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Tax reform is needed to raise productivity

    Yesterday I attended an event held at the Social Market Foundation with Paul Johnson the Director of the Institute for Fiscal Studies discussing tax policy. He was certainly interesting and there was much that he said with which I agreed. For example, our increasing dependence on a highly mobile elite for tax revenues is certainly a concern and I was also pleased to hear him endorse one of the key proposals in my paper, How to Cut Inheritance Tax, through his criticism of Agricultural Property Relief.

    It is clearly iniquitous and inefficient that some of the very wealthiest people who own vast tracks of land can pay absolutely no inheritance tax, whilst somebody who just owns a house in London will have to pay a 40% marginal rate. If we have to have inheritance tax at all, we may as well remove some of the absurdities in the current structure of the tax and broaden base by eliminating some reliefs to fund a sharp reduction in the rate.

    However, I did disagree with Paul when he argued that we would need to raise tax revenue from 36% of GDP to nearer 40% of GDP in order to pay for increased spending on public services. The relationship between the quality of public services and the amount spent on them is rarely clear. The benefit of reforming the public sector rather just spending more is something I think Paul underestimates. Nevertheless, given the sustained weakness in productivity the Government should be thinking about what measures it can implement in the Budget given the current fiscal constraints.

    Pro-growth tax reform will entail a significant rationalisation and simplification of the system. By ending the excessive growth in reliefs, exemptions and discounts, as suggested by CPS Research Fellow Michael Johnson, the Government could reduce the opportunities for avoidance and cut compliance and administration costs. Streamlining the tax system and easing the burden on households and businesses can only raise productivity.

    There are many potential areas of reform. For example, the complexity of the dividend tax system is a barrier to investment for firms and individuals. Basic rate taxpayers pay a 10% rate on dividends, higher rate taxpayers pay 32.5% and additional rate taxpayers pay 37.5%. Dividends also carry a tax credit which is equal to 11.1% of the amount of the net dividend which is to take account of the fact that companies pay dividends out of profits which have been or will be subject to tax. These special rates are applied to the gross amount of the net dividend and the tax credit and add an unnecessary complication to dividends. To simplify the system, the Government could eliminate the special rates system which were introduced in 1999 and have a flat tax credit of 25% on the dividend amount. This would lead to almost exactly the same real returns, would be revenue neutral and eliminate needless confusion.

    Whilst short term reliefs, caps and discounts can help ease the burden on business, there is a real need to carry out more radical, permanent reform of the business rates system which in its present state discourages the development of business property. The current system exerts a particularly severe burden on businesses because the tax charge does not vary with profitability or the economic cycle. Furthermore, the current rateable values are based on market rents that were last assessed in 2008. The massive growth in online shopping has made the current system based on property values rather outdated. Some steps that the Government should consider taking include ending temporary reliefs and introducing a simplified, banded system with revaluations on a more regular basis. The Government could also look at being much more ambitious with devolving the responsibility for business rates and allow local authorities to compete to attract businesses.  However, direct cuts in business rates may be a false friend for many firms because as I pointed in the Cost of Labour, there is in fact evidence that it can lead to higher rental payments.

    Capital Gains Tax, as Lord Flight and Oliver Latham explain in a CPS paper, reduces the capacity for productivity growth because it discourages entrepreneurship, savings and investment. CGT also distorts the normal functioning of capital markets by incentivising people to keep hold of assets which they would otherwise have sold and it diverts funds based on tax advantage rather than based on the highest returns. The Government should therefore examine if CGT is currently at its revenue maximising rate and reduce it immediately if it is too high.

    The distortionary impact of a complex VAT system increases costs on businesses and leads to inefficient outcomes. As CPS Research Fellow David Martin in his CPS paper asks, why are chocolate chip cake decorations zero rated but chocolate button cake decorations standard rated? If a gingerbread man with a chocolate mouth and eyes is standard rated, why is it zero rated if it only had chocolate eyes? Many VAT zero ratings and exemptions appear to have no logic behind them and the VAT base is narrow in the UK compared with most of Europe.

    For understandable reasons, the Government has pledged not to broaden the base of VAT because it would in this case hit the poorest the hardest by extending the tax to food and children’s clothing. Broadening the base in that way would be unacceptable. Nevertheless, the Government should still examine and simplify those rules which are clearly absurd.  If this did raise any extra revenue it should at least be matched through targeted tax cuts on low earners.

    The Government should also look to make tax changes permanent rather on a temporary or short term basis. There is a lot of evidence which shows that permanent tax cuts have a far more profound impact on behaviour, spending and investment than temporary changes. A study from the New York Fed for example shows the very powerful impact of permanent tax changes relative to temporary changes. A study by the Congressional Research Office shows the same point for business tax cuts. The Annual Investment Allowance is aimed at encouraging greater investment however its level has often been increased and extended. If the Government wants to keep the Allowance in the current form, it should fix the level and promise to leave it there. That would give business looking to invest in the long term, much more confidence about the tax treatment of their capital.

    The Government will be looking at a whole host of measures to boost productivity. Significant reform of the tax system needs to be one of those measures in the Budget and the Autumn Statement. 


    Adam joined the Centre for Policy Studies as Head of Economic Research in January 2014. 

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