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Ryan Gwinnett: UK tax system essay competition

Ryan Gwinnett, University of York

Ryan Gwinnett is a History and Economics third year student at the University of York. He is originally from Wigan. Ryan is the first team football captain of his college at York - Derwent, and is also a keen golfer.

Ryan was runner-up in a PwC UK essay competition. We publish his piece with their permission.


How would you change the UK tax system to improve future employment prospects and drive the UK economy?

Introduction

We have a Nokia 3210 tax system in the UK; it is clunky, difficult to navigate and out of touch with the modern Briton. While the economy's foundations have shifted and growth has steamed on ahead, our tax system has remained static. We need a tax system that is user-friendly, maintains revenue streams and reflects the global digital economy we now live in - not a throwback to our manufacturing past. It is time for a long overdue upgrade.

I will focus on specific changes that can be made immediately to improve job prospects in both the short and long term. Also, I will address how these changes can be viably implemented to drive the UK economy forward. I will assume that the reforms I propose must, at the very least, maintain revenues and the progressivity of the current system, whilst targeting job creation and long term growth. This essay is therefore split into three sections:

(i) 1.0 Making work pay;
(ii) 2.0 Driving the UK economy;
(iii) 3.0 Balancing the books.

Together, these reforms would satisfy the criteria and act as a platform for future reform and simplification.

1.0 Making work pay

Firstly, this section will look at shifting the lower earnings limit of basic National Insurance contributions out to £10,000 per annum from its current £153 per week threshold, in order to align NICs with income tax (with a view to a possible combination of PAYE and NI as one rate in the future). This change would make the tax system simpler and give the working public more disposable income, with the biggest proportional improvement for the poorest in society. I will then discuss and appraise the incentivising of the most receptive in society to join the workforce through innovative tax reform on both sides of the labour market. At this point it is worth noting the importance of maintaining revenue streams from taxes and, as such, the costs of all policy changes are discussed in 3.0 Balancing the books.

1.1 National Insurance changes

The original relationship between NICs and social security eligibility has become a tenuous one. In reality, NICs now act as effectively another tax that ends up in the same pot as the rest of tax revenue. Combining them into one income tax is a possible future reform and has been called for by a number of groups including the IFS, 2020 Tax and a considerable amount of Conservative backbenchers. However, as a starting point towards this, I would first extend the lower earnings limit of National Insurance contributions for both employers and employees to £10,000 per annum income, in order to align both the earnings period and the lower threshold of NICs with PAYE. This readjustment would make the tax system simpler and act as a stepping-stone for future changes. Moreover, the first £10,000 earned in a year would then be truly tax-free which would be a far more progressive move than an increase to just the income tax-free personal allowance.

This would have a two-pronged effect on both future job prospects and the economy. Firstly, it would make it cheaper for firms to hire workers as their employer contributions would only begin after the point where their employees earned more than £10,000. As a result, this would also reduce unemployment in a hard hit social group, as the policy would be biased towards the employment of low wage workers. This bias is because a reduction in employer contributions would mean a higher proportional saving to wages for employers of low skilled labour. Secondly, the increase of LEL across the labour force would give employee earning £10,000 p.a. or above, over £250 a year extra disposable income to spend thus driving the

UK economy through increased consumption [1]. £5 a week may not seem like much but across the entire labour market, this increased spending could have a strong expansionary effect on GDP. Additionally, the savings for firms on the cost of labour may also see funds transferring into other areas of the business providing the necessary stimulus for further investment, which would - in turn - drive the UK economy even further and provide employment prospects in the future.

I accept the cost of implementation would be considerable, coming in at gross £16.2bn not including the tax revenues from increased spending and investment as a result of the reform [2]. However, the redistribution, increase in job opportunities and growth that it would encourage would make it a worthwhile reform. This reform is accounted for in section 3.1. to ensure that, crucially, the required tax revenues are maintained. This could be potentially the first step to combining them into one income tax, as stated previously, but this initial step would be a welcome change regardless. A future single income tax move would require heavy research and cost-benefit analysis to determine its viability against its greater simplicity, a possible task for the Independent Advisory Committee on Tax Reform that I propose in section 2.1

1.2 Incentivising the most responsive

The IFS's 'Mirrlees Review' proposes many radical changes to the UK tax system; one of the most viable of these is the targeting of particular groups in society most responsive to tax incentives in order to encourage them to participate in the labour market [3]. Mothers of children of school age are more responsive to financial incentives than those with under-5s, and therefore the UK tax system should reflect this differential responsiveness. Similarly, the IFS also pick out the over-55s demographic by proposing the removal of NICs as they are similarly responsive to financial incentives. However, age is now a less reliable indicator of need and the exemption that current pensioners receive from NICs only benefits the richest 6.3% of pensioners who have incomes over the NI threshold, therefore not an effective redistribution [4]. For this reason, I will disregard the latter proposal and focus solely on the former. As the IMF argued recently, reducing inequality is empirically associated with higher and more durable growth and therefore the first policy suggestion would be a better tool for driving the UK economy [5].

Specifically, I propose reducing the Child Tax Credit for mothers of children of school age, whilst simultaneously increasing the CTC for mothers of children under 5, in order to effectively target mothers of older children. At this crucial stage of the life cycle, mothers of children of school age are more responsive to work incentives. What is more, the measure could be implemented as revenue neutral as explained in section 3.2. This redistribution from mothers of older children to those with younger children can be viewed as fair from a life-cycle perspective. Economically, the bonuses are clear. The IFS projects this could bring 73,000 school age mothers into the workforce with 21,000 mothers of under-5s going the other way - a net increase of 52,000 mothers or 0.2% of the workforce. This would result in a modest gain for the Exchequer but the major advantage would be the increase of economic activity within this demographic which would provide a welcome boost to the UK economy, as long as these incentives were echoed by cheaper childcare either side of school hours to make their return to work possible.

2.0 Driving the UK economy

The reforms I have already proposed would obviously have expansionary effects on the UK economy in the short term, which also make them politically viable. Political viability and 'short termism' has hampered the pursuit of a beneficial, long term strategy to improve the tax system, resulting in the complex layering and overlapping of tax policies from bygone governments that characterise the current UK tax system. I intend to try and change this structural flaw by introducing an Independent Advisory Committee on Tax Reform (IACTR), which I discuss in depth in 2.1. The IACTR would be in place to provide sound advice in order to nurture a long term strategy for the UK. In 2.2 Long term investment is vital, I propose a change in Capital Gains Tax and the tax liability on dividends in an attempt to encourage long term investment to support UK innovation.

2.1 Independent Advisory Committee on Tax Reform

A prospective IACTR could revolutionise the way that tax policy is debated and implemented in the UK. As a platform for research, discussion and consultation with the public and business, it would make taxation more accessible and less distortionary. This would also aid in the decentralisation of tax system policymaking away from HM Treasury and government by bringing in the opinions of independent commentators, enabling tax policies to be scrutinised by a panel of experts on their benefits to the UK economy, rather than its benefits to an election campaign.

Independent bodies already exist in a number of areas to help shape government policy through the provision of independent advice and expertise. With a remit to challenge and develop tax policy, the IACTR could prove an effective medium to depoliticise tax policy decision-making in the UK, which would encourage the pursuit of a long term strategy. The stability of monetary policy, since it was handed to the Bank of England, proves that depoliticising certain aspects of government can be beneficial. The case with tax policy is less straightforward than an inflation target, but it is still a valuable parallel to acknowledge.

To demonstrate the merit of increasing discussion in this relatively little discussed portion of the fiscal mechanism in the UK, some of the items that could be debated and put forward include: making environmental taxes less piecemeal, fiscal devolution and making greater use of the digital data that HMRC receive to tailor the tax system to the global, digital economy. These, not to mention the potential merger of NI and income tax outlined in section 1.1, would allow the system to become more democratic, more informed and less politicised.

2.2 Long term investment is vital

The reduction in the headline Corporation Tax rate to 20% has made the UK the most competitive nation in the G20. Beyond this, we need to ensure companies view the UK as a good place to do business, not just a cheap place to shift their profits. To accomplish this target, we need to encourage long term investment in the UK. Young, innovative businesses are under heavy pressure to become profitable quickly. This short termism, endemic in British business and highlighted in the Cox Review, provides a disincentive to recruit, invest, research and develop new products, which are all vital to the long term success of the UK economy [6]. Instead, we need to encourage long term investment in areas with high growth potential through a business-friendly and simpler tax system.

To rectify this issue, I endorse the Cox Review's proposal to taper Capital Gains Tax on shares annually from 50% in year one to 10% in year ten and reduce the liability of tax on dividends in yearly steps, from the prevailing rate of income tax in year one to 0% in year ten.7 These reforms will go some distance to changing the corporate short termism, which currently hurts the long term innovation in UK business and increasingly exposes labour to the business cycle. This is proposed to cost around £6bn for the Exchequer but would have the advantage of reducing unemployment and allowing British businesses to plan long term, safe in the knowledge that their funding is less volatile. The cost of this reform is offset, as described in section 3.1.

As a result of British business having more secure investment funding, the resulting increase in recruitment and R&D would make the UK a hub of innovation which would drive the future UK economy forward.

3.0 Balancing the books

As well as the tax reforms I have so far proposed, there is also the need to maintain tax revenues to ensure their feasibility. Obviously, the spending of receipts is a very contentious issue that attracts more debate than the tax system but this beyond the confines of the mandate. I have assumed maintaining revenues as a pretext to the reforms I have proposed, and so this section will deal with how to balance the books without dampening the recovery of job prospects and expansion that I project will result from the reforms.

The current system penalises economic success by the significant distortion between what an employer pays and what the employee receives, which is a disincentive to work. As a consumer orientated economy, a more progressive, less distortionary taxation system would be to place greater emphasis on expenditure rather than on income. This way, it is much easier to ensure compliance in a global, digital economy. I propose to broaden the VAT base in the UK to reduce complexity and raise the required revenue to pay for the more job-friendly tax reforms I have previously put forward. Additionally, VAT does not discourage labour and has the advantage of not discouraging saving and investment decisions, which are crucial to the long term improvement of job prospects and driving of the UK economy [8] -as discussed in section 2.2.

3.1 Broadening the VAT base

The UK has one of the lowest "C-Efficiency" ratings, which measures the efficiency of consumption tax system, in the OECD, mostly due to its complex maze of zero and reduced rated products. I would make this much less complex by abolishing the reduced rate entirely and keeping only food and construction at 0% VAT. I would also add domestic fuel and power to this 0% from its previous reduced rate of 5%. This should minimise the distortions of consumer spending decisions whilst protecting the essentials. It would also raise £14.4bn, which would mitigate the cost of the NI LEL increase whilst maintaining consumer welfare [9].

Many view broadening the VAT base as a regressive tax, hitting the worst-off hardest, as their spending-to-income ratio is highest, but this is a simplistic view. Reduced and zero-rating are a poor way of targeting the poorest in society and, in fact, benefits the richest in society far more [10]. I would simultaneously implement a welfare redistribution to offset the fall in spending power of the poorest households. This is a much more efficient way of being redistributive rather than trying to use an inefficient VAT system to do both jobs.

This reform is not a silver bullet to tax system inefficiencies but it would hopefully begin a trend towards a more expenditure based tax system. The IACTR could potentially research methods to continue this shift with a view to the eventual complete abolition of the 0% rate, to end anomalies such as VAT free caviar, whilst simultaneously offering a progressive package to limit the reform hitting poorer households disproportionately hard. Note, this reform does not propose any changes to VAT exempt items, such as financial services, which are generally exempt due to structures of their markets.

3.2 Revenue neutral CTC changes

The advantage of changing Child Tax Credit in order to incentivise mothers of older children to return to work is that it can be made revenue neutral for both the Exchequer and mothers. The IFS proposed increasing CTC for mothers of under-5s to £3,100 from £2,235, whilst also decreasing it to £1,550 for mothers of over-5s as an incentive to return to work. This would also keep government expenditure at the pre-adjustment level and CTC aggregate income the same.

Conclusion

In summary, the reforms I have proposed are specifically targeted at increasing future job prospects and driving the UK economy - both in the short and long term. These reforms would, respectively: reduce complexity, increase the labour supply and encourage long termism in government and in business. They would also initiate a trend towards modernisation of the UK tax system so it began to reflect how the global economy and way people transact has changed. These advantages can all be realised without any damage to the Exchequer's finances, which is crucial to their viability. The steps I have outlined are ones that can be implemented immediately and I have demonstrated how these can act as stepping stones for future, more radical reform that would further upgrade our Nokia 3210 tax system.

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[1] Calculation 1, Appendix 1.

[2] Calculation 2, Appendix 1.

[3] James Mirrlees et al., Tax by Design (Oxford: Oxford University Press, 2011), 111.

[4] Professor Nick Bosanquet, Clare Fraser, Dr Patrick Nolan, "Mind the (fiscal) gap: direct taxes, public debt and population ageing," Reform Ideas No 10 (2013): 2.

[5] Jonathan D. Ostry, Andrew Berg, Charalambos G. Tsangarides, "Redistribution, Inequality, and Growth" IMF Staff Discussion Note (2014): 4.

[6] Sir George Cox, "Overcoming Short-termism within British Business: The key to sustained economic growth," An independent review commissioned by the Labour Party (2013): 13.

[7] Cox, "Overcoming Short-termism within British Business," 37.

[8] "Growth-Friendly Fiscal Policy" IMF, 2014, accessed December 27, 2014, http://www.imf.org/external/np/g20/pdf/2014/fiscpolnote.pdf.

[9] Calculation 3, Appendix 1.

[10] Dale Bassett, Andrew Haldenby, Patrick Nolan, Lucy Parsons, "Reality check: Fixing the UK's tax system," Reform (2010): 28.


Appendix 1

Calculation 1:

LEL of NI currently = £153 per week/£7956 per year Extending to £10,000 LEL would give a Class 1 £2044 extra tax free £2044 x 12% (NI tax on Class 1) = £245.28 per year extra.

Calculation 2:

From ONS: 30.8m people in work earning an average of £456 per week.

From C1, £2044 x (12%+13.8%) = £527 a year less tax revenues for the Exchequer from the abolition of employer and employee NICs between £7956 and £10,000 p.a.. £527 x 30.8m = £16.2bn.

Calculation 3:

Estimated costs of the principal tax expenditure and structural reliefs (VAT)

Removal of all zero and reduced rates except food, construction and domestic fuel and power = 4450 + 300 + 1650 + 1850 + 2250 + 3300 + 300 + 700 + 850 + 300 = 15950m Cost of changing domestic fuel and power to 0% VAT from 5% = 4800 x (0.20/0.2-0.05) = 6400m Total raised by simplification of VAT = 15950 - (6400-4800) = £14350m

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