Why the tax system is broken

Six problems with the way we redistribute wealth
June 18, 2014

© Bumpermark

Government is a game of two halves—the spending half and the taxing half. If the latter isn’t pretty much as big as the former then in the long run we’ll be in trouble. To fund all the schools and hospitals, police and armed forces, roads and pensions, we pay more than £600bn in tax each year. That’s about £4 in every £10 generated by the economy.

The tax half really ought to get as much attention from policymakers, parliament and the public as the spending half. If you are going to take that much money from people and businesses, you are going to have quite an effect on their incomes, their behaviour and their welfare. But tax is different. While other bits of government have strategy papers, white papers and green papers by the bucketful, no recent government has set out a proper tax strategy. And in parliament there isn’t even a select committee focused specifically on tax. The political debate seems limited to worrying about one or two headline tax rates, or an individual or company making use of some ferociously complicated avoidance scheme.

Partly as a result we have ended up with a jumble of inconsistencies, complexities and downright inequities which are hard to square with any coherent set of objectives. Indeed these are often the complexities and inconsistencies which allow tax avoidance schemes to take root in the first place.

Depressingly things are, on the whole, not getting any better. The problems don’t just relate to historical baggage. Many have been actively created or knowingly allowed to occur by this government and its predecessor. If that seems too pessimistic just consider some of the ways the system works at present.

We have two entirely separate taxes on earnings

We hear a lot about income tax, but rather less about national insurance (NI) contributions, which bring over £100bn a year into the Treasury coffers and are nothing more than a second tax on earnings. NI is charged on a different definition of earnings to that used for assessing income tax, adding complexity and creating a big and wholly unnecessary cost for business and HMRC.

Governments are delighted to exploit our collective lack of focus on NI. While income tax rates have fallen time and again, NI rates have risen. Why? Because that is what governments feel they can get away with. This has had the effect, almost certainly unintended, of raising the effective rate of tax on earnings (and workers) relative to the effective rate of tax on investment income (and pensioners). This government has boasted about taking hundreds of thousands of working people out of income tax by spending billions on increasing the personal allowance: the amount of income workers earn before income tax is charged. But the government has taken almost no working people out of the direct tax net because it has not raised the point at which NI starts to be paid. More than a million low earners are now paying NI but not paying income tax. Politicians genuinely focused on helping the low paid should not be promising further increases in the income tax allowance; they should be talking about the NI threshold.

We continue to introduce new complications to the income tax system

A poorly understood policy brought in by the last government introduced a new 60 per cent rate of tax on incomes above £100,000. The current government has extended it so that it now reaches to £120,000. It wasn’t sold like that; it was sold as tapering away the tax free personal allowance. But the fact is that if you earn either £95,000 or £125,000 you face an income tax rate of 40 per cent. Yet if you earn between £100,000 and £120,000, the loss of the personal allowance results in a 60 per cent rate.

This government has announced that it wants to reward marriage through the tax system. It will do that by making part of the personal allowance transferable between spouses where one is not making full use of it. This benefits couples where one works and one doesn’t work, or at least earns below the tax allowance. Understandably this is being introduced in a modest way, such that nobody will benefit by more than around £200 a year. But this is a big and costly structural change to the system, which probably only makes sense if it is gradually extended as resources allow. But the way it is being introduced makes that almost impossible, because this £200 will be lost the moment one partner becomes a higher rate taxpayer. Earn £1 more, lose £200. It may not matter so much when the allowance is so small, but make it bigger and this could become a major problem.

Meanwhile the opposition wants to reintroduce the 10p starting rate of income tax it introduced and then abolished last time round. There is no justification for this additional income tax band. It achieves nothing that increasing the personal allowance doesn’t achieve more straightforwardly and more progressively. And as we’ve already seen, those who genuinely want to help the low paid through the tax system should raise the NI threshold.

We allow the tax system to expand through “fiscal drag”

In the past 25 years the number of higher rate (40p) income taxpayers has trebled and will reach more than five million next year. All three main UK parties seem very happy with this fundamental, but unannounced, redesign of our income tax system. It is a redesign that has, largely, crept up on us as the higher rate threshold has fallen relative to average earnings—and more recently been cut in absolute terms.

We also now have several elements of the income tax system that do not rise with inflation at all. These include the £100,000 point at which the personal allowance starts to be tapered away (and the 60 per cent rate of income tax becomes payable) and the £150,000 point at which the 45p rate becomes payable. Both have fallen by more than 10 per cent relative to prices since being introduced four years ago. If this government is so concerned about high marginal tax rates why has it let the real value of these thresholds fall like this? What is the plan for these? Will they be kept fixed for much longer, drawing more and more people into their net?

The taxation of housing is a mess

Council tax is the only tax I know of that is deliberately regressive; the amount you pay falls as a proportion of the value of your house as the property becomes more valuable. More absurdly, in England, the tax is assessed on the relative values of properties from nearly a quarter of a century ago. Neither the last government nor this one has had the courage to do anything about it. We look set to enter the 2020s paying a tax determined by the relative value of properties in 1991.

And then there is stamp duty. Its rate has been increased again and again despite the fact that it is one of our worst designed and most damaging taxes. It ensures that the housing market works even less efficiently, and it is designed in an absurd way. As you move into each new price band, the new rate of stamp duty is charged on the whole price of the house. At the extreme, a £1 increase in the house price can result in a £40,000 increase in stamp duty.

Nobody knows what is happening to the taxation of pensions

If there is one part of the tax system where some long-term stability and sense of direction is crucial then it is in the taxation of pensions. But we have absolutely no idea what is happening here. That makes it very hard for anyone to plan.

Having set out a clear direction, the last government performed a volte face just a couple of years later and set in train an absurd complication of the regime. The current government has substantially reduced the generosity of income tax allowances, but has given no sense of where it is headed. The Labour Party appears set on further complicating the system. And whatever you think of the most recent announcement on the taxation of annuities—effectively ending compulsory annuitisation—proudly springing it on the world unannounced and unconsulted upon is not the best way of making policy in this crucial area.

Businesses face continued change and instability

Businesses, especially small businesses, have many gripes about the tax system. Constant change is at the top of their list. That’s not surprising: in recent years there have been, literally, annual changes to the levels and structures of business rates, corporation tax allowances and carbon taxes. To take just one example, consider the annual investment allowance, which allows the immediate deduction of expenditure on most machinery from taxable profits. Knowing its level is an important consideration for investment decisions. The limit was set at £50,000 between 2008 and 2010, when it increased to £100,000. It was cut to just £25,000 in 2012 but increased to £250,000, supposedly temporarily, in 2013. In the 2014 Budget it was raised again to £500,000, but on current plans it will return to £25,000 in 2016. How is that supposed to help businesses that are planning for the future?

There is much about the tax system that works. HMRC manages to collect the great majority of tax due without having to do very much. We are, on the whole, a compliant nation. But there is a real and very substantial cost to all the problems that do exist. They hold back growth and mean we are all worse off than we need to be. Tax reform may be politically treacherous territory, but failing to do it is economically indefensible.