there will be scope for tax cuts before the end of the current parliament.
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