Sunday, February 12, 2023
There's no room for tax cuts, but plenty for tax reform
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

It is Sunday, so the Tory party is probably obsessing about tax, as it is every other day of the week. On a distant horizon there is a Shangri-La of low taxes and energising tax cuts, last visited, all too briefly, under Margaret Thatcher in the 1980s. One of her successors, if that is not too strong a word, has popped up again in recent days, when it might have been wiser to keep quiet, Liz Truss again making the case for unfunded tax cuts, despite everything that happened last autumn.

Another, Boris Johnson, rarely misses an opportunity to slip in a call for tax cuts, and thus increase the pressure on Rishi Sunak, and Jeremy Hunt, the chancellor, as he prepares for his March 15 budget.

One of the most damaging bits of economic analysis when it gets into the wrong hands is, as I have pointed out here before, the Laffer curve. The idea that there is a point when tax rates are so high that increasing them reduces rather than increases revenue is uncontroversial. But it has become so madly distorted as to be dangerous.

It has been a crazy 12 months since Sunak, as chancellor, delivered his Mais lecture at the Bayes Business School in the City of London a year ago. But his words then, in an address which talked up the desirability of affordable tax cuts, deserve repeating.

As he put it then: “I am disheartened when I hear the flippant claim that ‘tax cuts always pay for themselves’. They do not. Cutting tax sustainably requires hard work, prioritisation, and the willingness to make difficult and often unpopular arguments elsewhere.”

He was right. It is also right, as those responsible for establishing the Office for Budget Responsibility (OBR) have pointed out, to be aware that it, the government’s fiscal watchdog, takes into account dynamic effects when assessing tax increases or cuts, as does the Treasury. Those dynamic effects often mean that tax cuts cost a lot less than a crude analysis would suggest, Rarely if ever are they costless, however.

For me, the big surprise is that a crude debate about tax cuts has not become a debate about tax reform. The concern at the moment is that the aggregate tax burden, as measured and predicted by the OBR, will rise to 37.4 per cent of gross domestic product in the fiscal year starting in April, 2023-24, and further to 37.5 per cent the following year. These are the highest readings on record, the previous high being 37.2 per cent in 1948 (when records began), as the economy was being brought down from wartime levels of tax and spending.

The tax burden was lower in the past, but how much did it fall during that Shangri-La period in the 1980s? The answer is that it did not. It was 30.7 per cent of GDP in Thatcher’s last full year in office, 1989-90, compared with 30.4 per cent in 1978-79, the last year of the Labour government of the 1970s. The tax burden in the 1990s, under John Major and then Tony Blair, averages 30.3 per cent of GDP, compared with 32.1 per cent in the 1980s.

What did happen, of course, during the 1980s, as well as boost from North Sea oil revenues, was tax reform. It was during this period that two big shifts occurred. The first was the shift from direct to indirect taxation. The initial “tax-cutting” budget of the Thatcher era, in which the basic rate of income tax was reduced from 33 to 3o per cent and the top rate from 83 to 60 per cent, was in fact a tax-shifting budget, those cuts made possible by an increase in VAT to 15 per cent, from 8 per cent on most goods and 12.5 per cent on luxuries.

The second big shift was the Lawson doctrine of reducing tax rates by scrapping or restricting tax reliefs, most notably for corporation tax, but followed later with other taxes.

Given the state of the public finances now, there is little scope for net tax cuts but, given the state also of the tax system, there is plenty of scope for tax reform, which may have the effect of bringing in more revenue. One of the less-noticed buts of vandalism, during the Truss premiership was the abolition of her Office of Tax Simplification, announced on September 23 last year, as part of that notorious mini budget.

The income tax schedule is a case in point and, now that allowances and thresholds are frozen for a few more years to come, people will become more aware of its damaging idiosyncrasies. Income tax starts at a 20 per cent rate, rises to 40 per cent, the higher rate, then hits 60 per cent for more than £25,000 of earnings at £100,000, then comes down to 45 per cent. There are higher marginal rates along the way from some, caused for example by the interaction of income tax and child benefit withdrawal.

The logic to the 60 per cent marginal rate at £100,000 was that the higher paid should should not benefit from the then Tory policy of raising the personal allowance by more than inflation. But that policy has been abandoned, and replaced by a prolonged freeze, and this messy system needs reform.

As for corporation tax, the government is about to do the opposite of the Lawson doctrine, by raising the rate, from 19 to 25 per cent, and reducing reliefs, the super deduction, at the same time. If a higher rate is necessary, it should be accompanied by incentives to invest.

Then there is VAT. The current VAT turnover threshold if £85,000, below which small businesses do not have to charge it, above which they do. The now-abolished OTS pointed out that this creates a bunching of turnover just below the threshold, because small firms are unwilling to go above it, thus limiting their growth, and growth in the economy.

Tax Policy Associates, run by Dan Neidle, who recently helped expose Nadhim Zahawi’s tax affairs, suggests replacing this cliff edge, which is higher than in most other countries, with a phased increase in VAT eligibility, beginning at a lower rate and at a much lower level of turnover. People will have their own ideas about how best to do this, and about many other areas of our tax system where reform is desirable and would be economically beneficially.

As it is, reports said to be emanating from “sources close to the chancellor” suggest that one of his priorities for the budget is maintaining the 5p a litre cut in fuel duty announced by Sunak in March last year. It is a curious thing to do, except in the context of pleasing Tory backbenchers – who are calling for other tax cuts - given that petrol prices are 14p a litre lower than they were then and is the opposite of meaningful reform. The Social Market Foundation think tank describes it as “a reckless waste of public money”. We need tax reform, not unnecessary gimmicks.