Tax Policy: Breaking the Impasse

We have an extra bonus guest post this week from a very special guest.

We’re welcoming a third Freedman to Comment is Freed: Professor Judith Freedman, Emeritus Professor of Taxation Law and Policy at Oxford University, and also my Mum.

As well as her time at Oxford, where she was the first woman to be a statutory professor in the law faculty, she has held numerous roles in the tax policy world, including editing the British Tax Review, which she still does, and being a member of the IFS Council. She has advised the Treasury and HMRC over many years on tax avoidance and was also on the Board of the Office of Tax Simplifcation.

Professor Freedman / Mum has written for us on the challenges of making tax policy well given the politics, using October’s budget, and the various rows that have arisen since, as a case study.

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In the UK (and we are not unique), circumstances have combined to make sensible tax reform a near impossibility. All attempts at change, however small, and however sensible, meet with outrage from the losers and their cheerleaders. During elections and, it appears, even when no election is pending, politicians fall into the trap of making promises that prevent rational developments. Opinion polls and protests take the place of debate and analysis. Research results and statistics are available but are not used as part of a holistic, cross government review and the consequences of tax change for other parts of the tax system and different areas of public policy, and vice versa, are often not properly considered.

Sam has written recently about the “deepening dichotomy between politics and policy” and tax is an excellent example. Tax design has always faced this problem, so much so that political possibility has been built into the test of doing it well. Adam Smith’s canons of taxation in the 18^th century are as much concerned with reducing resistance to taxation as they are with equity.¹ And in the 17^th century, Jean-Baptiste Colbert commented on the need to pluck “the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”.

The problem has worsened as the objectives of taxation have become more diffuse, with commentators on every problem, from equality to climate change, turning to tax as a potential solution. In trying to perform these functions, in addition to raising revenue and helping to manage the economy, the tax system has become complex to the point of incomprehensibility.

Stories of large businesses and the wealthy avoiding tax abound, reducing tax morale (the willingness of the general population to pay taxes). Voluntary tax compliance is also undermined by the digitalization of taxpaying, with a deliberate policy being pursued to cut costs by making it difficult to contact HMRC officials in person. The vast majority of taxpayers have no need to contact HMRC because they pay all their tax by deduction at source, largely through the PAYE system.

But this very PAYE system, in which the UK tax authorities take great pride, distances people from an understanding taxation and tax policy. It means they can be taken unawares, as we have seen, for example, in the case of those caught out by the Higher Income Child Benefit Charge because they did not realize they had crossed the threshold for claiming untaxed child benefit.

This piece discusses how we might resolve the conflict between the need for structural reforms to the UK tax system and resistance to all change. It will require political will, knowledge, proper use of research and consultation (not just focus groups and opinion polls) and institutional change.

We made some steps towards a new institutional approach with the unfortunately named Office of Tax Simplification (OTS), but since its abolition by then Chancellor Kwarteng we have gone backwards. It is time to replace the OTS with a more robust tax policy office, not one that will dictate tax policy to politicians - this is impossible - but to be a resource for them when they are making decisions about the tax system or any other matter that can unintentionally impact on or be affected by taxation.

Can we separate tax policy from politics?

This is not a plea for a technocratic approach to tax policy. As Peter Riddell has commented, “….tax decisions cannot be taken out of politics. They are the stuff of the party battle.”

He was responding to a suggestion that there should be “a body to oversee the public finances’ directly accountable both to Parliament and the executive.” This he called naïve. We do now have the Office of Budget Responsibility (OBR), established in 2010 shortly after Riddell wrote this piece, but it does not have responsibility for fiscal policy or put forward alternative policies.

Some commentators are now calling for a Royal Commission on Taxation to put forward tax policy proposals. Simon French writing in The Times comments that:

“The advantage of a royal commission is that it elevates smart, evidence-based policy design above the cut and thrust of daily politics.”

Sadly, this suggestion is naïve. Quite obviously, tax is not a purely technical issue, as the post Autumn 2024 Budget discussion around VAT on school fees, the removal of an accidental Inheritance tax relief from pension funds, the imposition of additional national insurance costs on employment and the reduction of business and agricultural property reliefs has made very clear. Whatever learned arguments and models we academics and commentators come up with, we cannot ignore the political issues or the practicalities. The losers from any change will propel the tax changes that affect them to the centre of daily politics, as we have seen so vividly recently, with tractors rolling into Westminster.

We do not need a Royal Commission. Any attempt to set one up would quickly descend into a row about who should be a member. Technical tax experts can produce and process data but any analysis will need consideration of a wide range of issues and recommendations would require value judgements, so that a one-off set of recommendations would need to involve judgements going beyond technical expertise. Even if such a body were to produce proposals that were widely accepted, there’s little reason to think future governments would commit to following its recommendations.²

There are plenty of experts in think tanks and lobby groups who can analyse data and put forward ideas for reform. It is the weighing, balancing and explaining those ideas, bringing people along with them and translating them into practice that is lacking. For that we require politicians who are either interested in tax reform as an idea or prepared to be advised by those who are. But this cannot be a quick exercise. It requires long-term thinking and that can only be provided by having a bank of knowledge and understanding upon which to draw. That requires an ongoing advisory group or office and not a one-off commission.

The 2024 Autumn Budget: a case study

The process

The failure of the 2024 October Budget shows starkly why we need to change our approach. In the attempt to be politically acceptable (which does not appear to have been a great success), the Budget failed to be coherent. This was a Budget at the start of a full term, with a strong majority. We could not have expected a complete tax reform blueprint, but we might have thought we would get some broad consultations and a sense of direction. Instead, most of the Budget changes will do little to fill the ‘fiscal hole’ of which we have heard so much, nor will they improve our broken, over complex and illogical tax system.

Most disappointingly, the process revealed little interest in tax reform. The obsession with filling the ‘fiscal hole’ and the over-simplistic process of purporting to match every new expenditure proposed with a specific source of revenue to cover it, has resulted in an unhelpful list based approach, with expenditures on one side of the sheet and estimated revenues on the other. These numbers lend a spurious precision to the debate that cannot possibly be sustained.

For example, the idea that charging VAT on private school fees will be matched by the ability to recruit a particular number of teachers will be challenged if the amount raised does not cover the costs of recruitment. Yet there was never any suggestion that the additional tax raised would be hypothecated to pay for teachers. The debates about how much this policy will raise have been a distraction from the policy question of how the VAT system should be designed. Imposing VAT and business rates on private schools needs to be supported on the basis of policy - broadening the tax base and distributional issues - not by virtue of an artificial pairing of revenues and expenditures and a mathematical calculation that is a hostage to fortune.

The media and commentators are not without blame here - politicians are forced to explain exactly how they would raise the revenues needed to do action X and so say they’ll raise tax on Y. Somehow, then X and Y became associated although there was no reason why the one should be linked to the other. We end up with a series of changes designed to fill in gaps of particular sizes rather than looking at the whole picture.

This is not how the tax debate should proceed, nor how tax reform should happen. If we had a better debate initially, bringing in wider considerations, maybe politicians would not get drawn so easily into this ridiculous exchange.

Increasing the cost of employment: bad politics and bad policy

The most rational moves in the 2024 Budget - moving away from the non-dom regime and increasing capital gains tax by a small amount were, noticeably, ones that had been discussed at length previously and in the case of the domicile regime, where detailed preparatory work had been done by HMT and HMRC.

However, the only Autumn 2024 tax proposal that will go a substantial way towards meeting the need for revenue is the increase in employers’ national insurance contributions (NICs). Even if we accept the need to raise significant sums and to find a way out of the straightjacket into which the Chancellor had tied herself with pre-election promises, this was still one of the worst changes to the large revenue raising taxes that could have made.

It does not take an economist to work out that the owners of businesses are unlikely to absorb the whole additional cost of higher employer NICS. Owners require a certain return on their investment, come what may. The increase is a cost that has to be paid for and at least some of it will have to hit consumers and employees in some way.

This increase backtracks on one of the few positive structural steps the previous government had taken in tax reform: trying to reduce national insurance costs. Calling taxation ‘national insurance contributions’ has long been a way in which governments try to mask the true level of taxation on work. There is only the most tenuous link between the amount paid in NICs and the amount of benefit to which any individual is entitled in benefits, including the state pension. The NHS is largely funded by general taxation. Sunak and Hunt did appear to appreciate this (even if their timing and lack of any compensating changes meant that his cuts were unaffordable).

The way in which the increase was constructed exacerbates the problem. Only £11.8bn of the £29.5bn raised by the policy comes from raising the employers’ rate from 13.8% to 15% (on static costing – e.g. before behavioural impacts are taken into account). The bulk of the money comes from a reduction in the threshold at which the employer must start paying contributions for an employee to £96 per week from £175 per week. This means that the rate of NICs is not increased as much as it would otherwise be but it does impact contributions for low paid workers more than the higher paid.

When all the other adjustments and behavioural changes are taken into account the OBR reckons that the amount actually going into Treasury coffers will be only £16.1 billion. And that is before the extra payments needed from the Government to the public sector and to GPs, hospices, care homes and charities to compensate for the higher cost of employment where this cannot be passed on to customers and employees so easily.

This brings to mind Adam Smith’s fourth canon of taxation

‘Every tax ought to be so contrived as to take out of the pockets of the people as little as possible, over and above that which it brings into the public treasury of the state.’

It doesn’t seem very efficient.

The decision to raise revenue in this way is strange, not only due to this economic inefficiency, but also because of its distributional impact and its direct clash with the Government’s objectives for encouraging those now economically inactive back into work. This threshold change plus the rate rise increases the cost of employing the lowest paid and part-time workers more than it does for average and higher earners.

The pre-Budget threshold was high and there might have been scope for some reduction over time, but to do this so rapidly when also increasing the minimum wage is a real deterrent to the maintenance or increase in part-time work at the lower end of the pay scale, such as hospitality and care workers.

Until April 2025 a part-time employee on minimum wage can work 15 hours per week before NICs kick in whereas after April 2025 it will be just 8 hours. This decreases the incentive to create low paid jobs, while maintaining the permanent full expensing rules for investment in plant and machinery, thus favouring mechanization, such as self-serve tills over staff on supermarket tills. Perhaps this is a deliberate policy to reduce unattractive work and increase efficiency and productivity, but this is probably to give credit for more thought than actually went into this change. It is more likely that the politicians, advised by HMT, saw an untaxed pot and decided to tax it without fully thinking through the consequences.

Getting those who are economically inactive through ill health or because of caring responsibilities back into work requires part-time work and many starter jobs and apprenticeships will be at the lower end of the pay scale. These workers will not see an immediate change to their pay packets because they are on minimum wage in any event, but the availability of the kind of jobs they seek may well decrease.

Adding to this pressure will be the Employment Rights Bill, which seeks to protect employment rights and to regulate the use of zero hours contracts. This is based on the governments strongly held views on labour law, and protecting exploited workers is commendable, but the thinking has not been joined up with these Budget changes or indeed tax law generally. This flagship legislation may be undermined by making employment even more expensive versus alternative forms of labour supplies. All the incentives work together to provide strong reasons for business to avoid taking on employees and use other forms of services where they can.

Employee NICs already create an unwarranted difference in tax levels between employment on the one hand and self-employment or work through a personal service company on the other. At a time when the government is attempting to encourage employment and make it more secure, why would they undermine this policy by further increasing the additional cost of employment over and above using the services of free-lance or gig workers? (A point well made by Sarah O’Connor in the FT). The self-employed do not pay employers NICs at all and those who provide their work through companies will not do so if they are able to pay themselves via dividends.

Those caught by the provisions known as IR35, which effectively deems them to be an employee, already a disgruntled group, are not able to escape employers NICs through incorporation and are complaining vociferously that this will put them at a disadvantage as they may be tied into contracts priced on the basis of lower employer NICs than they now have to pay. In due course, their prices will need to rise to reflect the higher NICs or they will have to take a pay cut, in a reflection of what will happen to all employment.

Others not affected by the employer NICs increase are high earning partners in professional firms such as law and accounting firms, since they are not employees, although why their earnings should be left untouched while those of the lowest paid suffer an increased levy is very hard to fathom. Of course this outcome would have been completely avoided by increasing income tax instead of NICs, but this was not considered to be a political possibility. The result is counter to any sensible policy and, although the route chosen was designed to save face for the government in the short term it is also, in the long run, bad politics.

Using political capital for little revenue

Other than the NICs increases most of the other 2024 Budget changes are small in terms of the revenue raised and relate to very limited areas of the tax system. Some of the ideas, especially those to limit or remove inheritance tax reliefs for a particular group, such as farmers and owners of AIM shares and other business assets and those who have invested through their pension pots, are consistent with good economic theory, but they needed to be linked to wider reviews of inheritance tax and considered in context.

Data is important but cannot tell the full story. If a relief has been in existence for several years, whether a good relief or not, people will have relied upon it and need time to adjust. Reliance on agricultural property relief (APR) and business property relief (BPR) , for example, has meant that farmers have not done the tax planning they might otherwise have done and has impacted on property values in ways we still may not fully understand, all creating a confusing situation which scares those involved and makes them feel they have been unfairly done by.

Being told to take planning advice is rubbing salt into the wound if it is too late for some. And the over simplistic comments and advice of politicians may mislead - for example the widely cited £3 million figure before inheritance tax is payable in a farm is one that suggests those referring to it do not fully understand the complexities of inheritance tax works. More importantly, why should farmers, or anyone else for that matter, have to engage in complicated tax planning, and be lucky to live long enough, to end up with the result the government apparently wishes for them? Tax law should achieve the result intended without any need for such planning and chance.

Similarly the imposition of inheritance tax on certain pension pots that were exempt by dint of change of pension law on annuities in 2015 makes sense. The exemption arose because of lack of joined up thinking when changes were made on annuities and the pension industry seized their opportunity. There is no reason whatsoever why already highly tax favoured pension savings should not form part of a person’s estate for inheritance tax purposes.

But people were led into thinking this was a reasonable tax planning route through marketing by financial advisers and government inaction. Sudden removal is bound to lead to complaints and there are technical problems that have not been thought through. That there is not more fuss about this change is probably only because greater changes were feared and many people have not yet realised what it means to them. The estimate of revenue that will be raised by this pension change is three times that that will be raised by the reduction of both APR and BPR combined.

These changes can be justified as a matter of principle, but taken on their own are they worth the degree of pain and lack of trust they are causing? Would it not have been better to have saved them up as part of a more significant package of inheritance tax reforms? The answer from the government will be that they were needed now to fill that fiscal hole but it’s a very small amount of revenue compared to the scale of UK finances as a whole. The changes to IHT on pension wealth account for £1.5 billion by 2029-30, with another £0.5 billion from the changes to APR and BPR. This makes for a big political hit for very small gain.

Where do we go from here?

We seem doomed to continue this cycle of promises and damaging tinkering with the tax system unless steps are taken to extricate ourselves. For this we need an Office of Tax Policy, independent of the Treasury and politicians, along the lines of the Office of Budget Responsibility. It would have ongoing review and response capabilities but would not make policy, only collate options and costings. This would not be a commission making a set of proposals but a resource for government and the civil servants who advise them.

Why can’t HMT do this itself? First because it is part of government, answering to politicians and responding to their priorities. Also, HMT on its own is not enough - the work has to be cross departmental, including all relevant departments e.g. DEFRA in the case of the agricultural reliefs. Civil servants are subject to an array of pressures, both political and career based, and they move around from job to job so frequently that expertise and institutional memory are undermined. A body dedicated to examining tax issues and setting out options could consult at one remove from government and utilise a wider range of research and inputs.

Isn’t this what the Office of Tax Simplification was supposed to be doing? Sadly, the OTS was never given sufficient independence or resource to do undertake this task. As I noted when it was set up, the focus on simplification was too much of a limitation, since simplification cannot be a driver of policy, only a factor in its implementation. As the OTS gained a statutory basis, it quietly expanded its definition of simplification, and began to produce valuable reports, but this also signed its death warrant as ministers, civil servants, and tax professionals became wary of the role it might play and how it might interfere with their position. During its final review and on its abolition, the support shown for it was lukewarm at most. It had its hands tied behind its back and was then criticised for having insufficient impact.

A government with some vision about structural, long term reform of the tax system would not feel threatened by a body set up to help it develop policy options. Politicians who have been bruised by the Budget process might even be persuaded that it could help them to achieve their political objectives, not because it would be partisan but because it would not be.

1. ‘(i) The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities ... (ii) The tax which the individual is bound to pay ought to be certain and not arbitrary ... (iii) Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it. (iv) Every tax ought to be so contrived as to take out of the pockets of the people as little as possible, over and above that which it brings into the public treasury of the state’ taken from An Enquiry into the Nature and Causes of the Wealth of Nations, 1776. All the canons sound principles but all also nod to the need to carry taxpayers along with the endeavour of tax raising.

2. We have only to consider the fate of the Dilnot Commission on Social Care, commissioned by the Coalition Government, to see that widely admired expert commissions will not solve problems if there is no political willingness to implement them. Strangely, on setting up the Casey Commission on Social Care this month, Streeting, secretary of state for health and social care has commented that there is no lack of good ideas on how to address the social care crisis, but only a lack of good politics. I argue that on the contrary commissions can, if anything, provide the good ideas and that politicians will have to deal with the politics. While I hope that Louise Casey will be able to assist, in the end only the politicians can produce and implement solutions to the social care crisis. In the case of the even more multi-layered and broad issues raised by taxation, this is certainly true.