15 October 2020

Britain’s tax system lags the competition – changing that is key to the Covid recovery

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The UK tax system isn’t nearly as competitive as we like to think. And rumoured tax increases would make matters much worse. Those are two of the key takeaways from the 2020 International Tax Competitiveness Index, released today by the US-based Tax Foundation.

Let’s look at the status quo first. On this year’s Index, the UK ranks 22nd out of 36 OECD countries, down one place from 2019. That puts us just behind the United States and Canada, and a long way back from Australia and New Zealand (which finish 9th and 3rd respectively). What’s more, there are 16 European countries that score better than the UK for tax competitiveness. Estonia tops the rankings (as it has done for the past seven years) but even high-tax Sweden does considerably better than the UK, with its 7th-place finish.

The important thing to realise here is the International Tax Competitiveness Index isn’t a comparison of tax burdens; nor is it simply an assessment of marginal tax rates. Instead, the Index looks at the underlying structure of developed-world tax systems. For a given amount of revenue, does the tax system raise it in a neutral way that supports economic growth? Or does it damage incentives, distort behaviour, and deter investment? Unfortunately, the UK falls into the second category in a variety of ways.

Even corporation tax, where British policymakers (rightly) boast of having one of the lowest headline rates in the developed world, causes problems. Britain has one of the least generous systems of investment allowances in the OECD, which discourages economically vital capital expenditure, and creates a bias against investment-heavy business models. As a result, the UK is judged by the Tax Foundation to have only the 17th most-competitive corporation tax in the OECD.

We fare worse in other areas. The UK ranks 24th out of 36 for personal income taxes. The capital gains tax regime is broadly competitive, but our top rate on dividends is among the highest in the OECD. Combined with corporation tax, this means that the British tax system can swallow half the profit made by a business before it reaches investors. The top rate on ordinary income is above the OECD average, too.

Property taxes are a particular sore point. We raise a lot of revenue from property (as a percentage of GDP, only France matches us) and we do so in a highly distortionary way. Because business rates apply not just to site values, but also to buildings, infrastructure, and a range of plant and machinery, they discourage investment in commercial premises. We also rely heavily on transaction taxes that wreak havoc on the markets affected, with Stamp Duty Land Tax being the most egregious example.

As for consumption taxes – where Britain ranks 22nd out of 36 – the International Tax Competitiveness Index suggests Britain misses a trick by leaving so many businesses, goods, and services outside the VAT net. Broad-based consumption taxes can bring in lots of revenue without weighing too heavily on growth, but Britain has one of the narrowest VAT bases in the OECD. That’s troublesome in its own right (can anyone explain why we pay tax on a chocolate digestive, but not on a chocolate-chip cookie?) but also means that other, potentially more economically damaging taxes have to be higher.

Needless to say, taxes are not set in stone, and it is quite possible that Britain could reform its tax system in a pro-growth way and shoot up these international competitiveness rankings. Indeed, I’ve spent the last few months working with researchers at the Tax Foundation on a plan that would achieve precisely that – and the findings will be released within the next fortnight.

Yet much of the current chatter in Westminster is about hefty tax increases, with the Treasury rumoured to be considering a sharp rise in corporation tax and the alignment of capital gains and dividend taxes with ordinary income tax rates. As I explain in a new Centre for Policy Studies briefing, such changes would be a bad move at the best of times – but are particularly misguided now, when the economy is in such a fragile state. 

Not coincidentally, the rumoured changes would also have a significant impact on the UK’s tax competitiveness. Given the existing problems with UK corporation tax, adopting an “average” tax rate by international standards would leave us with a distinctly below average corporation tax overall. We would slip from 17th to 25th in that part of the International Tax Competitiveness Index. 

Meanwhile, aligning taxes on investment income with those on ordinary earnings – something I’ve looked at for CapX before – would leave us with the second-highest top tax rate on dividends and the highest top rate on capital gains (from shares) in the OECD. That would give Britain the least competitive personal income tax system of any rich country. Our overall ranking on the International Tax Competitiveness Index would fall from 22nd to 30th – representing a sudden and substantial deterioration in Britain’s attractiveness to business and investment.

Between lingering Covid-19, an uncertain Brexit, and longstanding weaknesses on wage growth, business investment, and productivity, the last thing the UK needs is for the government to wilfully add another economic headwind to the mix. There will come a time for closing Britain’s fiscal gap, but we’re not there yet. For now, we need policymakers to focus on growth. Maintaining Britain’s international tax competitiveness – and hopefully improving it – should be a central part of that effort.

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Tom Clougherty is Head of Tax at the Centre for Policy Studies.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.