Some commentators have argued that the right way to reduce the deficit is to take on large scale tax avoidance rather than public spending. The argument goes that large companies are shirking their responsibilities, while families and small businesses carry the burden of rescuing the public finances. Yet the evidence on who is actually avoiding tax does not support this. For example, HMRC data show that three-quarters of the £40 billion tax gap (the difference between the amount collected and the amount that should be collected) is due to VAT, Income Tax, National Insurance and Capital Gains Tax. Reducing the tax gap not only requires a focus on the big end of town but on the activities of many families and small to medium enterprises. The entire tax system needs to be simpler and less open to abuse.
If the coalition is serious about reducing the tax gap they should move to a simpler tax system with a broader base and lower rates. Two key changes could help with this.
1) The coalition should scrap the zero-rating and reduced rating of VAT on products. As Reform noted last year, the design of the VAT system is out of step with European norms. Britain is one of only four EU countries to apply a zero rate to food, and one of only three to apply a zero or reduced rate to children’s clothing. As Reform, the IFS and the OECD have argued, rather than inefficiently trying to use the VAT system to help the poorest other approaches (such as an increase in benefits) should be used. Reform calculated that the government could scrap the zero and reduced rates of VAT, while compensating the poorest, and still raise approximately £15 billion extra revenue.
2) The coalition should scrap their plans to increase the personal tax allowance and lower the threshold for the 40p rate. Workers’ tax burdens should be reduced, but this is not the way to do it. Increasing the personal allowance would provide little benefit to lower income earners, with the lion’s share of the benefit going to people above the allowance. First, much of the benefit of this change goes to people who are above the threshold and who are not often seen as being in the target group for these reforms. All of the spending on this change (based on a static analysis) goes to individuals earning above the current level of the personal allowance. Of this total the large majority (£13.2 billion of £14.2 billion) goes to people who are above the new personal allowance. Only £1 billion goes to people on individual incomes below £10,000.
An increase in a tax allowance may have other unintended consequences. For starters, If changes to behaviour are taken into account, then the costs are likely to be higher. There will be no real benefit for working more, so the change will be unlikely to expand the tax base. Second, as we discussed in our recent report, tax allowances create incentives to split income between family members to make multiple use of personal allowances. As the level of the personal allowance increases the incentives to engage in this tax avoidance increase also.
George Osborne’s first budget was right to set the goal of eliminating the structural deficit within the term of a Parliament. Yet since then the coalition’s programme for consolidation has too often been a series of half measures, with many of the real drivers of government spending remaining unaddressed and little effort going into creating a tax system with a broader base and lower rates. George Osborne may claim that he has “asked what is required” and that it is time to “move on,” but the real work is yet to begin. The question that this week’s Budget must answer is: does this government really stand for economic reform and moving away from the flawed economic model in place prior to the financial crisis?
Patrick Nolan is chief economist at Reform.
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