How to cut taxes — and raise more revenue

A journalist asked me last week whether I could support the argument that the government would lose revenue from the NI contribution hike planned in April. My response was that it was a bad tax but it would still raise revenues. Offsets from lower activity might reduce the planned £12 billion increased take to £10 billion. But the tax increase itself could not be cancelled without fiscal consequences.

I spent nearly ten years of my life at the CBI campaigning against Denis Healey’s National Insurance Surcharge (a deliberate act of revenge after CBI encouraged the Liberals in the Lib Lab pact to vote to reduce income tax) and eventually after many years of what one CBI Director General called the Chinese water torture treatment we finally got the surcharge rescinded in 1985. There are very few arguments against National Insurance increases that I haven’t deployed.

But claiming that they don’t raise revenue is not one that cuts much ice even with me, let alone the Treasury.

However, there are taxes that currently exist that could be cut without loss of revenue. Indeed in some cases (generally after a few years) the tax cuts would generate more revenue. In theory the Chancellor could even abolish the planned NI increases AND cut these taxes and still end up with cash in the bank. Of course Treasury officials, who tend to be unreasonably cautious about the benefits of cutting taxes, will deploy their arguments against. But many of these Treasury arguments are specious – indeed those against the VAT Retail Export scheme (see below) were described in the Administrative Court recently as ‘containing schoolboy errors’.

Stamp Duty

The 40% fall in housing transactions from their Q1 peak to their Q4 level last year after the stamp duty rates returned to their previous levels shows the extent to which property transactions are affected by stamp duties. Short term tax holidays work partly by shifting the timing of transactions but that effect washes out eventually. 

But my colleagues at Cebr have looked at the long term impact of keeping the holiday permanent. Even then £4 billion of initial revenue loss is offset by increased revenues of between £2-4 billion gains elsewhere. But replacing the high rates (as much as 12% and in some cases 15%) with a low rate of at most 3% across the board would almost certainly generate more revenue, not less.

The withdrawal of allowances from those earning more than £100,000 

This is a dog’s dinner of a tax, one of the remnants of Gordon Brown’s fag end administration and announced so that it would not come into effect until he had left office. It’s well known that the key to efficient taxation is to keep marginal rates low. So what did he do – he raised the marginal rate of tax to 62% on the rise in income from £100,000 to £125,000 by phasing out tax allowances for those earning over £100,000. In effect imposing a massive marginal tax rate not on the very rich but the sort of aggressive middle managers who the country most needs. And the April rise in NI takes this marginal rate up to 63.25% It’s worth noting that this means that out of every £1,000 you earn, you pay £632.50 additional in tax. Leaving you with only £367.50 in income. Research in the US shows that those earning above $100,000 are especially sensitive to marginal rates of tax with an income elasticity of 0.57, nearly one and a half times that of lower income earners. This implies that restoring the allowances would have little or no long term cost.

The VAT Retail Export Scheme

This is a scheme where overseas visitors can purchase and reclaim their VAT when they return home. It worked so well that pre pandemic Bicester Village rivalled the British Museum as the UK’s largest tour attraction as tourists from the Far East and Middle East flocked there for the shopping. Rishi Sunak scrapped the scheme after being told by his Treasury officials that post Brexit he would otherwise have to extend it to all comers instead of those from outside the EU.

The Treasury seemed to base their claim on the assumption that only a million applications for VAT returns were made. This, as was pointed out in the Administrative Court, was only one of a series of schoolboy errors in the Treasury calculation – in fact many tourists from the Far East travel in groups and the group guide handles the VAT reclaims which is why there are fewer claims than the number of tourists affected. 

Cebr’s calculation showed that far from saving money, high value tourism from the Middle and Far East would crash post abolition and that it would cost the Treasury around £500 million a year. Obviously tourism has crashed though clearly most of that is the pandemic. But we estimate that, as tourism returns, reinstating the scheme would generate that lost £500 million.

But what would make more sense would be to extend the scheme to visitors from the EU. This would generate additional revenue if on a smaller scale (£100 million or so) and allow for big retail parks near the Channel ports as the post Brexit need for lorry parks diminishes. It would also prove especially irritating to the French….

With tourism returning, countries around the world will be doing what they can to get more than their share. Here is an easy way. And it would make money too!

Corporation tax 

The Chancellor seems to be operating under the delusion that high corporation tax rates generate revenues. In which case why did the Irish fight so hard to retain their low 12.5% rate? In reality cuts in Corporation tax lose revenues only in the very short term and normally raise them in the longer term. 

Simulations on Cebr’s model show that it would take fewer than 5 years for a corporation tax cut to 15% to start to raise revenue and that 10 years on GDP would be up as much as 7% and tax receipts up by nearly £20 billions. Why wait?

Dividend tax

The UK’s top rate of dividend tax, 38.1% on incomes over £150,000, is one of the very highest in the world and is a huge disincentive to savings. Moreover it is set to rise to 39.35% in April.

Most of the theory on optimal taxation suggests quite low rates, if any, on dividend taxation. Mankiw and his colleagues write ‘Both statutory tax rates on capital and measures of effective tax rates remain far from zero, the level recommended by standard optimal tax models’.

The reason for the high rate in the UK is to reduce the incentive for high income taxpayers to pay themselves in dividends rather than income. But the disincentive to building up profitable companies is considerable. And it’s not clear that the higher rates of dividend taxation have in fact yielded additional net revenues.

Top marginal tax rates

For many years the UK’s top marginal rate was 40% and the country prospered. But Gordon Brown, in yet another booby trap which he left for his successors, put the rate up to a nominal rate of 50%. George Osborne managed to get the rate down to 45% (actually 47% with the NI Surcharge) and it is due to go up now (including the surcharge) to 48.25% in April.

Cebr’s analysis of the impact of the 50p rate was that the alleged £2.5 billion that it raised initially were on course to becoming a £1 billion loss after 5 years. And of course when the tax was cut revenues went up, even grudgingly admitted by the Treasury.

Reversing the recent trend and getting the tax back down would improve the country’s economic finances as well as making it more attractive to outsiders.

The importance of low taxes has increased in recent years. 

First, both business and people have become increasingly globally mobile. Higher taxes are shooting yourself in the foot in the race to attract high value business and people. 

Second, post pandemic, there has been a supply side crunch. People are no longer so willing to work even a full 5 day week let alone long hours. The break in routines caused by working from home has caused people to reconsider whether to work at all let alone long hours. One of the most attractive features of leisure time is that it is not taxed. This means that the economic cost in reduced effort from high marginal rates of tax has risen and that optimal marginal tax rates have fallen even from the revenue maximising 40% calculated a few years ago.

Perversely the less willing people are to work, the more they have to be incentivised by lower taxes. But the good news is that taxes CAN be cut without harming fiscal rectitude if the cuts are targeted carefully.

Douglas McWilliams is the founder and Deputy Chairman of Cebr, the economics consultancy.