2 March 2020

Why cutting taxes needn’t be taxing

By

The first budget after an election is rarely the time that governments start cutting taxes. According to the Institute for Fiscal Studies, on average over the last three decades tax rises worth £13 billion have been announced in the first year of each parliament. Governments often come in on the back of major spending pledges which need to be paid for, and tax cuts tend to be kept in the goody bag until the next election is in sight.

The new Chancellor, Rishi Sunak, faces these same realities in the upcoming budget. The IFS warned this week that if the government is to meet its promises of more money for the NHS, police and schools, while also keeping to its stated fiscal rules, then it will have to raise taxes. There has been extensive speculation in the press about how they might do this, with the Treasury reportedly considering mansion taxes and cuts to pension tax relief.

But what the Treasury mandarins often underestimate is the dynamic effects which tax changes have on the wider economy and on revenues in other areas. Tax rises often fail to bring in the revenue which would have been anticipated on a simple static model – increasing a tax from 10% to 20% does not simply double your revenue. Similarly, potentially sensible tax cuts are sometimes labelled as ‘unaffordable’ because the offsetting effects of behavioural change and greater economic activity are not properly accounted for.

A new paper from the Centre for Policy Studies makes the case for greater consideration of the dynamic impact tax changes can have, which means tax cuts often cost far less in revenue than the headline numbers would suggest –  and over time can lead to more revenue because of their economic benefits.

Take Stamp Duty Land Tax (SDLT), for example. Most economists agree that it’s a very bad tax. Why? Because it taxes transactions, and therefore acts as a disincentive for people to move home. In some areas, particularly at the top end of the market where marginal rates can be up to 12%, SDLT is clogging up the market completely. If prohibitive stamp duty bills are discouraging people from selling their property and moving elsewhere, that just means fewer transactions, and fewer transactions means less revenue for the Exchequer. It also means that fewer houses actually get built, which means less revenue for the government through planning gains and more required spending on affordable housing grants.

If, for example, you were to abolish SDLT on primary residences altogether a static analysis (that is, one which does not take account of the dynamic effects of tax reforms) would tell you the Treasury would lose £5.1 billion in revenue. CPS analysis suggests that once you account for the likely increase in transactions and new builds, the actual cost would fall to £3.3 billion, and that is without accounting for the wider economic benefits such as greater mobility and more efficient allocation of the housing stock (for example, more older people downsizing and freeing up family homes).

The CPS has suggested a package of reforms to significantly reduce SDLT for most homebuyers (including no duty at all on properties below half a million pounds) which would cost £3.7 billion on a static analysis but would in fact cost closer to just £1.6 billion when the wider impact of the reforms is taken into account. Of course, modelling behavioural changes is necessarily imprecise, so the paper emphasises its most conservative estimates. However, CPS modelling suggests the dynamic impact of the reforms could actually offset up to 95% of the static cost.

The same logic extends to duties on specific consumer goods, such as alcohol. Spirits, for example, are taxed in the UK at a level which is 177% of the EU average (we have the fourth-highest tax rate in Europe) and 3.7 times as much as in the US. In the latter stages of the last Labour Government (and for a while under the Coalition) spirits were subject to significant increases in duty, with annual duty rises of more than £1 a bottle on average. Revenue did increase, but not as strongly as you’d expect. What’s more, the succession of sharp tax rises clearly generated diminishing returns: in 2012 and 2013, for example, duty was increased by £2.70 on each litre of pure alcohol; yet revenue went up by less than £100 million across 2013-2014.

After that point, the Government started to recognise that spirits could play an important role in the UK’s export strategy and duty was frozen in 2014 and then cut in 2015 by 2%. Overall, the duty has risen by only 52p in the last five years. In that same period, revenues have risen by a quarter – a marked contrast to the previous period of rising duty rates – and at the same time there was a massive 40% rise in exports driven by an investment boom in the industry that was catalysed by the government’s more enlightened approach to taxation.

The CPS paper looks at other taxes too, calling for an in-depth HMRC review of the 45p top rate of tax to see if it is possible that a reduction would in fact lead to more revenue or at least pay for itself as the last cut seems to have done. The approach under the Coalition was to slightly reduce the rate while clamping down on avoidance and closing reliefs which encouraged income shifting, in line with the approach recommended in the seminal Mirrlees Review in 2011. The result has been that the proportion of overall income tax revenues being paid by the highest earners has hit record highs.

Overall, the message is clear: if you want to raise more revenue, you have to think carefully about the impact taxes have on the economy and how people behave. Just bumping up rates by a few percentage points does not cut it. There are ways to change the tax system to improve incentives and benefit the economy which do not have to cost much, and can even lead to more revenue in the long term. The new Chancellor Rishi Sunak has a good reputation for smart thinking on these issues – let’s hope he looks intelligently at the best ways to raise the cash he needs.

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James Heywood is a Senior Researcher at the Centre for Policy Studies