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Lucy Parsons: The right way to raise taxes

Lucy Parsons Lucy Parsons is Senior Economics Researcher at the independent think-tank Reform and co-author of Reform Budget 2010: Taking the tough choices.

Next week the Coalition Government will set out its Emergency Budget.  So far the focus has been on where the axe will fall on public spending, but given the size of the hole in the public finances tax increases can be expected too.

The Chancellor, George Osborne, has quite rightly argued that the bulk of the consolidation should come through spending cuts, and has proposed that the balance between tax rises and spending cuts should have a ratio of 20:80. Based on this we can expect to see an increase in the tax burden to the tune of around £16 billion (including those increases already announced by the previous Labour administration).

Yet the Chancellor has been disappointingly silent on the principles that will guide where taxes should be increased and the Coalition’s tax policies so far give little indication that they take the principles of simplicity and economic growth seriously.

The Coalition agreement sets out some ambitions for a tax system that is “competitive, simpler, greener and fairer.”  What is missing from these objectives is arguably the most important of all – economic efficiency.  As Reform sets out in its alternative Budget published today, a tax system should aim to raise revenues in the least economically damaging way possible as this would reduce the degree to which they hold back growth and make reducing the deficit easier.  The best way to achieve this is through a low rate, broad base tax system.  The Coalition Government’s tax policy would lead to a narrower base and higher rates.

A key policy of the new Government is, for example, to increase the personal allowance to £10,000 over time. This proposal is expensive, costing at least £16.5 billion, and poorly targeted, with Reform’s analysis showing at least 85 per cent of the benefit of raising the allowance to £10,000 would go to individuals with incomes over the threshold. This policy would also undermine the integrity of the tax system through encouraging income splitting, where families pay out income from their businesses to different family members just to make multiple use of allowances.

This policy would be funded by damaging rises in other taxes, including the Capital Gains Tax rate.  It would also mean that harmful tax rises introduced by the previous Government will not be immediately reversed, including the 50p rate, restriction of higher rate relief on pension contributions and the rise in employee NICs. These tax rises have already worsened the UK’s attractiveness as an investment location and had an impact on employers’ plans for recruiting new and retaining existing staff.

A better way to raise revenues is to start with the least economically damaging taxes.  Reform has proposed that the best way would be broadening the VAT base, by eliminating the zero and reduced rates on things like food, construction of new homes and households’ gas and electricity.  These exemptions create costs through economic inefficiencies and are out of kilter with European norms (only three other EU countries apply a zero rate to food and only two apply a zero or reduced rate to children’s clothes). The UK has one of the narrowest applications of the standard VAT rate in the EU.  Reform has calculated that benefits could be increased to compensate the poorest households while still raising £15 billion extra revenue.

While attention may be on public spending cuts, tax policy is incredibly important.  It creates the link between public services and their funding.  It improves or worsens the business environment and attractiveness of the UK for investment.  It helps drive or depress economic growth.  The right tax decisions now will help rescue the public finances and set the conditions for stronger economic growth in the future.


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