Objectives for a post-Brexit tax policy
It is not yet known whether Philip Hammond will follow this. He is said to be looking at a wider range of options, which is sensible because Osborne’s proposal, although fundamentally based on a good idea, to show that the UK is open and attractive to business, is far from being the most important tax reform.
Leaving the EU gives the UK an enviable opportunity to reshape its tax policy without some of the restrictions that have been imposed on us. But what should the priorities be? In this article I will look at some domestic tax issues; more international issues will be covered in a subsequent piece.
Taxing investment income
The UK has generally had a fairly sensible approach to taxing dividends. A company paying a dividend has already been taxed on its profits, so taxing the shareholder again at the full income tax rates would be unfair double taxation.
Instead for decades we have used a combination of lower income tax rates and tax credits so that, more or less, the overall tax paid is the same whether you operate a business yourself as a sole trader (paying income tax on the profits) or via a company (with the company paying corporation tax on the profits, and you paying a lower amount of income tax on the dividends).
This principle was recently abandoned by George Osborne as Chancellor, who has increased tax rates on dividends and replaced the tax credit with an extremely complex system of special allowances for different types of income.
The overall effect of Osborne’s changes will be to discourage investment, at least for any investment above a minimal level. They need to be reversed quickly, returning at least to the previous regime until a more fundamental reform of the interaction between the two taxes can be decided on.
Top rate of income tax
The 45% top rate of income tax is a piece of political posturing that has gone on for too long. Initially a Labour proposal, it probably does at least as much harm as good, in discouraging business expansion; why bother growing your business if it just brings you into higher tax brackets?
The 45% rate raises almost no more money than the main 40% higher rate, but it sends out a message that investment, entrepreneurship, effort and success are discouraged.
A related tax provision that is ripe for abolition is taking away the income tax personal allowance from people earning more than £100,000 per year. Again it raises very little revenue, but it adds hugely to the complexity of the tax system and it creates a 60% effective marginal tax rate for people with income between around £100,000 and £120,000, because each extra pound of income is effectively taxed twice. We should return to the principle that the personal allowance is for everyone; a level of income that everyone should be able to earn free of tax.
In the medium term we need to move to a flatter, simpler tax system, as I have argued for many times in the past; abolishing these vindictive taxes would send out a powerful message that the government is moving in the right direction.
Income tax threshold
Whenever I have proposed a flat tax for the UK, I have always coupled it with an increase in the personal allowance, the income tax threshold, so that low earners are taken out of tax altogether.
To his credit, Osborne has done a lot of this, but not enough; he has raised the allowance in nominal terms to the sort of levels that I was proposing ten years ago, but it has taken so long to get there that inflation has reduced its value.
Ideally the personal allowance should be pegged to the minimum wage; it makes no sense to say that this is the level of income that is needed for modern life, but to then take some of it away in tax.
This would also solve the problem of the “Living Wage”; as Tim Worstall has shown, the current minimum wage would be worth as much as the proposed living wage if it were not taxed. And reducing tax would be less damaging to job prospects for low earners than raising the minimum wage, which risks pricing many people out of work.
Taxation of landlords
Some of the above measures were initially proposed by the last Labour government, but the next thing to be looked at is a tax for which Osborne can take the blame.
The principle of income tax on business income has always been that you are taxed on your profits, that is, the gain minus any legitimate expenses. But that is now being abandoned for rental income. Landlords are now facing a restriction on the amount of mortgage interest they can deduct from their rental income in calculating their taxable profits.
This could, in many cases, leave the owners of property businesses paying more in tax than they have made in profit on their rent, because their ability to deduct mortgage interest is restricted.
What’s worse, the effect of this is random. Imposing higher tax rates on the profit of rental properties, whilst still a bad policy, would at least be understandable and apply equally to everyone. But the effect of this will depend on how much of your rental income you have to pay out in mortgage interest.
Bizarrely Osborne’s plan favours the wealthy, who own their investment properties outright and do not have any mortgage and so have no interest payments to be affected, and only penalises those who are trying to build a property business.
Of course the housing market is overheated, this is not the way to solve it. Property prices are a function of supply and demand, and for years supply has not kept up with demand. The problems of housing need to be solved through the land use planning system, not by tinkering with the tax system.
Intelligent tax design
Critics may say that most of the above measures benefit the better off, or investors, or some other unfavoured group.
But that is to look only at the immediate effects. The evidence is now clear that taxes on investment and business mostly harm not the business owners or investors but their employees and the unemployed. Higher taxes reduce investment, make labour less productive and reduce job opportunities.
Rather than pretending that the economy is static, a cake to be divided up, we need to look far more at the longer-term effects of taxation and judge tax reform on how it will affect the economy rather than attempting to micro-manage small transfers of income from one group to another.
This is just a start; there is much in our tax system that is in need of reform. But these measures would do a great deal, not just to solve immediate problems but also to show that the UK is moving towards a dynamic economy, open to growth.