Call of duties

It is no secret that the Budget on 26th November is likely to need to raise taxes. We cannot yet know exactly how much revenue will be needed, but since the Spring Statement there have been notable ‘U-turns’ on Winter Fuel Payment and Personal Independence Payment policy, totalling a little over £6 billion. There has also been a rise in debt-interest costs and a slight underperformance of tax receipts, and it is widely expected there will be a downgrade in the forecast trend rate of productivity – all of which will likely contribute to a fiscal deterioration. The Chancellor is also highly likely to want to afford some giveaways, whether that be measures to help with growth or the cost of living, with a Child Poverty Strategy also expected.

Simply increasing expected borrowing, for example by abandoning the fiscal rules, is not a viable option given very real concerns about UK borrowing costs, which are currently the highest among our rich-country peers. Indeed, to avoid being back in the same position next year, and to reassure the gilt market, there is much to be said for increasing the buffers held by the Chancellor against her fiscal rules.

All together this could leave the Government plausibly needing to find £20-40 billion a year in total savings. Faced with such a large hole, the Government may well seek to have lower spending play some role. There are, though, significant challenges in using this as the main lever. Spending totals for departments have been set until 2028-29 in the multiyear Spending Review completed only in June. Quite apart from the disruption that would be caused by revisiting them so soon, 90 per cent of the additional day-to-day funding in the Spending Review was allocated to health and care, so any reductions would make ambitions to improve the NHS harder to deliver. In order to score welfare reforms this autumn the details would need to be announced without consultation – hardly the type of change needed, or likely to be deliverable, following the chaos of the summer’s attempt at changes.

So tax must play a role (and anyone who claims otherwise should tell us how else they might save such a sum). How might a large gap be decisively filled through tax changes, given the concerns about the outlook for growth, living standards, inflation and jobs? It is not an easy challenge, but this report sets out what we think are the best options.

Above all, the Government must respond decisively, avoiding the sense that it is lurching from one fiscal event to another. To achieve this, the Government should take a strategic approach, putting our £1 trillion tax system on an improving path. Such a strategy needs to reflect its wider priorities and not simply be designed to fill a fiscal hole. And while raising revenue will inevitably come with losers and costs, there is no shortage of areas in the tax system where there is scope for improvement. There are many measures that can move us to a less distortionary tax system, and so support much-needed productivity growth over time, as set out in work such as the Mirrlees Review and our Economy 2030 Inquiry. Tax changes can also align with other parts of the Government’s agenda such as health and environmental goals.

To address all of these challenges – and, via clear directions of travel, reduce uncertainty and increase credibility that the Treasury will always have the tools to balance the books in future – we focus on three areas. First, reducing arbitrary tax differences across businesses to improve competition and so support increases in productivity that can partly offset the effect of higher taxes. Second, raising personal taxes while protecting employees given existing unfair and distortionary tax differences. And third, raising revenue from reasonable taxes on harms where possible – while avoiding pressures on inflation in the short-term – for a greener and healthier country. We do not propose a net wealth tax, as we do not believe it is the best way to tax wealth more or better, but we do propose significant changes to how the accrual and gains of wealth are taxed.

The big increases in employer National Insurance (NI) and Corporation Tax rates that we’ve seen in recent years should not be repeated, and indeed there are areas of business taxation (within Corporation Tax and business rates in particular) where significant new tax cuts in future would help boost investment. But there are options that would raise revenue while supporting competition, which is too often distorted by unjustified differences in taxes.

But before raising any taxes, the Chancellor should look very hard at those who aren’t paying their correct taxes. There is a glaring problem of unpaid small business Corporation Tax, where the estimated tax gap has grown in real terms from £5 billion in 2018-19 to £15 billion in 2023-24. The Government has consulted on ‘e-invoicing’ to simplify and solidify tax reporting, but further measures will be needed to take this problem seriously and try to roll back the trend. The Government should also act to reduce deliberate policy biases across businesses. The UK’s high £90,000 VAT registration threshold (around double the OECD average) leads to a big divide between those that must apply VAT and those that don’t, with observable ‘bunching’ below the threshold as firms deliberately hold down or underreport their turnover. The best solution is for most businesses to be above the threshold, so we suggest reducing the threshold to £30,000 over the next four years, raising £2 billion.

There are also tax biases that favour larger businesses. We’ve just had an employer NI rise that was particularly large for the lowest paid. But partnership income – e.g. in top law firms – was not affected by this, despite over 70 per cent of this income going to the top 1 per cent of taxpayers. The lack of employer NI for

partnerships leads to a distortion around how businesses are structured (avoiding becoming companies) and around how workers are classified. And it is fundamentally strange that a receptionist at such a firm would attract employer NI but a partner on £2 million a year would not. A version of employer NI should therefore be extended to Limited Liability Partnerships (LLPs) at least – these being particularly close competitors to companies – with an equivalent of the Employment Allowance leaving the smallest firms unaffected. This would raise around £1 billion a year, primarily from very high earners.

Another way that employer NI could be made broader and more even-handed would be to extend it to more pension contributions, given the £22 billion a year cost of exempting employer contributions. This year’s employer NI rise should preclude big changes this autumn, but small changes would be reasonable as part of a broader package. One option would be to look at reducing the generosity of relief within pension salary sacrifice arrangements. These schemes lead to different tax treatments for different businesses and workers for no good reason, with the administrative barrier and costs being disproportionately high for small businesses (and with the lowest paid unable to benefit due to minimum wage rules). Applying employer NI to these salary-sacrificed contributions, at half the usual rate, would raise another estimated £1 billion without being a major new burden for employers as a whole.

The previous Government noted that there was an unfair ‘double tax’ on work. Income Tax, personal NI and employer NI all reduce take-home pay for employees, while other income sources are often taxed at much lower marginal rates. This is unfair on (working-age) employees, but also causes a range of economic problems. Choices about how to structure work are distorted, with differing tax rates across (and within) employment, self-employment and dividend income. Choices about what assets to invest in, and how long to hold on them, are distorted. In some cases, entrepreneurs are actively encouraged to leave the UK. Pensioner demographics are not accompanied by matching pensioner tax revenue. And the separate and distinct Income Tax and employee NI systems make the tax system much more complicated.

The UK has made some progress on these issues in recent years with, for example, the alignment of the starting point for paying NI and Income Tax; employee NI rate cuts; cuts in separate allowances for different income sources; and Capital Gains Tax (CGT) rate rises – although the Government’s employer NI rise went in the opposite direction. So the Government should now look to focus on non-employee tax rates, and on continued movement towards abolishing employee NI.

First, dividend taxes warrant limited reform. Given the combination of Corporation Tax on profits plus dividend tax rates, the higher and additional rates of dividend tax are similar to the rates of wage taxation. But the basic rate of 8.75 per cent is low compared to taxes on wages, to CGT, and to that in other countries, and encourages artificial arrangements whereby the timing and amount of dividends is carefully managed each year. A consistent approach would raise this to (at least) 16.5 per cent, raising £1.5 billion.

There are a range of possible ways to better align tax rates on other income sources. But one that would combine multiple benefits would be a ‘tax switch’ whereby the rates of Income Tax rise by 2p, but employee NI rates are cut by 2p. Crucially, such an approach would leave employee tax rates unchanged, protecting the pay packets of working-age employees. But it would be a significant step in reducing the disincentive to employment (versus other forms of income) that exists in the tax system. With this 2p switch, the higher and additional tax rates would be aligned across different income sources at 42 and 47 per cent respectively (rather than only workers paying these rates), and the new basic rate of 22 per cent would get closer to the 28 per cent paid by employees. Despite not raising taxes for employees, this 2p tax switch would raise £6 billion a year and move towards major simplification, at the cost of asking more of those groups that currently face lower tax rates than employees. In particular:

• Rental income, taxable interest and some other forms of capital income – which do not attract NI – would face a 2 per cent tax rate rise.
• The self-employed (excluding LLPs) would face a 2 per cent tax rate rise. At the basic rate, this would mean alignment with employees given the current 2p gap there, but the resulting 28 per cent basic rate for the self-employed would still be the lowest in decades except for the past two years. At higher rates, their personal tax rates would become higher than employees’, which would represent the beginning of a form of employer NI to the self-employed. This could be a quid pro quo for inclusion in the Government’s proposed Unemployment Insurance benefit.
• Pensioners who earn above the personal allowance would see a 2 per cent tax rate rise on earned and unearned income, although future pensioners would benefit from higher upfront tax relief on employee pension contributions, where employee NI currently applies.

By definition, only those who are currently relatively undertaxed – due to not being liable for employee NI – would see an increase from this switch. Given where different groups start in terms of tax rates, that prioritisation would be fair – and indeed the tax switch approach could be scaled up. Of course, it does require the political courage to argue that the principle of protecting pay packets for employees is the core interpretation of the Labour manifesto promises. In any case, given the precarity of the public finances, there may also be a need for broader tax rises that affect working-age employees too. On balance, extending the personal tax threshold freezes into 2028 and 2029 to raise £7.5 billion would be sensible, asking £140 extra of basic-rate employees (but with no impact before April 2028). In isolation this would ask relatively little of the highest-income households (partly due to the over 1 million additional-rate payers being unaffected by personal allowance changes), adding to the case for accompanying top-heavy measures.

Two other changes that would focus on the very wealthy would be the removal of distortionary CGT loopholes by which large bills can be completely side-stepped. First, the UK is a relative international outlier in not applying a settling-up charge on (most) built-up gains when people leave the UK. This means that someone who moves to Spain or Ireland before selling or winding up a company would make very large tax savings on gains generated in the UK. This makes no sense, and indeed all the other G7 countries bar Italy require emigrants to settle up their CGT. Second, when assets are held until death, any built-up gains are written off for tax purposes. This creates perverse incentives to avoid realising gains, and is a particularly valuable tax concession to those with very large business wealth. Instead, full tax should be paid whenever beneficiaries later realise gains. The combination of these two measures would raise an estimated £4 billion a year and fix some of the weakest links in the system for taxing wealth in the UK.

It is sensible for public policy to tax harms, to make prices reflect the true costs to society. Reform here could raise revenue while simultaneously helping to efficiently achieve other Government and societal goals such as decarbonisation, better health and a better NHS, and better and less noisy roads.

Motoring taxes are an important part of the tax system, but they are also an obvious and significant fiscal risk. It should be stressed that the fiscal forecast already assumes that the ‘temporary’ 5p Fuel Duty cut in place since 2022 will expire next spring and that each year will feature RPI-inflation-linked uprating. But we should be sceptical that this is currently much more than a ‘fiscal fiction’ given the last Fuel Duty rise was in 2011. Continuing with the pattern of delayed and cancelled rises would be very expensive: the previous Budget spent £1 billion cancelling one uprating, and by 2029-30 the cost of continued freezes would be over £5 billion annually. With the cost of petrol at its lowest real value in decades, it is time to show that Fuel Duty can rise like most other taxes, rather than diminishing in real value every year.

We suggest three changes to the Fuel Duty uprating regime that might help achieve this. Instead of an RPI link, which would deliver bigger increases when inflation is expected to be high, a fixed change such as 3 per cent a year could be chosen. Instead of big annual jumps every spring, there could be smaller quarterly changes. And instead of the temporary 5p cut expiring in March when concern about inflation is likely to still be high, this could be spread over (say) 10 quarters. Compared to what the OBR is forced to assume, this package of changes would be an inflation-lowering tax cut in the short-run, but would have no cost by 2029-30 and – crucially – mean greater fiscal credibility.

Electric vehicle (EV) tax reform is also needed, and one option is to do this through Vehicle Excise Duty (VED) reform for all vehicles sold in future. Reform here must deal with the fiscal challenge of low EV taxes, distributional unfairness in EV VED, and its lack of any links to harms, but all while not undermining the EV transition. VED for EVs sold in future should change to be a function of distance driven and weight. Weight is a useful metric as it is correlated with road damage, noise, tyre and brake pollution, danger to others, reduced front visibility, road footprint, energy use and car value. Together with a record of miles driven, this would provide a good link between harms and payment. This should be supported by reforming VED for other new vehicles, perhaps also with a weight link, and this combined package, which also includes ending the ‘pavement tax’, could raise £2 billion in 2029-30 but go on to raise over £10 billion by 2035.

Another net zero related measure would be to expand the scope of the UK Emissions Trading Scheme (ETS), to apply carbon pricing more consistently and efficiently. Specifically, the Budget could score something the Government has already agreed in principle to do as part of the recent UK-EU agreement, which is to match the EU’s broader scope on aviation (where the UK treats longer-haul flights more generously) and shipping. These changes could raise £2 billion.

Government consultations also point to likely changes in gambling duties and the Soft Drinks Industry Levy (SDIL). The gambling duty landscape is complex, and the Government has suggested combining three existing duties into one. There are many possible design choices here but, as an example, aligning rates that currently vary from 15 to 25 per cent across four different duties into a streamlined 25 per cent rate could raise £1 billion. An expected slight broadening of the SDIL will not raise as much money as that. But we think the Government should go much further and take up the National Food Strategy’s suggestion of a Sugar and Salt Reformulation Tax. With rates of £4/kg for sugar and £8/kg for salt, applied at the industry level, this would raise around £3.5 billion by 2029-30 – net of abolishing the SDIL. It is right to be concerned about recent food-price inflation and living standards – but change would take several years to design and roll out, and even after implementation the total impact on inflation would be relatively small. Revenue should be earmarked for the Child Poverty Strategy, mitigating the regressive impact. This is a relatively simple public health measure that could have major impacts in support of the Government’s health mission, with the salt element alone estimated to add 0.6-1.8 months to UK life expectancy.

The tax changes suggested here provide options for raising over £30 billion of additional revenue in 2029-30 – with smaller impacts in the near term but additional fiscal benefits from tackling the risks surrounding motoring taxes. They would support productivity growth through fairer competition and greater consistency across tax rates, without significant tax rises on business investment. They would reduce the tax system’s bias against employees and make progress towards ending the complexity of employee NI. They would mean a cleaner environment, healthier food and less damaged and congested roads. And by meeting the fiscal challenge without adding to near-term consumer prices overall, they would facilitate the hoped-for path of lower inflation and cuts in interest rates – to help bring down borrowing costs.

Clearly there would be vocal losers – particularly among taxpayers that have previously benefited from taxes that are low compared to working-age employees, or to known harms – but that is unavoidable given fair, base-broadening tax rises. Designed well, this Budget could simultaneously provide fiscal reassurance, a meaningful Child Poverty Strategy, and long-lasting beneficial tax reform.