Recent reforms have focused on raising the personal allowance to ‘take the poorest out of tax’, but this is not the progressive policy it purports to be. If we want to genuinely support lower income households, we need to engage with reforming a broad range of different taxes as well as looking to the much bigger prize of the benefits system.
Often in discussions of inequality, ‘progressive’ politics and ‘fairness’, the debates around tax are dominated by how we should tax those at the top. But it’s just as important to look at the people this is supposed to be helping. This means considering how taxes could be reformed to help low and middle income families directly,1 as well as what limits there are to helping them through the tax system. Recent debates on tackling tax evasion and calls for new taxes on the richest are welcome, but from the perspective of low earning families, their direct relevance is limited. At the same time, there has been great emphasis on raising the‘tax free’ personal allowance for income tax – sold as ‘taking the poorest out of tax’ and a ‘tax cut for low earners’. This represents a shift from discussing cutting rates to raising allowances, which is far more helpful for the poorer half of society. However, while very popular, it is not as progressive as proponents often argue (and note that the same applies to the very similar policy of reintroducing a 10p band). First, almost all income taxpayers benefit from the policy, which makes it very expensive and not well targeted, with most of the gains going to the top half of income groups. Furthermore, as ever more taxpayers are already ‘taken out’ of tax, there are diminishing returns for the poorest income
groups. Finally, income tax is not such a large part of the tax paid by low income families, representing only 19 per cent of their total tax burden on average.2
So, if we want to reform taxation in a way that genuinely supports lower income households, we need to engage with reforming the broad range of different taxes that make up the bulk of the low income tax burden.
Making tax fairer for the poorest
First, there’s income tax’s ugly and criminally-neglected sister: National Insurance (NI). This kicks in at around £8,000 while the income tax allowance for 2015–16 is £10,600. This means there are around 1.5 million low earners who have been ‘taken out of tax’ but still pay NI. Realigning these thresholds, and therefore abolishing a 12 per cent tax band for the lowest paid, should be a greater priority than further income tax cuts, though it would again be higher income households who would benefit most.
Indeed, the existence of a separate NI system now seems more of a burden than an ally for poorer households. NI more generally is unhelpful in achieving ‘vertical’ or ‘horizontal’ tax equity and transparency; that is people in similar circumstances pay similar amounts, and that the better-off pay at least the same proportion as the less well-off. For decades, governments have cut income tax while increasing NI. The result is that if your money comes from owning property or stocks, you pay income tax at 20 per cent, but if your money comes from employment, you pay a combined rate of 32 per cent (even before considering 13.8 per cent employer NI – which arguably lowers salaries). Similarly, the regressive structure of NI, with the rate falling from 12 per cent to 2 per cent at higher incomes (and a flat rate for employer NI), means that the progression of tax rates is not as steep as the headline income tax rates suggest, providing a further progressive case for reform.
Even more of a burden for lower income families is VAT, which makes up 23 per cent of their overall tax burden on average. This is a greater proportion than either income tax or NI, despite the fact that many goods and services are exempted or subject to lower rates (the UK having one of the narrowest VAT bases in the EU). Similarly, the impact of corporation tax and business rates may be passed onto consumers through prices or employees through lower wages. But there are strong arguments in favour of keeping all of these taxes, and of avoiding frequent changes. So given the expense of cutting these economy-wide taxes, better targeted approaches need to be found.
Perhaps surprisingly, taxes on alcohol, cigarettes and transport are together roughly as significant for poorer households as income tax, at 17 per cent of their tax bill on average. Of course, such ‘sin’ taxes are deliberately high, but any opportunity to reduce this burden should be explored – demonstrating the links between tax and other areas of public policy. For example, a big reduction in smoking, such as due to a wholesale shift to e-cigarettes (assuming that they are far less unhealthy than tobacco), would be an extremely significant tax cut for low and middle income families, more so than many of the tax cuts that are bandied around. The long-term need to reform fuel duty and Vehicle Excise Duty (despite recent changes to the latter) to reflect the greening of cars may also present opportunities to make these taxes more progressive while maintaining their behavioural and revenue-raising goals.
Finally, there’s council tax, which makes up 13 per cent of the poorer half’s taxes (before considering benefits), offering one of the clearest opportunities to make the tax system fairer for lower income families, through both revaluation and reform of tax bands. Partially inheriting its design from the poll tax, council tax is unusual in being deliberately regressive. A property worth hundreds of times more than another may nonetheless incur a maximum of three times the tax. As Paul Johnson puts it, “We wouldn’t charge a lower rate of VAT on a Ferrari than on a Nissan. It is not much more evident why we should charge a lower rate of council tax on a £2 million mansion than on a £50,000 flat.”
Together with the fact that it is based on property values as they stood in 1991, and that this is likely to still be the case in 2021, it is ripe for reform. Many of the UK’s neighbours offer examples for reform. Ireland has moved to a system that uses bands but is proportional (except at the top where the tax rate actually increases). In the Netherlands, properties are revalued every year and are taxed at a flat rate set by each municipality. And in Norway, municipalities can tax property at up to 0.7 per cent of value. If these and many other countries can manage it, why can’t the UK?
In the recent general election, Labour and the Liberal Democrats both proposed extra council tax bands – or their equivalent – at the top of the system. But there is a need for more bands at the bottom too, as demonstrated by the fact that in the north of England and the midlands, 42 per cent of households are lumped together in Band A, as Resolution Foundation analysis has shown. A limited reform (but still ambitious given the past 25 years) would be a revaluation with new bands or a percentage charge at the top, funding at least one extra band towards the bottom. The goal – whether achieved incrementally or in one, and nationally or via devolution – should be to move closer towards a tax that would be around 0.5 to 0.6 per cent of the up-to-date property value each year (so, for example, a £100,000 home would pay £500–£600).3
So, there are some limited opportunities and longstanding possibilities to reduce taxes for low and middle income families. And there are some ways to fund those within the same taxes, but – to take a brief look at the taxes of those on higher incomes – how else might revenue be raised?
One critical yet achievable goal would be better scrutiny of tax breaks. These are often well-intentioned, designed to support growth or fix a wrong elsewhere in the system, though cynics might suggest many have more to do with winning votes or simply historical accident. But assessment of whether these tax expenditures are meeting their goals is limited at best, and incomparable to the scrutiny that spending programmes receive, despite their equivalent budgetary impact.
These tax breaks might be incentives to encourage business creation (such as loopholes in capital gains tax or inheritance tax); the differing NI treatment of different sources of income, as discussed above; pension and age-related tax breaks (such as the NI exemption for older workers); or the favourable treatment of property ownership. Some go to the top 1 per cent or 10 per cent; others to those on high but not super-high incomes. Most importantly, none are well targeted at the bottom. And while they may have benefits – and we should seek a tax system that supports long-term productivity growth, employment, economic stability and homebuilding – it’s worth asking whether these tens of billions of pounds per year could be better and more evenly dispersed. As William Gladstone put it in 1863, “in every case exemption means a relief to A at the charge of B”. In effect “B” is usually the typical low or middle income employee. So we need to improve both the formal scrutiny and informal discourse around tax breaks, while also laying out the size of the potential prize: how else could taxes be cut for the same cost?
The limits of conventional tax cuts
However, there are limits to what can be done through the tax system. On direct taxes, 43 per cent of adults already pay no income tax4 (though some of those pay NI), and it is arguably even harder to target indirect tax cuts on poorer families, meaning the potential for boosting their incomes through cheap tax cuts is limited.
The benefit system, on the other hand, works very well at targeting low and middle income families – and even universal benefits are more progressive than almost any tax cut. The introduction of universal credit is a good chance to consider the importance of the benefits system. It will cover around a third of working-age households, including half of all children, and a large number will face a withdrawal rate (with their benefit being reduced as earnings increase) of 65 per cent, which when combined with direct taxes will most often mean a 76 per cent effective tax rate. What’s more, and in a change from the current benefits system, two thirds of any gains from income tax and NI cuts will now, just like extra earnings, be withdrawn from universal credit households.
From a low income perspective, ensuring the benefits system works as well as possible therefore offers a much bigger prize than tweaking the tax system, as the Resolution Foundation’s recent review of universal credit has shown. However, although out-of-work welfare reliance is at its lowest level since the 1970s at least,5 “hand-outs” will never be particularly popular with the public. On the other hand, tax cuts are extremely popular. So to ensure continued (or even increased) support for lower income families, one answer might be to rebrand or reform benefit giveaways as tax cuts.
For economists, at least, the two aren’t particularly different. Consider, for example, council tax support, which provides a discount to council tax: is that a benefit or a tax cut? Many would say it’s clearly a tax reduction – and indeed there have been campaigns to rename it as a tax ‘rebate’ – but it is not counted as such. The distinction is important for public perceptions, and for the numerical size of ‘the state’ and the ‘welfare budget’, even if it makes no difference to disposable incomes.
Similarly, under the tax credit system, the benefit was recorded as a tax cut for those paying income tax and as ‘spending’ for those not. We should consider extending this idea within universal credit. It’s fairly common to be paying thousands of pounds in income tax and employee NI, and another thousand in council tax, while also receiving similar amounts in benefits. It would not be affordable to cut taxes so far for everyone that no one on universal credit would face taxes. But instead of both receiving benefits and paying tax, would it not be possible to deliver universal credit (or child benefit, or others) as a cut to your income tax, employee NI, and council tax, with only the remainder delivered as a ‘benefit’? None of this would directly change people’s incomes or work incentives, and it would require significant administrative change. But it could change people’s perceptions of our entire tax and benefit systems and whether they or others deserved support. More broadly, beyond the taxes that can be directly cancelled out, one could paint a large proportion of – though certainly not all of – welfare spending as effectively tax rebates (or prebates) for VAT and other indirect taxes. Again, discourse should reflect the fact that the benefits system and tax system do not exist in isolation. There are therefore tax reforms that would help low and middle income families, and many more if we cast our nets only a little further to the deeply linked benefits system. While much recent rhetoric has focused on ostensibly popular but relatively poorly targeted changes to income tax, a broader programme of reforming and reframing taxes and benefits could have a far greater impact. If we want to see truly progressive tax reforms focused on the bottom half, political bravery and determination will be essential.
2. For the poorest half of non-retired households. This and other figures (all excluding retired households) from ONS, The effects of taxes and benefits on household income, financial year ending 2014 (2015).