19 October 2022

Without careful reform, Britain’s tax system will keep sapping growth


Before the dramatic events of the last few weeks, Britain’s tax system lagged well behind the competition. And now the situation is even worse. Without carefully designed reform, the tax system is likely to be a big hindrance to our growth prospects in the years ahead. 

These are some of the obvious conclusions to be drawn from the latest edition of the International Tax Competitiveness Index, published this week by the US-based Tax Foundation.

In the official version of the rankings, Britain sits 26th out of 38 OECD countries. It is well behind G7 members Germany and Canada (15th and 16th) and somewhat behind Japan and the United States (21st and 22nd) – but still comfortably ahead of Italy and France, who claim the bottom two spots in the ranking.

Yet there’s no room for British complacency. The Tax Foundation’s Index is based on a snapshot of internationally comparable data, which means it doesn’t always capture the latest developments in individual tax systems. And – in case you’d somehow missed it – British fiscal policy has been on a wild rollercoaster ride in recent days.

The essential point is that the Index, as published, assumes two things about the British tax system that aren’t going to be true for much longer – a 19% headline rate of corporation tax, and a 130% ‘super-deduction’ for qualifying capital investment. Those two features of the business tax regime combine to put us in 10th spot on the Tax Foundation’s corporate tax rankings, and flatter our overall position.

But we now know that corporation tax will rise to 25%, as new Chancellor Jeremy Hunt tries to balance the books. And as yet, no suitable successor to the super-deduction appears to be forthcoming. As a result, Britain’s tax competitiveness is set to plummet.

The Tax Foundation was kind enough to provide an updated projection of the UK’s tax competitiveness to the Centre for Policy Studies (the think tank that publishes CapX). The results – out today – will not and should not make for comfortable reading in the Treasury. With the revised corporation tax picture taken into account, Britain falls 23 places on the corporate tax ranking, and slumps to 33rd out of 38 OECD countries on the competitiveness index overall.

This is despite topping the rankings on cross-border tax rules (we have the widest network of tax treaties in the OECD). Our individual taxes, meanwhile, are judged slightly worse than average (24th) and our property and consumption taxes are seen as a clear drag on growth (we rank 34th in both categories). 

It is worth being explicit about the fact that a country’s position on the International Tax Competitiveness Index bears little relationship to its overall tax burden. Indeed, on the official rankings, 13 of the 25 countries that rank above the UK raise more tax revenue as a percentage of GDP than we do. 

Furthermore, the Index is only partly based on relative marginal tax rates. Many of the 41 variables that make up a country’s score focus on the underlying structure of the tax system as well. Ultimately, what the Tax Foundation is trying to measure is neutrality: the degree to which tax systems distort economic decisionmaking, discourage work, and are biased against saving and investment. In short, this is about how we tax, not how much. And that’s what should worry British policymakers.

So what are we getting wrong? Absent the super-deduction, our corporate tax base remains a big problem. Stingy capital allowances create a systematic bias against business investment. Onerous and badly designed business rates often do the same. Stamp duties inflict massive deadweight costs relative to the revenue they raise. And our top rate of tax on dividends is, remarkably, one of the highest in the OECD.

On the other side of the ledger, we have the highest registration threshold for VAT (or equivalent) of any OECD country, and our consumption tax base is one of the narrowest around. These tax design choices distort behaviour – see the obvious bunching of firms just below the registration threshold – and mean that other, more economically damaging taxes have to be higher. (Broad-based consumption taxes are generally the best way to raise significant revenue without holding back long-run growth.)

Listing these competitiveness-sapping flaws in the British tax system does, of course, suggest a route to improvement. You could broaden the VAT base (potentially raising tens of billions in revenue) while reforming business rates and capital allowances. You could put stamp duty on a path to obsolescence, by transitioning to a more rational residential tax system as properties change hands. You could even abolish the highest rates of tax on earnings and dividends (yes, I know…) and make a concerted effort to smooth out the structure of effective marginal tax rates elsewhere in the income distribution.

All of which, needless to say, is easier said than done – especially in these newly straitened times, when getting borrowing under control, and quelling the immediate crisis, must surely take priority. VAT reform, in particular, is fraught with political and distributional difficulties, and base-broadening is a non-starter during a cost of living crisis. In the short run, then, the focus of pro-growth policy must inevitably shift to long overdue regulatory and supply-side reforms.

Looking further ahead, though, the case for the Treasury developing a realistic package of pro-growth tax reforms is clear, and doing so need not threaten our fiscal sustainability.

If we wanted to have the most competitive tax system in the G7 – leapfrogging the United States, Japan, Canada, and Germany – then the Tax Foundation suggests the following package would do the trick: abolishing the additional rate of tax (again, I know), bringing in ‘full expensing’ for business investment, cutting business rates by removing ‘improvements’ from the tax base (and essentially turning it into a land value tax), and lowering the VAT registration threshold to the OECD average. Doing all that would lift us up to 15th on the International Tax Competitiveness Index.

Now, this may not be the right agenda for today, or even tomorrow – though reviving Rishi Sunak’s planned overhaul of capital allowances should happen sooner rather than later. But eventually tax reform will be back on the menu. At that point, the Tax Foundation’s discomfiting assessment of our relative standing will be a useful guide to the way forward.

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Tom Clougherty is Research Director & 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.