Sam Dumitriu is Head of Research at the Adam Smith Institute.
Politicians tend to get tax cuts wrong. In the hunt for short-term headlines and a good budget speech gag, they use the tax system to dish-out treats to deserving groups. Whether it’s animators at Aardman, motorists, or first-time buyers, budgets are an opportunity to show that the Government is on their side. It’s fiscal virtue signalling.
But voters soon forget headlines. Budget giveaways may be good tactics but they are bad strategy. In the long-run, the Conservatives’ best bet for countering Corbynism is to kickstart growth through lower, simpler taxes. Tinkering around the edges simply won’t cut it.
We need to be realistic. Deficit-financed tax cuts aren’t tax cuts. They’re taxation deferred. If the Government cannot resist calls to increase NHS spending and public sector pay, then taxes can’t fall. When money is tight it’s vital to prioritise the cuts that deliver the most bang for your buck.
Stamp Duty Land Tax is an obvious candidate for the chopping block. By making moving house more expensive it traps people in homes that are simply not right for them. Pensioners are discouraged from downsizing, while growing families are stuck in homes without enough bedrooms. It saps productivity, too, by making it harder to move to where the best jobs are.
Economists estimate that Stamp Duty Land Tax destroys 75p of wealth for every £1 it raises, making it the most destructive tax on the books.
In his last budget, Philip Hammond’s move to slash stamp duty for first-time buyers won plaudits. But the real hit to growth comes at the top-end of the market, so the Chancellor should go further and scrap the tax altogether. If he wants to recoup the £13 billion that Stamp Duty raises each year, he would be better off adding extra bands onto council tax. This would boost growth and make the tax system more progressive at the same time.
Corporation Tax is another levy ripe for reform. George Osborne deserves strong praise for cutting Corporation Tax from 28 per cent to 19 per cent. By making tax rates competitive, the UK became an attractive destination for multinational companies to headquarter, bringing investment and jobs with them.
But where Osborne went wrong was how he funded it. At the same time as he slashed the headline rate, he also made reliefs for capital investment substantially less generous. By lengthening depreciation schedules and scrapping them altogether for industrial buildings, he blunted the impact of his Corporation Tax cuts. As a result, the marginal tax rate on capital investment is only three per cent lower than it was under Gordon Brown.
To boost wage growth we must do better. On tax reform, we should follow the US’s lead. The Tax Cuts and Jobs Act recently signed by President Trump not only brought down the headline tax rate, it also allowed firms to immediately write-off new investments in equipment and machinery. So-called full expensing reduces the effective marginal tax rate on capital investment to zero. Academic evidence from the US finds that full expensing boosted investment by 17.5 per cent, wages by 2.5 per cent and output by 10.5 per cent. Research from Oxford University found similarly positive impacts on investment and wages. It’s no wonder that American corporations are unveiling major plans to increase investment.
Moving to full expensing wouldn’t come cheap. It would reduce Corporation Tax receipts by around £18 billion, but it would be worth it. It should be funded in part by eliminating the tax deductibility of corporate interest expenses. This would remove a major distortion in the tax system that biases firms into taking on debt rather than selling equity and bring down the cost of full expensing by about £11 billion.
Looking forward, major tax reform will become increasingly necessary. If we were designing the tax code from scratch, it would probably look very different to the status quo.
First, the array of reduced and zero-ratings for VAT creates massive complexity. Courts waste time debating whether Jaffa Cakes are cakes or biscuits. The aim may be to exempt essential purchases from tax to give the poorest relief. But a banker buying baby shoes from Gucci and food from Ocado receives a much bigger tax break than a single mum shopping at Matalan and Aldi.
Second, there is a growing tax gap between the employed and self-employed. Once you factor in Employers’ National Insurance Contributions, an employee on £40,000 a year will pay over £3,000 more in tax than a self-employed person on the same income. There is simply no good justification for this.
Third, the UK has one of the highest VAT cliff edges in the OECD. When firms earn a penny over £85,000 they incur a £17,000 bill. It means firms have a strong incentive to stay inefficiently small, contributing to the UK’s persistently low productivity levels.
We’re barely scratching the surface here. But in each case reform is easier said than done. Osborne’s attempt to bring a tiny bit of logic to VAT was branded the Pasty Tax. Hammond’s attempt to lessen the gap between employees and the self-employed was dubbed the White Van Tax. In both cases u-turns soon followed. In the last budget, Hammond wisely wimped out of lowering the VAT threshold.
The lesson? If reforms are seen as nothing more than stealth tax rises, they will fail. If the Conservatives are serious about simplifying the tax code (and they should be), then they need to combine reforms with a bit of fiscal lubrication.
Rolling back VAT exemptions and zero-ratings might be more popular if combined with a hefty rise in the National Insurance threshold. Closing the tax gap between employees and the self-employed is more palatable if cuts to Employer’s National Insurance means that employees take home bigger pay packets. Small businesses are less likely to kick-up a fuss when the VAT threshold falls if greater business rates relief is made available for firms investing in their property.
To win the case for free markets, fiscal virtue-signalling won’t do. What’s needed is an agenda that eliminates distortions, reduces complexity and incentivises wage-boosting investment. It might not grab headlines, but it will deliver the growth needed to win the next election.