Tax reliefs should remain a focus of tax reform

It may not be exactly what is on your Christmas present wishlist, but this week has brought two exciting goodies. First, and most importantly, the Economy 2030 Inquiry’s final report – Ending Stagnation; and, second, HMRC’s annual update of tax relief statistics. This blog takes a look at the overlap between the two, with a focus on some of the tax reliefs that a fiscally responsible strategy for supporting growth and lowering inequality should reform or scrap.

Tax reliefs need even more scrutiny in a high-tax world

There are many good reasons to think that higher taxes are here to stay. The Government’s debt-interest costs are up and it is plain to all that additional public service spending will be needed just to maintain standards. What’s more, Ending Stagnation makes the case that public investment must rise (all the more so given the Autumn Statement’s plan for declining investment), and that fiscal policy will in general need to be tighter. But we need to match higher taxes with better taxes: making the system both more efficient and fairer, regardless of the precise level of taxes overall. And reforming tax reliefs should be an important part of any such tax plan.

HMRC reckons that there are 341 ‘non-structural’ tax reliefs (with structural reliefs being those that are more fundamental aspects of the tax system, like the personal allowance in Income Tax, although what counts as structural can be subjective), and their very welcome costings for these allow greater scrutiny of the policy choices involved. It would be a stretch to say that all tax reliefs are unwelcome, and in many cases it is difficult to imagine imminent reform. For example, zero or reduced VAT on food and energy cost the Exchequer £32 billion this year, but politicians have little appetite to change that. Meanwhile, the lack of Capital Gains Tax on main residences also ‘cost’ £32 billion, but plausible reforms would raise far less. However, there are many tax reliefs where abolition or at least limitation is both desirable and doable.

Employer National Insurance could be broadened to cover employer pension contributions

Pension tax reliefs are a good place to start given the huge sums involved. Debate has often focused on Income Tax reliefs but the case for reforming pension National Insurance (NI) reliefs is harder to argue with. At the moment, NI is not levied on employer pension contributions (and nor is there any NI in retirement). These pension contributions are therefore favoured by the tax system over other forms of compensation, benefiting some workers more than others. HMRC’s updated stats show that the annual cost of this tax break is a massive £25 billion in total, which should demand some consideration about whether this is really a worthwhile feature of the tax system.

Ending Stagnation recommends that employer NI (but not employee NI) should in future be applied to employer pension contributions – which would have raised around £16 billion this year (before modelling any dynamic impacts). However, a significant portion of the tax rise would come from the public sector and likely need to be reimbursed. In addition, £4 billion should be used to remove personal NI from personal pension contributions. This combination of tax changes would align the treatment of employer and personal pension contributions – noting that (often lower-paid) auto-enrolled workers cannot take advantage of the biases in the current system – and tilt tax relief towards basic rate payers. But the net result would still be a tax rise of around £9 billion in 2027-28. Such a significant choice would mean trade-offs at a time when we would like to see both stronger real pay growth and higher pension contributions, but, on balance, it is a plausible and progressive way to raise substantial revenue if or when it is needed – particularly if coupled with the complementary changes below that would ensure that other forms of income pay their way too. Alternatively, broadening the base of employer NI in this way would allow its rate (13.8 per cent) to be cut by at least one percentage point.

Current taxation of the self-employed distorts the labour market

Biases in the tax system have led to significant distortions in the labour market. For one, self-employed income attracts far less NI than employment income, particularly due to the lack of employer NI. HMRC’s stats show that this tax relief costs around £6 billion a year. And while the Autumn Statement’s NI changes reduce this distortion somewhat for higher earners, they did little to reduce the bias overall. In Ending Stagnation, we have proposed a £1.5 billion change, which (following rate changes in the Autumn Statement) would mean a flat 8 per cent NI rate for the self-employed, rather than lower earners paying 8 per cent and higher earners – including some very high-earning partners – facing a 2 per cent rate. This would mean taxing the marginal pound of a high self-employment income at (almost) the same rate as high employee wages (around 53 per cent).

Equally, we should look at the UK’s internationally high VAT registration threshold, which encourages people to stick below £85,000 a year of turnover and costs £2.9 billion this year (relative to having no threshold). Policy here should aim for the threshold to be as low as possible, so that the question of whether (and how) to stay below the threshold applies to some mini-jobs but not to anyone working full-time. And concerns about administrative burdens can be overstated: the threshold for detailed, quarterly, digital accounting (Making Tax Digital for Income Tax) is already falling to £30,000 in 2027, and so this would be a sensible threshold for VAT registration too.

Capital gains are taxed at much lower rates than other forms of income

As with pensions and self-employment, the overall direction of travel in personal tax policy should be towards taxing all forms of income at similar rates, and that includes capital gains. The necessary reform here goes beyond tax reliefs to a complete overhaul of tax rates while reintroducing inflation indexing so that only ‘real’ gains are taxed. But the HMRC stats show that Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) cost an estimated £1.5 billion this year – a substantial sum even after the welcome tightening introduced in 2020. As we have been highlighting for years, allowing some very large incomes to attract tax rates of just 10 per cent is probably not a cost-effective pro-growth policy, and it may be best for it to be swept away along with the favoured – and perhaps legally shaky – treatment of carried interest and the writing off of Capital Gains Tax when people die or (for business assets) leave the country.

Inheritance Tax needs a range of reforms

In light of rumours that the government considered Inheritance Tax cuts for the Autumn Statement (and could return to them in the Budget or Conservative manifesto), the scale of its reliefs is of particular interest. The three key reliefs are George Osborne’s main residence nil-rate band (now costed at £1.8 billion), Agricultural Relief (£0.4 billion) and Business Relief (£1.3 billion) – with the latter costing having been greatly revised upwards. Scrapping all three (as well as the exemption of inherited pensions) would not only simplify the tax and ensure that large estates pay their fair share, but also allow the marginal tax rate for smaller estates to be lowered – with three bands of 20, 30 and 40 per cent, for example – to allay concerns (even if mostly unfounded) that low-wealth households will lose 40 per cent of what they pass on. There is also the more limited option of capping and better-targeting Agricultural and Business Reliefs so that they are more focused, given that 53 per cent of the cost of Business Relief in 2019-20 was accounted for by just the top 4 per cent of claimants, for example.

We need better, rather than just higher, taxes

In Ending Stagnation we have set out more tax recommendations beyond these reliefs, along with ideas covering a wide range of other policy areas. But the reforms above, highlighted by HMRC’s new statistics, would be significant in themselves. Even after delivering some significant personal pension contribution and Inheritance Tax cuts (and ignoring major CGT reform), the changes to seven tax reliefs highlighted here would raise roughly £15 billion a year.

Such changes should be considered even if you don’t think taxes should rise overall. For example, that sum could more than cover the cost of desirable tax cuts such as halving Stamp Duty Land Tax rates for homeowners and businesses to boost dynamism, and scrapping the high marginal rates that the withdrawal of Child Benefit and the personal allowance produce. A broad tax reform agenda – improving the quality rather than just the quantity of taxation – would aim to deliver all of these changes as well as provide the fiscal space to increase rather than cut public investment.

We should not pretend that tax reform by itself is going to unleash much faster growth, but realistic and efficient changes in the context of a broader economic strategy can help the country become both more prosperous and more equal.