Tax the aged

Earlier this year Ed Balls correctly argued that no sensible plan for rescuing the public finances can fail to look at pensioner benefits. This does not just reflect the Government’s short term money problems but fundamental changes taking place in society, especially the ageing of the population. Not only are baby boomers (people born between 1946 and 1964) starting to retire in large numbers but people are living longer. The result is that fiscal sustainability is more of a concern and future governments cannot avoid tough decisions.

These tough decisions are not just limited to government spending but involve revenue too. As the independent Office for Budget Responsibility has shown, even with planned spending cuts, taxes are projected to increase by £380 per family by 2033. But this will not be enough and debt will still rise to unsustainable levels. The UK faces a triple whammy: little money for essential services, higher taxes and unsustainable debt.

The high level of indebtedness is especially concerning. To give just one illustration, as the Treasury’s own figures show, if government bond yields were to increase by 1 percentage point then annual debt interest payments would grow by around £8.1 billion by 2017-18 and a 1 percentage point rise in effective mortgage rates would add £12 billion a year to households’ mortgage interest payments.

Some may argue that there is no reason to reform the tax system as any fiscal hole could be filled by reducing the corporate tax gap (reducing tax avoidance and evasion). Yet while it is right to close the tax gap, efforts to do this will only take you so far. The evidence from HMRC is that the share of the tax gap that can be attributed to corporation tax, especially of large and very large businesses, is relatively small. Inaccurate returns from individuals and indirect taxes like VAT make up the largest holes in the UK’s tax base.

Any proposals for reducing tax burdens must represent real value for money. As Reform and the IPPR, among others, have shown, Conservative and Liberal Democrat ideas to increase the personal allowance to £12,500 are misguided. The Labour Party’s proposal to introduce a 10p rate requires rethinking too. Overall the change would do little to improve living standards. The maximum tax cut under this proposal would be £100 per annum. Nothing would go to people with incomes below £9,440 or above £41,450. People whose incomes are at or below the minimum wage for 35 hours per week (based on the 21+ rate and 52 weeks of work a year) would only receive 4.3 per cent of the benefit. And around 111,000 people would face higher marginal effective tax rates as they hit the 40p rate sooner.

The better approach would be to consider measures to ensure that older people share in increasing tax burdens. Two areas requiring attention are the exemption from NICs for people over State Pension Age and pension tax relief. The exemption from NICs does not reflect the modern labour market in which age is now a less reliable indicator of need. Ending the exemption would raise £735 million per year and only affect the richest (by income) 6.3 per cent of people aged over 65. Pension tax relief is expensive, poorly targeted and fails to achieve its policy objectives. Yet reform in this area requires real care, as not only is there the prospect for double taxation but changes will largely impact on younger taxpayers. Most of the relief (61.2 per cent) currently received goes to people aged 35 to 55 and nearly 20 per cent of the relief is received by people below 35.

There is no doubt that these latter changes would raise political challenges. Yet they are essential to ensure the burden of taxation does not just fall on younger generations of workers. The priority must be to set out a way to raise revenue and lower economic costs, while also ensuring fairness within and between generations. This is a hard, but not impossible, task, and requires a stronger focus on the design not just level of taxation.

Patrick Nolan is Chief Economist at Reform