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9 May 2005

A giant headache for the next four years

Election: the future - tax. Tax is such a political hot potato that no party wanted to touch on t

By Robert Chote

If our newly victorious representatives think they will have no more need of the Nurofen once they have got rid of their post-election hangovers, they are wrong. For Treasury ministers in particular, Britain’s tax system will present a giant headache over the next four years. The public sector now absorbs more than 40 per cent of national income and will do so for the foreseeable future. At the same time, globalisation increasingly threatens the nation state’s tax-raising ability.

The most substantial tax debate in the election concerned council tax, which is set to raise £21bn this year. Labour promised to retain (but reform) it after an inquiry into local government funding reports later this year. The Liberal Democrats proposed replacing it with a local income tax. The Conservatives promised to abandon the revaluation that would link council tax bills to house prices in 2005, rather than 1991. But what about the key issue: is it desirable to raise revenue from taxes on property (the biggest part of most households’ wealth) rather than on income or spending? The Liberal Democrats think income is the best measure of a household’s ability to pay and the contribution it should make to local services. Yet it can be argued that wealth confers advantages above and beyond the income it generates, and we do not, in any event, tax the income that homeowners receive implicitly by living rent-free.

The Treasury claimed recently that housing is “undertaxed”. This may be true when one views housing in comparison to consumer goods, such as cars. But it is harder to make the case that it is undertaxed compared to other investments. Council tax is only one of five main taxes on housing, alongside stamp duty (which the parties have been competing to reduce), capital gains tax (where the house is not used as the owner’s main residence), inheritance tax and VAT on repairs.

If the government did want to raise more money from housing – or to replace the council tax without introducing a full local income tax – it could look at a Danish-style annual property wealth tax. In Denmark, this is charged at 1 per cent of the market value of most properties; pensioners are allowed to defer payment and have the money taken from their estates when they die. The trouble is that such proposals, like council tax revaluation or a move to local income tax, create significant numbers of losers as well as winners. As the Liberal Democrats discovered during the campaign, this can be a tough sell.

A second question facing the new government has to do with business taxes. As widely reported during the election campaign, the Institute for Fiscal Studies believes that, in four years’ time, the Treasury’s revenues will be about £9bn below its plans. This “black hole”, as the press and opposition parties called it, can be explained mainly by slower growth in tax revenues from company profits.

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The difficulty here is not just the likely strength of revenues from City firms, but also, and more fundamentally, the very ability of nation states to continue taxing profits. Increasingly, companies operate in many different countries. The rules about where their profits should be taxed are complex, and governments now compete to offer the most favourable tax regimes.

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Corporation tax is due to raise £44bn in Britain this year. Until recently, at 30 per cent, our headline corporation tax rate was below the EU average. But nine of the ten countries newly admitted have even lower rates and, as a result, the UK is now almost 4 percentage points above average. Austria has cut its rate in response and the German government proposes to do so, too. At the same time, multinationals have been increasingly successful at the European Court of Justice in challenging national tax rules that fav-our domestic firms.

So, higher taxes on business are not a promising source of extra revenue – if anything, the government will have to collect less from them and more elsewhere. That would not necessarily be socially regressive. Remember that firms are legal fictions and that all taxes are eventually borne by individuals. In a world of open capital markets, the main effect of taxes on corporate income is to drive investment away, depressing labour productivity and wages. Employees are thus taxed indirectly, while investors take their money elsewhere in the global capital market and continue to earn the going rate of return.

But the great advantage of taxes on companies is that most voters think somebody else is paying them. It would take a brave government to write them off as a lost cause. Likewise, National Insurance has persisted long past its useful life, because voters like the idea of a contributory scheme. Yet it would be far more efficient to merge National Insurance with income tax, given that both are treated alike by the Treasury as sources of revenue. If we move towards a “citizen’s pension”, to which all residents would be entitled regardless of their “contributions”, the justification for National Insurance will become even more threadbare.

In the same way that Gordon Brown looked to the US for inspiration for his tax credits in 1997, the most ambitious reformers now look to eastern Europe, where countries are increasingly adopting “flat taxes”. In recent years, most industrial countries have reduced the number of different tax rates they impose. Flat taxers favour a single rate, sweeping away most reliefs and allowances to keep it as low as possible. Russia and Ukraine, for example, both have a single 13 per cent rate (instead of our rates ranging from 10 to 40 per cent). One tax-free allowance for everybody ensures a degree of progression because it leaves the poorest people out of tax altogether and so increases the average rate as incomes rise.

Simplifying the tax system minimises the incentive for people to spend time arranging their affairs to reduce their tax bills when they could be doing something more useful. Put another way, it stops us all wasting so much money on accountants. But over the past eight years the government has been happy to complicate the tax system to influence (or distort, if you prefer) people’s behaviour – for example, to encourage research and development.

Some distortions are more defensible than others. Even if it were agreed to get rid of them all, however, attempts to rewrite the tax system on the back of a postage stamp are doomed to fail. We all think we know what income is – but it’s hard to nail down legally. As the economist Dennis Robertson once observed: “The gaols and workhouses of the world are full of people who gave up as a bad job the admittedly difficult task of distinguishing capital from income.”

There are plenty of other issues facing the British tax system over the next four years: the scope for taxing environmental “bads”, for example, or the question of whether we want a tax and tax credit system that treats people consistently either as individuals or as members of households.

During the past two parliaments, Gordon Brown has imposed a clear vision on monetary and fiscal policy management, but not on tax policy. He is, after all, an accomplished politician and he knows that losers are always more angry and vocal than winners are grateful. And some time over the next four years, he wants to achieve his ambition to become prime minister.

Robert Chote is director of the Institute for Fiscal Studies