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Britain’s broken tax system

How political expediency overrides logic and fairness in the UK’s chaotic finances.

By Will Dunn

How much tax do you pay? Perhaps the answer seems obvious: 20 per cent on your earnings over £12,570, and 40 per cent if you’re fortunate enough to earn anything over £50,270 (if you earn over £150,000, we can assume you’ve already asked your accountant to answer this question).

Add in some National Insurance, and the main earner in a typical household might guess that if they finally get that pay rise they’ve been arguing for since inflation arrived, they’ll hand around a quarter of it to the state. The truth is more variable, and wildly unfair. In the public debate between nurses and the government over pay, for example, there is relatively little discussion of the fact that a recent nursing graduate on £28,000 a year will surrender half the amount they actually take home from an extra pound on their salary through an effective marginal tax rate of 49.8 per cent.

If you have three children and earn between £50,000 and £60,000 a year, a quirk of the child benefit system raises your effective marginal tax rate to 68 per cent. If you’re a working parent on Universal Credit, a similar mechanism means you’re likely to be even worse off: the marginal tax rate on an extra pound earned can be more than 70 per cent.

[See also: We need a reform of council tax, not a rise]

This may help to explain why, as a widely discussed piece of polling for the New Statesman revealed last year, even people earning £60k to £80k – well above the UK median income – feel as if they are barely scraping by, and they are right to do so: in the messy, convoluted system of taxation, spending and benefits, their money can be governed by completely different rules to that earned by the people next door.

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This is especially true if the people next door have started their own business (perhaps as a landlord to students, or running a private nursing agency) and are turning their business income into capital gains, thus incurring a top rate of not 40 but 20 per cent. Should they decide to sell that business for anything less than a million, entrepreneurs’ relief means they’ll pay just 10 per cent. As research from Warwick University has shown, UK citizens on £10m a year pay, on average, an effective tax rate of only 21 per cent.

Kwasi Kwarteng was right, then, to claim in his speech announcing his short-lived but spectacular “mini-Budget” of 23 September 2022 that “high tax rates… reduce the incentive to work”. But he was wrong about who is disincentivised by high tax rates: it’s not partners at law firms or FTSE 100 CEOs – for whom Kwarteng abolished the 45p tax rate – but working parents on Universal Credit and the hundreds of thousands of small-business owners who know they’ll face a huge VAT bill if taxable revenue goes a penny over £85,000.

Fortunately, Kwarteng’s ill-conceived attempt at reshaping the tax system was brief thanks to Paul Johnson, director of the Institute for Fiscal Studies (IFS). In his erudite and informative new book Follow the Money Johnson doesn’t go into how he defenestrated the Truss-Kwarteng government, which is a shame as it would make for entertaining reading. Truss and Kwarteng were at least self-aware enough to understand that, as charmless extremists, they wouldn’t be able to persuade policymakers that their “Growth Plan” would work – so they didn’t try. Instead, they sacked the Treasury’s top official and prevented the Office for Budget Responsibility from publishing its forecasts on the impact of their policy. And so it was left to the IFS to point out that the plan would mean selling an ever-increasing supply of government debt to financial markets.

[See also: Why the Tory right wants hush from Truss on tax-cuts]

Johnson casts himself as a mild-mannered geek at the head of “a small charity”, but after the IFS delivered its analysis, financial markets quickly repriced the UK’s government bonds in the way that markets often do when they expect a huge increase in the supply of something, which quickly made Britain’s borrowing much more expensive. A sudden risk of catastrophe materialised for pension funds and mortgages, and Liz Truss had to return to the Downing Street podium – which, as was widely observed, bore a newly appropriate resemblance to a pile of Jenga blocks – to announce that she’d done such a great job as PM that 45 days was probably enough.

It was later reported that the Jenga podium cost the taxpayer more than £4,000, an expense not detailed in Johnson’s otherwise comprehensive explanation of the cost of the British state and the difficulty of raising the funds to pay for it. In fairness, there are bigger present and future costs: the price of the podium equates to less than the per-second cost of the annual NHS England budget of £180bn, which is projected to need (at current rate of spending increase) an extra £100bn a year by the early 2030s.

If nurses are alarmed to hear that a large portion of whatever pay deal they eventually get from Rishi Sunak will be consumed by their marginal tax rate, they will be still more perturbed to learn that they, along with teachers and doctors, suffer from an ailment only an economist can diagnose: Baumol’s cost disease.

This is the observation, made by the Princeton economists WJ Baumol and WG Bowen in 1965, that because there is no way of reducing the number of musicians in a string quartet, their output per hour is fixed; their productivity cannot increase. A new technology might enable a factory worker to make thousands more items per day, but no equivalent exists to allow a GP to add thousands more ten-minute appointments to their day. This means that as wages rise, the services they provide become relatively more expensive. This is why you can buy an enormous TV made with exotic minerals from around the world for less than £300, but a university degree that can be completed using a handful of nearby people and some books costs £50,000.

As Johnson makes clear, because simply charging people more (or indeed anything) to use the NHS is a political taboo, we will have to find more money for it. Also taboo is the “triple lock” on the £11bn-a-year state pension, which means retirees, unlike nurses, will get a 10.1 per cent pay rise this April, in line with inflation. In a country in which one in four pensioners have a household wealth over a million pounds, this is a huge and growing expense, but it is one that no government wants to confront.

Johnson admits that he is, as “an unelected nerd”, free to express sensible ideas about the economy without ever needing to get them past the electorate, but throughout the British state – in social care, education, health, local government – he finds political expediency reliably takes the place of economic sense. “This is how our state develops,” he writes: “unplanned, huge, almost constitutional change as a panicked response to soon-forgotten newspaper headlines.”

[See also: The Tories’ tax delusion]

One way to raise more money would be for HMRC actually to enforce tax law and collect all the outstanding tax owed to it, which currently stands at £42bn, according to the Commons Public Accounts Committee. But as the anonymous “Rebel Accountant” explains in Taxtopia, there exists a well-paid and intelligent industry devoted to ensuring that doesn’t happen.

Where Johnson offers a somewhat Olympian view of the British economy, this is a cheerfully blunt, autobiographical account of a career in the tax avoidance industry, replete with the loopholes that can easily be found in the tens of thousands of pages of the UK tax code. Among its revelations is that one of the UK’s biggest benefits claimants is James Bond, who – as well as being a violent misogynist – has taken £122m in film tax relief since 2007. If Bond could drive a car without causing it to explode, he’d also benefit from the lack of capital gains tax on selling one, which may be why so many wealthy, tedious men collect classic cars.

In a few cases, these loopholes have created the means for workers to recoup some of their pay, most notably HGV drivers, who often set up companies to reduce their tax bills. That was until 2021, when the government brought in stricter enforcement of the IR35 rules on these practices – at which point tens of thousands of drivers either decided they weren’t going to sleep in lay-bys for less money, or that they’d do so in the better-appointed lay-bys of France and Germany.

For the most part, however, the option to not pay tax is reserved for the very rich. Chief among these are the 68,000 people in the UK who have “non-domiciled” status, an arrangement which allows a group equivalent in size to the population of Bognor Regis to avoid paying £3.2bn a year in tax.

Ideas for reforming the tax system often fail because they are written by the Rebel Accountant’s former colleagues and executed by politicians like the former chancellors Rishi Sunak (whose wife, a centimillionaire, was until April 2022 a non-dom) or Nadhim Zahawi (who last year paid a reported £4.8m, including a £1m penalty for “careless” use of an offshore company to reduce his tax bill). Asking these kinds of people to design the tax system is like asking the foxes to draw up blueprints for the henhouse. They get away with doing so partly because there’s a blithe assumption that tax is dull and hard to understand. As these books show, this has been a very expensive mistake.

Follow the Money: How Much Does Britain Cost?
Paul Johnson
Abacus, 320pp, £25

The Rebel Accountant
Octopus, 368pp, £20

Purchasing a book may earn the NS a commission from, who support independent bookshops

Read more:

A low-tax Labour Party would destroy the Conservatives

Rishi Sunak will further alienate his MPs with his taxation “idiots” comments

Why have the BBC and Labour Party learned Tuftonspeak?

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This article appears in the 08 Mar 2023 issue of the New Statesman, Why universities are making us stupid