Overdue tax reform in Britain for the common good | Laura Sánchez Pérez
A framework for the future reforming of the UK tax system
Even before the coronavirus struck in the early months of 2020, the British economy had noticeable weakness, and faced difficult headwinds. Average GDP growth per capita averaged just 1.1 percent a year in the 2010s, compared with 2.5 percent in the 1980s and 1.9 percent in the 1990s. What growth there was rested largely on more hours being worked across the economy as a whole, with productivity growing at just 0.3 percent a year across the decade.
More importantly, average wages remain lower in real terms than they were before the financial crisis, and business investment has continued to disappoint. Indeed, the Office for National Statistics estimates that from 1995 to 2015, the UK had the lowest average business investment of any OECD nation. More recently, political uncertainty– not least around Brexit– has had a chilling effect on Britain’s growth prospects.
While the UK’s departure from the European Union certainly presents a lot of opportunities, crucially there are economic challenges to overcome as well. In short, UK policymakers had a difficult enough task before the global pandemic; today, raising Britain’s trend growth rate looks all the more difficult.
It is vital, however, that we should not take lacklustre growth as a given– as something to be put up with and adapted to without an ability to fundamentally affect. On the contrary: all nations have tools at their disposal that can increase economic growth. These might of course involve controversial policy choices and difficult political trade-offs, but at the very least, they are there, if only governments are bold enough to grasp them.
Tax reform is one of the main levers that the government can pull in its quest to boost the economy in the long run. Improving a country’s tax system can attract business and investment, can encourage entrepreneurship and work, and can eliminate deadweight costs that hold back growth. Tax reform is not the only thing that matters, of course, but it is one of the most important and consequential things that the government has directly under its control.
Naturally, overhauling the tax system is not a straightforward task. We need to identify the parts of the tax system that merit the greatest attention. We need to decide which reforms will do the most to encourage growth. And we need to work out how tax reform can be implemented when significant cuts to the overall tax burden look unlikely, if not impossible. These are all difficult issues. Addressing them is the primary purpose of this article.
A pro-growth approach to tax policy
So what does a pro-growth tax system look like? Fundamentally, there are three distinct ways to answer that question. The first is to look at marginal tax rates. All things being equal, lower marginal tax rates are better for economic growth than higher ones, because they do less to discourage economic activity. Put simply, generally, the less you tax something, the more of it you tend to get, and vice versa. Marginal tax rates are also an important determinant of a country’s tax competitiveness– of how attractive it is to businesses and investors relative to other countries. In today’s globalised world (notwithstanding the impact of COVID-19), capital is highly mobile, and businesses can choose to invest in any number of countries to maximise their after-tax rate of return.
If marginal tax rates are too high in the UK compared to other developed economies, investment is likely to go elsewhere, and economic growth is likely to suffer. This will have a detrimental effect on society. After all, investment brings employment opportunities and with that, economic growth for households up and down the country. In turn, in addition to making our people more prosperous, this can aide their self-actualisation, as they would master new professional and personal skills in the workplace and develop a sense of responsibility for the products they produce or the services they offer.
Although it is somewhat a truism, more responsible and satisfied individuals are less likely to commit crimes and undermine our social order. Indeed, empirical criminology has repeatedly confirmed the presence of an inverse correlation between employment and crime.
Whilst Brexit will present opportunities, the UK’s economy had been in trouble for decades. The COVID-19 crisis will exacerbate things greatly. The need for serious tax reform is immanent.
Another way to approach pro-growth tax reform is to focus on neutrality—on the extent to which the tax system lets businesses and individuals make decisions based on their economic merits, rather than for fiscal reasons. Absolute neutrality might not be a practical objective: all taxes affect behaviour to some degree, and sometimes that is actually the point (as with an environmental tax designed to discourage pollution).
Nevertheless, a tax system should arguably not distort the way people choose to work, save, or spend. The economy will do better, and consumer welfare will be higher, when investors see fewer arbitrary barriers to entry and when the government does not undermine confidence in the future of the economy by unnecessary market intervention.
In practice, neutrality often means combining lower tax rates with broader tax bases. Taxes should apply as equally as possible across the economy, without targeted tax breaks (or special tax regimes) for particular products, sectors, or groups of individuals. There is an important qualification here though: in a few cases, a broader tax base can actually cause economically damaging distortions of its own. For example, a corporation tax base that does not allow the deduction of investment costs creates a bias against capital-intensive industries. This is because there are many downsides to debt financing— highly leveraged firms, meaning the ones using borrowed capital for an investment, are more vulnerable and face bankruptcy costs, agency costs may lead to an increased use of debt, and debt issuance and dividend policy have signalling effects.
Corporate tax systems balance this scale by favouring debt-financing through the tax-deductibility of interest payments. When this is taken into account, the value of the leveraged firm increases as compared to an unleveraged one by the tax shield value of debt, equaling the amount of debt times the corporate tax rate.
Similarly, a personal income tax that does not distinguish between ordinary earnings and investment income is likely to be biased against savings. In other words, “broaden the base, lower the rate” is a useful rule of thumb, but is not an iron-clad guide to a neutral, pro-growth tax system.
The third way of approaching pro-growth tax reform is by looking at the balance among different sources of revenue, as some taxes are much worse for growth than others. A pro-growth tax system would seek to maximise revenue from the least distortional taxes, while minimising reliance on the most harmful ones. For example, widely cited research by the OECD suggests that corporate income taxes are the most damaging type of tax in terms of GDP per capita, followed by taxes on personal income. In the US, where corporate taxes were highly uncompetitive compared to most countries, after the corporate tax rate dropped from 35% to 21% in 2018 with Donald Trump’s Tax Cuts and Jobs Act (TCJA) United States multinational enterprises have repatriated $1 trillion in past overseas earnings that were previously invested abroad.
On the other hand, recurrent taxes on immovable property tend to be the least economically damaging source of revenue, followed by consumption taxes and other forms of property tax.
However, other studies, this one by the Australian Treasury, suggests that a particular type of property tax– “stamp duty on conveyances”– is considerably more harmful than corporation tax (its other findings are very much in line with those of the OECD). Moreover, it is quite possible to design income taxes so that they function a lot like consumption taxes– Estonia offers one real-world example.
Nevertheless, shifting the tax burden away from corporate and personal income taxes and towards well-designed property and consumption taxes will make the tax system more supportive of economic growth and cultivate more reasonable consumption habits for society. Put this together with competitive marginal tax rates and a neutral tax structure and you have a good recipe for a programme of pro-growth tax reform.
Economic situation
The UK economy is forecast to contract by as much as 14 percent due to the COVID-19 crisis.
Capital investment has been a declining contributor to GDP growth in recent years.
To overcome headwinds from COVID-19 and Brexit, the UK must work to build and maintain an internationally competitive tax system.
Competitiveness and sources of revenue
Overall, the UK ranks 22nd out of 36 OECD countries on the 2020 International Tax Competitiveness Index.
Nearly half of UK tax revenue is raised from individual income taxes and national insurance contributions.
Tax revenues have fallen significantly due to COVID-19, with VAT receipts falling the most.
Summary of UK tax reform solutions
Individual income taxes
Taxes on individual income from wages and dividends should be reformed to minimise complexity and double taxation. Current individual taxes are embedded with high effective marginal tax rates due to the introduction and withdrawal of various reliefs that make it difficult for individuals who are moving up the earnings ladder to realise the benefits of higher wages.
Property taxes
A property tax can be a simple and efficient way for a government to raise revenue. The UK, however, relies on property and transaction taxes, which distort markets and create double taxation. By shifting toward taxing the value of land and removing transaction taxes, the UK property tax system can move toward efficiency.
Consumption taxes
The UK’s Value-Added Tax (VAT) is a critical source of revenue, but it underperforms relative to VAT systems in other countries. The VAT has carved outs for large swaths of consumption; this undercuts potential revenues and is an extremely inefficient way of addressing concerns about regressivity. Our VAT, however, might be an exception. That it is simultaneously one of the least damaging taxes– especially when coupled with the price elasticity of most retailers, coupled with a need to reduce the excesses of consumption for environmental reasons, broadening the VAT base would generate revenue to reform other parts of the tax system, without a necessary need to lower it.
Corporation tax
Though the corporation tax rate is quite competitive among other developed countries, the UK has a corporate tax base that is ripe for reform. The UK should work to eliminate biases against investment, reinforce countercyclical policies, and evaluate targeted tax reliefs that can introduce a variety of distortions in behaviour and economic activity.
International tax rules
The UK international tax system is broadly competitive given its territorial nature and the UK’s broad network of tax treaties, the broadest among OECD countries. However, the government’s approach on the Digital Services Tax (DST) runs counter to global cooperation on efforts to reform international tax rules. The UK risks being part of a harmful tax and trade war with the DST as part of its efforts to raise tax from foreign multinationals. Narrow policies are ripe for distortions and the DST introduces several by both selectively taxing certain business models and basing the tax on gross revenues rather than profits.
Conclusion
The goal of this article has been twofold: first, to assess the competitiveness of Britain’s tax system versus those of other OECD countries; and second, to develop a series of reform proposals that would make the UK tax system significantly more pro-growth without putting a dent in government revenues. On the first point, despite its tax system having some appealing features—like a low corporation tax rate and a wide network of international tax treaties—the UK finishes only 22nd out of 36 OECD countries on the latest edition of the International Tax Competitiveness Index. Particular weaknesses include a strong bias against capital investment, which is apparent in the structure of both corporation tax and business rates; relatively high top rates of tax on earnings and dividends; and a property tax system that is both burdensome and highly distortional.
The reform proposals follow naturally from this comparative analysis and are designed to address the flaws in Britain’s tax system—the rates and rules that diminish its economic growth prospects– head-on. On corporation tax, moving towards “full expensing” of capital investment. On personal income taxes, flatter tax structure that fully reflects taxes already paid at the corporate level. And on property taxes, changing the business rates tax base and abolishing taxes on transactions. This is by no means a fix for every problem in the British tax system, but the focus has been on competitiveness, and the goal is to target reforms that will have the biggest impact on Britain’s relative standing, and on its future growth potential.
Inevitably, though, competitiveness-boosting reform will involve some tax cuts that reduce government revenue, at least in the short and medium term. How, then, to balance the books without undermining the pro-growth nature of our tax reform package as a whole? We are under no illusions about the political popularity of our main revenue-raising suggestion, yet any worthwhile policy agenda must involve tradeoffs, and if a modest extension of the VAT base can fund pro-growth tax reform and policies to protect the low-paid, then it is surely something that should be considered. It is also striking that those tax increases, such as raising corporation tax or capital gains tax, which polls suggest are more palatable to the public (and therefore to politicians), are also among the most damaging to long-term growth.
Ultimately, if there’s one message that policymakers should take from this report, it’s that the UK cannot afford to take its tax competitiveness for granted. Britain needs real economic growth, and it needs it badly. But short-term stimulus is not the answer– we need growth that is broad-based, sustainable, and based on better long-term economic fundamentals. Tax reform is no silver bullet, but it is an essential part of turning that need into reality. The proposals outlined in this article would—if enacted—leave the UK with one of the 10 most competitive and pro-growth tax systems in the developed world. That may not be the answer to all of Britain’s problems. But it would be a very good start.
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