Tax reform is long overdue: The coalition must act soon to boost long-term growth

Andrew Sentance
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THE CONTENT of next week’s budget has been the subject of intense speculation. What will the magic budget briefcase contain? A tycoon tax or a cut in the 50p rate? Help for small businesses or low earners? Relief from rising fuel duty or restrictions on pension tax relief?

Most of this discussion is around short-term measures. There is much less focus on the medium-term agenda. Yet setting out a clearer direction for medium-term tax reform is one of the most useful things that the chancellor could do in his budget next week.

Why is this so important? There are three reasons. First of all, the chancellor has limited room for manoeuvre in the short-term. PwC’s estimate is that public borrowing this year will come in £7bn below the latest Office for Budget Responsibility forecast – at £120bn rather than £127bn. But the chancellor also needs to be cautious about the future outlook for public finances, so cannot afford any big giveaways.

Second, a major overhaul of the tax system is long overdue. The last chancellor who had a clear and comprehensive tax reform agenda was Nigel Lawson, who left office over two decades ago. In the meantime, the annual budget cycle has encouraged successive chancellors to make many piecemeal changes to the tax system. Though very well-intentioned, this approach has led to complexity, distorted economic behaviour, and spawned a wide array of tax reliefs and exemptions.

Third, tax reform is one of the levers which a government can use to support longer term growth and boost economic competitiveness, by improving the climate for business, enterprise and employment. It is part of a broader “supply side” agenda, including lightening business regulation and measures to ensure that the labour market is working effectively. In the 1980s and 1990s, changes to the UK tax system helped to change the international perception of the UK and create stronger incentives to create wealth and new jobs. Tax reform and other supply side measures need to be the focus now that there is very limited scope to boost the economy by expanding demand.

So what should the chancellor do next week? There are three broad principles that underpin a tax reform agenda that supports economic growth and employment. First, keep tax rates low and limit the extent of tax reliefs so that there is a broad base to generate substantial revenue, even at low rates of tax. Second, tax income and wealth when people spend it rather than when they earn or invest it. Third, tax and hence discourage activities which create problems for society – such as pollution, smoking and traffic congestion.

The government has already laid out a clear tax reform agenda for corporate taxation which aims to cut the corporate tax rate to 23 per cent. But three other areas of taxation also require attention. First, within the personal tax system, there are genuine concerns about the impact of high marginal rates and disincentives, both at the top and the bottom of the income spectrum. Taking lower earners out of tax is a government priority. But so also should be ensuring that the UK does not appear to have a penal tax regime for successful entrepreneurs and business managers.

Second, at the heart of the taxation of spending is a VAT system in which a wide range of items is zero-rated. Can it make sense for caviar to be zero-rated for VAT (as a food) while toothpaste and soap carry the full 20 per cent rate? A narrowing of zero-rating to more basic items of expenditure could create greater scope for reductions in personal or corporate tax rates, benefiting the economy as a whole.

Third, the application of taxes to address environmental problems is very ad hoc and uneven, with individual sectors bearing a disproportionate burden – notably motorists and air travellers. A more even-handed approach could help both the economy and the environment.

There is no lack of advice at the chancellor’s disposal. The Institute for Fiscal Studies recently published the Mirrlees Review on tax reform, and the Taxpayers’ Alliance and the Institute of Directors are supporting the 2020 Tax Commission, which should report shortly.

The chancellor should not rush to set out detailed measures in this budget – he needs to prepare the ground first. But he can set out the direction of travel. Next week, he could announce in his budget speech that the Treasury will produce consultations (Green Papers) on tax reform in the three areas I have highlighted – personal taxation, expenditure taxes and the environment. He could also set out the principles which will underpin reform – lower tax rates on the creation of wealth, a broader revenue base and clearer economic principles to drive the tax agenda. This would be a strong signal that the government supports enterprise and wealth creation. Go for it, George!

Andrew Sentance is senior economic adviser to PwC and a former member of the Monetary Policy Committee.