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  1. The Weekend Report
24 June 2023

Can Labour afford to be ambitious?

As the era of cheap money ends, the party needs to get radical on tax.

By Will Dunn

As the last Labour government left office in 2010, the chief secretary to the Treasury, Liam Byrne, dashed off a friendly note to his successor: “I’m afraid there is no money.” Five years later, he would write of how he “burned with shame” for what he assumed would be taken as a private joke, but was used by the Conservatives at every opportunity as an admission of socialist profligacy.

The worst thing about the note was that while it wasn’t true then – short-term government borrowing costs were roughly half what they are now, while the national debt was 65 per cent of GDP – the Conservatives have arguably made it true now. This week, Britain’s national debt exceeded 100 per cent of GDP for the first time since 1961. Government borrowing costs are higher than at any point since the 2008 financial crisis and, as Liz Truss demonstrated so dramatically last year, the investors who buy Britain’s debt will not finance unfunded commitments. After 13 years of Conservative rule, the UK’s economic headroom has been exhausted.

Labour is on the verge of a return to power next year, but it will inherit a far more troubled county than in 1997: Keir Starmer and Rachel Reeves promise five “missions” of high economic growth, a clean-energy revolution, an improved NHS, reduced crime and improved education, but one of the party’s signature pledges – to invest £28bn a year in green energy – has already been delayed. How will Labour pay for its policies?

The wealth question

In recent decades, Britain’s finances have changed in a fundamental way – in ways not reflected in the tax system. “Household wealth, as a fraction of national income, has doubled over the last 25 or 30 years,” explains Paul Johnson, the director of the Institute for Fiscal Studies (IFS) and the author of this year’s Follow the Money, a guide to the UK’s tax and spending. But while Britain’s income has increasingly come from ownership rather than work, he says, there has been “no corresponding increase in the amount of tax collected” on wealth.

It’s for this reason that discussion of Labour’s tax and spending options often focuses on the three major property taxes: capital gains, inheritance and council.

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The simplest of these is inheritance tax, for which a number of large loopholes exist. If you inherit a farm, or a large business, or certain kinds of shares, no tax is charged – which is why there’s a healthy business selling agricultural property to billionaires. A politically achievable move would simply be to close these loopholes. Dan Neidle, the founder of Tax Policy Associates, estimates that this would raise around £1bn, largely from the very wealthy. Inheritance remains the least popular tax, however, and the UK’s 40 per cent rate is already one of the highest in the world. But Labour might want to use the windfall from the super-rich to ease the burden on the middle class.

Much more complicated – but more useful – would be the reform of council tax, which Neidle calls “hilariously regressive”. In our outdated and inaccurate system – the bands are based on 1991 property values – the owner of a Mayfair mansion is charged a tiny fraction of the rate levied on a Newcastle new-build. Landlords pay nothing at all (they also, as we’ll see, pay no National Insurance on the rents they accrue). One of the most important changes Labour could make would be to introduce a fairer system in which the owner of a property pays tax on the real market value of their asset, and that money is then shared, using a Barnett formula-style system, across local government.

This would increase funding for cash-strapped councils and help to subdue the most overheated housing markets (because more expensive properties would be costlier to own). It would also be technically achievable – but it would begin a nationwide and possibly unwinnable battle over how the funds were distributed, as well as a fresh debate over the “mansion tax”. Some halfway measure – such as adding more bands with much higher rates to the current system – should be achievable, however.

The biggest revenue-raising change to these three taxes would be to charge capital gains tax (which is levied on money you make from selling assets, such as shares or a painting) at the same rate as income tax – as the late Conservative chancellor Nigel Lawson once did. Under current rules, if you sell a piece of expensive jewellery your taxable income would be subject to half as much tax than if you earned the same money driving a bus. (Capital gains tax is capped at 20 per cent for assets except residential property, and at 28 per cent for the latter.)

Estimates differ greatly, however, as to how much revenue this would actually generate. Arun Advani, an associate professor of economics at Warwick University, says it would raise £14bn-£16bn; Paul Johnson suggests a figure “in the small billions”. Predicting how much a new tax policy will raise is hard because it requires predicting the behaviour of millions of people – many of whom will take measures to reduce their tax liability.

Capital gains offers significant revenue and political advantage – it is, after all, the reason Rishi Sunak pays a lower rate of tax on his considerable investment income than many doctors do on their salaries – but Reeves has said she has “no plans” to increase it. When it seems like such an obvious win, why not? She may agree with Johnson on how much the move would actually raise, but she’s also said that such a policy would be a deterrent to growing and selling businesses – and therefore economic growth.

Taxing for growth

Liz Truss memorably told the Commons in one of her few Prime Minister’s Questions that “this country will not be able to tax its way to growth”, and that the UK would only attract investment if it kept corporation tax to a minimum. (Sunak’s government has since increased the rate from 19 per cent to 25 per cent.) Businesses disagree: what matters is being able to plan. Dan Neidle, who spent more than two decades as a corporate lawyer, explains that when a large company from the US or Asia looks to set up a European headquarters, “they look at everything: internet speed, schooling, culture, everything. And tax – they actually don’t care about tax rates very much, but tax uncertainty is a huge factor. Huge.”

One policy to which Neidle says foreign investors would give a “standing ovation” would simply be to set a rate of corporation tax and announce that it would remain unchanged for five years – or ten, if re-elected. Neidle says this would have “a major pro-growth impact… If you can’t plan, if you can’t model it, people don’t do it.”

One way in which tax does impede growth is in the various thresholds that kick in, not only on the incomes of workers but on businesses. Thousands of small businesses restrict their incomes below £85,000 to avoid the “cliff edge” of VAT exemption, which is removed after that point – and inflation is encouraging many more to similar limitations. Lowering this threshold – but using the proceeds to reduce VAT for everyone – would, says Neidle, give these businesses a reason to earn more.

As happens everywhere in the tax system, there are some people who don’t pay VAT. Private schools are a notable example: they enjoy an estimated £1.6bn tax break every year through their charitable status, which Labour has said it will remove (special needs schools would remain exempt). Whether this would actually raise £1.6bn is debatable, but the evidence from the private education market (in which rising fees have significantly outpaced inflation) is that parents can afford it. The UK’s public libraries currently receive less than £900m in public spending.

Private schools will be throatily defended by the right-wing press, but one tax change that would come, as Neidle observes, at “no political cost” is a change to the provisions for the UK’s 70,000 “non-domiciled” residents, a group that contains many well-off individuals (including, until last year, Akshata Murty, wife of Sunak). The current law means their income is only taxed when it is brought to the UK, which not only creates a loophole but opposes growth – in general, we’d prefer people to bring their money here. Advani says there is “a lot of money at stake” in how this small group is taxed; his research suggests around £3.6bn could be raised, even accounting for allowances and behavioural responses (some billionaires would leave but many, like Murty, would decide to stay). Again, this is a policy to which Labour has committed.

[See also: Andrew Bailey must go]

The taxes we pretend aren’t taxes

Remember when Jeremy Hunt stood up in the House of Commons in March and announced a 4p increase in the basic rate of income tax? No, because he didn’t – but he did announce that the thresholds for income tax would remain frozen, which is (according to the Office for Budget Responsibility) essentially the same thing. As millions of people’s pay rises, they will give over more tax at the higher 40p rate (known as “fiscal drag”), netting tens of billions for the Exchequer over the next parliament.

“Of all the ways to raise £30bn,” says Paul Johnson, this is “probably the most painless way of doing it, from a political point of view”. Given the sums involved it seems Labour will have little choice but to maintain this stealth tax. In a time of high and persistent inflation, however, it may start to bite, as earners close to the thresholds decide there’s little point seeking a promotion or a new job and choose to reduce their hours instead – with implications for growth and the labour market.

National Insurance is another part of income tax that it is politically expedient to pretend isn’t really a tax. The well-worn fiction is that a worker’s contributions go into a pot that later pays their state pension. But in reality National Insurance is just more income tax – but with loopholes. Until the 1980s, landlords and business owners paid an extra charge on “unearned income”, but this was removed and never replaced, so the people now benefiting from Britain’s rental crisis are effectively being subsidised to do so. Warwick’s Arun Advani says extending National Insurance to all unearned income could raise “almost £10bn”.

Again, this would be politically easier than raising income tax itself – prior to the Truss mini-Budget, the Tories had planned to raise National Insurance – but some workers, such as self-employed tradespeople, would lose out. It’s easy to imagine a Sun campaign against the “builder tax”. “You need to be showing that it’s fair,” says Neidle. “And actually, most people will win from the change.”

The Zahawi lesson

Nadhim Zahawi’s tenure as chancellor last summer was remarkable only for its brevity: 63 days. How he managed his personal finances has had a more lasting impact – there are often questions to be asked, and revenue to be found, in the tax affairs of the wealthy. Research conducted by Advani in 2018 showed that every additional £1 invested in HMRC would return up to six times its value in extra tax collected.

Neidle agrees there are significant sums to be caught: when commercial property is bought and sold, for example, it is the company owning the property that changes hands, a loophole that costs the UK £1bn a year. The big money, however, is in stopping the proliferation of “criminal, or quasi-criminal tax-avoidance schemes being sold to people on relatively modest incomes”, he says. With expanded penalties and new offences “it seems plausible that there’s several billion you could get from that”.

[See also: Rishi Sunak’s target to halve inflation is even worse than Tories think]

The hard truths

The most fundamental issue in funding the state is that if governments want public spending to account for 40 per cent of GDP, which it roughly does, they need to tax around 40 per cent of economic activity. The Covid-19 pandemic, and the inflationary period that has followed, have nullified the promise by successive governments of European-style public services and American-style taxes.

For Labour, if it wins, the challenge of simply keeping the state running will be very significant. Public-sector workers are already striking over pay. The cost of servicing the UK’s debt is rising, and other sources of income are falling: the transition to electric cars, for example, could leave a hole of more than £25bn in Britain’s finances as fuel duty disappears (and becomes a tax on people who can’t afford a new electric car). Universities are facing an influx of new students, while many schools are cutting back as pupil numbers decline; in both cases, demographic shifts will introduce new funding pressures.

Our ageing society means the demands of health and social care are growing much faster than the economy. Our dependency ratio – the number of workers supporting the number of retirees – has been kept low by the arrival of younger immigrants and changes to the state pension age, but in the years to come it will become a more pressing issue. The borrowing opportunity that was afforded to the Conservatives by low rates and quantitative easing – electronically created money used to buy governments bonds – has disappeared.

At the same time, the Biden administration has shown, through its Inflation Reduction Act which includes $375bn of subsidies for green industries, that both the public and the bond markets can be convinced to support investment if it supports growth. It may be that the sheer level of waste in the system – the £29.3bn burned on the Test and Trace programme, tens of billions lost to useless Ministry of Defence contracts – is Labour’s greatest opportunity. Borrowing may no longer be cheap, but competence is priceless.

[See also: The housing crash will be different this time]

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