Tax reform is one of the main levers the government can pull in its quest to boost the economy over the long run. Improving a country’s tax system can attract business and investment, encourage entrepreneurship and work, and eliminate deadweight costs that hold back growth.
It was encouraging to hear Chancellor Jeremy Hunt say last week that his ambition was for the UK to have ‘nothing less than the most competitive tax regime of any major country’.
Of course, it might be hard to square that ambition with the pending rise in corporation tax, the looming expiry of the investment super-deduction without an adequate replacement, and the decision not to meaningfully reform business rates – as my colleague Robert Colvile pointed out in his response to the Chancellor’s speech.
But let’s take the Chancellor at his word. How could he turn his tax competitiveness ambition from rhetoric to reality?
In assessing that question, I’ll first consider what tax competitiveness actually means. Then I’ll look at the characteristics of an ideal tax system and see how Britain’s one compares. Finally, I’ll look at the reforms that would be needed to give Britain the most competitive tax system of any major economy.
What makes a tax system competitive?
At a fundamental level, there are three distinct ways we can assess relative levels of tax competitiveness.
The most obvious and familiar way is in terms of marginal tax rates. Lower marginal tax rates are better than higher ones, because they do less to discourage economic activity. They also send an important signal to internationally-mobile workers and investors about a government’s attitude towards business and success. Two important things to look at here are the top rate of tax on various forms of personal income, and the headline rate of corporation tax.
Another way to assess competitiveness is by looking at how neutral different tax systems are when it comes to economic decision-making. There are a few exceptions, but as a rule you don’t want the tax system to distort how people and companies work, invest, or spend. The economy will grow fastest when those decisions are left to individuals responding freely to market incentives, without undue government interference.
Unfortunately, most modern tax systems produce significant distortions. Taxing business income twice – once at the corporate level, and then again for individuals – can lead to a bias against investment. Taxing the return on savings, as well as the earnings that were saved, can encourage people to consume now rather than later. And requiring that companies’ capital spending is written-off in line with lengthy depreciation schedules, rather than straight away, can deter productivity-enhancing expenditure. (This is not an exhaustive list.)
Many tax systems have features designed to mitigate these and other distortions. Their relative competitiveness often depends on how effective such offsetting measures are, and how close to the ideal of neutrality they are therefore able to come.
The final element of a country’s tax competitiveness is the balance between different sources of revenue. This is important because we know that some taxes are much worse for growth than others.
Economists generally see recurrent property taxes as the least harmful type of tax in terms of GDP per capita, but there are clear limits as to how much revenue such taxes can raise. Broad-based consumption taxes are the next best source of revenue from a growth perspective, and can generate very significant receipts. Taxes on corporate income are typically reckoned to be the least-growth friendly option, followed by personal income taxes.
As a result, the most competitive tax systems will tend to focus on efficient consumption taxes – and, to a lesser extent, well-designed property taxes – while trying to keep the burden on corporate profits and individual incomes as light as possible.
The ideal of a competitive tax system (and how Britain compares)
No country in the world has a ‘perfect’ tax system. But that doesn’t mean that the ideal of a pro-growth tax code is simply a matter of theory. In fact, while no single jurisdiction gets everything right, almost everything you’d need to construct an ultra-competitive tax regime is in operation in one developed country or another. You just need to learn the right lessons from the right tax systems.
The Tax Foundation’s International Tax Competitiveness Index provides a detailed ranking of the various tax systems of the OECD, and is rooted in the same fundamental principles outlined above. So looking at the top-ranked countries in each category (property, consumption, corporate, and income taxes) gives you a pretty good idea of the sort of policies that make for a competitive, pro-growth tax system.
For example, the best property tax systems feature recurrent taxes based on land values, which typically raise a modest amount of revenue. Such taxes encourage efficient land-use practices, and do not discourage investment or burden ‘produced inputs’ (like buildings and infrastructure) that businesses rely on. Estonia and New Zealand each employ this sort of property tax. They are also alike in eschewing taxes on wealth, assets, inheritances, and property transfers.
It is similarly easy to identify the essential features of the most competitive consumption tax regimes. The highest-rated countries, like Switzerland, Japan, and Korea, maintain very broad VAT bases – effectively taxing 70% of total consumption at their standard rates. Keeping the use of exemptions and reduced-ratings to a minimum avoids complexity and the distortion of spending decisions. It also enables these countries to keep their main VAT tax rates low. Of course, combining a broad VAT base with a somewhat higher tax rate – as New Zealand and Estonia do – can generate an enormous amount of revenue, and make it possible for other growth-sapping taxes to be lower, or even eliminated altogether.
When it comes to corporation tax, it is hard to look past the Baltic republics of Latvia and Estonia (again). These countries have completely overhauled their corporate tax bases, so that only distributed profits (i.e. funds paid out to shareholders) are subject to tax – and at a relatively low rate of 20%. This cashflow treatment of corporate income means that investment costs are, to all intents and purposes, immediately deductible, and that loss carryforwards and carrybacks are implicitly unlimited. It is worth noting that structuring corporation tax in this way essentially transforms it into a kind of consumption tax – as long as profits are reinvested rather than paid out, no tax is due.
Of all the elements of a modern tax system, it is probably personal income taxes that are the most difficult to structure in a truly competitive, pro-growth way. This is partly because personal income taxes do so much of the heavy lifting when it comes to revenue – on average, OECD nations generate about half of their total tax receipts by taxing personal incomes. Income tax systems usually play a redistributive role as well, which makes it difficult to keep rates low (and work incentives intact). What’s more, avoiding the double taxation of dividends and capital gains, or the discouragement of saving, is both practically difficult and – at times – politically toxic.
Nevertheless, there are still countries we can look to for inspiration. For low rates and broad tax bases, most would point to the flat tax regimes of central and eastern Europe – and, indeed, these do score well in the Tax Foundation’s rankings. However, they also tend to be combined with rather onerous employer-side payroll taxes, which mean labour is taxed a lot more heavily than it might at first appear, even if capital income receives an agreeably light treatment.
New Zealand might offer a better income tax model. Its progressive structure has a top rate of 39%, and there are no additional social security taxes to pay. The tax on dividends is reduced to reflect the corporation tax already paid (a system it shares with Australia) and there is generally no tax applied to capital gains at all. No other country does a better job of avoiding the high marginal tax rates and anti-investment bias that most modern income tax systems entail.
How does Britain do?
So how does Britain’s tax system compare to these international exemplars?
There are certainly things we do well. At 19%, our corporation tax rate is joint fourth-lowest in the OECD – but is set to rise to 25% in a few months’ time. Our capital gains tax regime is competitive, if needlessly complicated. And our generous tax-free (or tax-advantaged) savings and investment vehicles mean that the double-taxation of capital income can sometimes be avoided or at least minimized. Furthermore, our territorial corporate tax system and extensive network of tax treaties (the widest in the OECD) gives us a clear advantage in a globalized economy.
Yet despite those positives, the UK ranked 26th out of 38 OECD countries in the Tax Foundation’s most recent competitiveness rankings – putting us well behind several G7 economies (namely Germany, Canada, Japan, and the United States) as well as fourteen EU member states (plus Norway and Switzerland). Worse still, CPS research has shown that coming changes to corporation tax will drop the UK to 33rd place in the rankings.
Our problems include a top tax rate on earnings that is too high to be truly competitive, and a top rate on dividends that is the fourth-highest in the OECD. We raise more money than anyone else from property taxes, but do so in a way that is almost calculated to do economic damage: with swingeing non-domestic rates that punish business investment and punitive stamp duties that gum up the property market.
What’s more, until the government introduced the temporary ‘super-deduction’ for capital investment at the March 2021 Budget, we had for many years undermined the appeal of our low headline corporation tax rate by combining it with some of the least generous investment allowances in the rich world, especially for structures and buildings. As things stand, we are set to return to the status quo ante in April.
We also have one of the narrowest VAT bases in the OECD, equivalent to applying the standard tax rate to little more than 40% of consumption expenditure. That’s bad in itself, because it leads to complexity and economic distortions, but also problematic because it means other, less growth-friendly taxes have to be much higher to make up the difference.
It’s worth considering that Estonia, which tops the Tax Foundation’s competitiveness rankings, has roughly the same overall tax burden as the UK (c. 33% of GDP) and the same standard rate of VAT (20%). Yet Estonia gets almost 40% of its tax revenue from consumption taxes, compared with around 30% in the UK. This suggests that if the UK’s VAT base was as broad as Estonia’s, we could make more than £75bn worth of tax cuts and reforms in other areas, without losing any revenue overall.
Making Britain’s tax system the most competitive in the G7
The Chancellor’s ambition to give Britain the most competitive tax regime of any major country is obviously open to interpretation. For the sake of argument, though, let’s say he wants to make us the top-ranked G7 country in the Tax Foundation’s International Tax Competitiveness Index. What would it take to get there?
Fortunately, such a commitment would not necessarily mean that we had to adopt a perfect amalgam of the various tax systems discussed above. That might be a desirable objective, but on any realistic time horizon, it isn’t a politically realistic one. Instead, it would be enough to simply make our tax system more competitive than Germany’s, leap-frogging the United States, Canada, and Japan in the process.
Needless to say, there are many possible permutations for a tax roadmap that would meet this objective. However, one relatively straightforward package of reforms that would achieve this goal, while touching on every major area of taxation, is as follows:
- Abolishing the additional rate of income tax, to create a much flatter tax structure and improve incentives;
- Letting companies ‘fully expense’ all capital spending, to remove the tax bias against business investment;
- Removing ‘improvements’ from the business rates tax base – essentially making it a land value tax – so as to cut the tax burden and (again) boost business investment;
- Lowering the VAT registration threshold to the OECD average (around £40,000, down from £85,000) to broaden the VAT base and ameliorate one of the best-documented distortions in the tax system.
If you wanted to go further, and push for a place near the top of the tax competitiveness rankings, you would want to abolish stamp duties, properly address the double taxation of investment income, and apply the standard rate of VAT to as many goods and services as possible – ideas I’ve explored in detail here.
Depending on how far you were prepared to push VAT reform – which is the key to making any set of pro-growth reforms revenue-neutral, but would also have challenging distributional consequences – you could start to think about significant cuts to income tax and National Insurance.
Such proposals obviously do not constitute a comprehensive solution to every problem in the UK tax system; nor do they give life to every tax policy ambition the government might have. But they would be more than enough to give the UK the most competitive tax regime of any major country. In doing so, they would undoubtedly deliver a significant boost to business, investment, and economic growth.
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