The UK should not waste its fiscal crisis

By Hugo Dixon
April 7, 2010

hugodixon–  The author is a Reuters Breakingviews columnist. The opinions expressed are his own  –

 The UK should not waste its fiscal crisis. As Britain embarks on its election campaign, this is a perfect opportunity to engage in radical tax and spending reforms designed not just to restore the country’s fiscal balance but to boost its long-term productivity and competitiveness.

It is, of course, necessary to cut the deficit, which is currently running at an unsustainable 12 percent of GDP. It is also important that spending cuts rather than tax rises bear the brunt of the belt-tightening. Otherwise, the UK will find that companies and rich people are increasingly driven off-shore.

The two main political parties — the Labour government and
the opposition Conservatives — broadly buy into this. However,
neither party has spelt out what spending it would cut and where
it would raise taxes. Nor have they given any inkling of seeking
to take advantage of the crisis to push through deep-seated
reforms. They are unlikely to do so during the coming campaign,
fearing that too much detail will scare the voters.

GUIDING PRINCIPLES

Nevertheless, the next government, faced with the immensity
of its fiscal challenge, will be forced to slaughter at least
some sacred cows. What then are the principles that should guide
it?

First, simplicity. The current tax system is a patchwork
quilt of loopholes, allowances and special arrangements. This is
an incentive to engage in elaborate contortions to avoid tax.

While perfectly legal, such activity is socially wasteful. Tax
lawyers and accountants benefit — as do the rich who are the
only people who can afford their expensive advice. Everybody
else loses out.

A second principle should be low headline tax rates. The
highest earners have just started paying 50 percent tax on
income above 150,000 pounds. This is a bad advert for the UK. Of
course, there are lots of ways for high-earners to cut their
effective tax rate. But it would be far better to close the
loopholes and limit the allowances — and compensate taxpayers
with lower tax rates.

Yet another principle should be that the government should
have no business subsidising the lifestyles of the middle class,
let alone those of the rich. Sure, there is a vital role in
helping out the poorest members of society. But many benefits
and tax breaks also help those in the middle and at the top of
the economic tree. Cut these, and tax rates can drop
substantially.

Finally, government needs to think long-term. Some action
does need to be taken to rein in the deficit in the short run.
But not all the belt-tightening has to come through in the next
parliament, which could last up to five years. Slow-burn reforms
that cut spending or bring in money over a horizon of five to 10
years — or even longer — are extremely valuable.

What would applying these principles mean in practice?

DON’T BE RETIRING

The current matrix of pensions policies have crimped the
UK’s productivity, created a government liability that is
unsustainable, and don’t even provide a good pension for the
people at the bottom of society.

There are three main culprits. First, the official
retirement age is too low. Men can collect their state pension
at 65, while women can still do so when they turn 60. This is
despite the fact that life expectancy keeps rising and many
people are living well into their 80s and beyond.

Second, the state gives generous pensions for public-sector
employees. The net present value of this liability is now 65
percent of UK GDP, according to actuaries Towers Watson — and
it’s not even included in the official debt figures.

Third, tax perks for pension saving benefit the fairly well
off who don’t really need an incentive to save for their old
age.

There are three solutions:

* The official retirement age should be raised to 70 for
both sexes over the next 20-30 years. Thereafter, it should be
further increased automatically as life expectancy improves.

This wouldn’t just save the state money; it would encourage
people to work for longer, so increasing the economy’s
productive capacity. Both the Conservatives and, to a lesser
extent, Labour are planning to increase the pension age. But
neither is nearly as radical as this.

* The government should close final-salary pension schemes
for both current and new public sector employees. That way, its
liability will at least stop rising.

* The raft of costly tax incentives for private-sector
pensions should be swept away. Instead, there should be a simple
incentive focussed more on those at the middle and bottom of
society. My colleague, Neil Collins, has proposed an excellent
plan for achieving this: the buy one get one free pension. Under
“Bogof”, any money put into a pension scheme (up to an annual
limit that is meaningful for the poor but peanuts for the rich)
would be matched pound for pound by the state.

CAPITAL IDEA

The capital gains tax (CGT) regime is another perk for the
wealthy. The rate is now only 18 percent, way below the new top
rate of income tax of 50 percent. Not surprisingly, high-earners
are using their ingenuity to turn income into capital gains
wherever possible.

This distortion in the tax system is unsustainable. The best
solution would be for people to pay the same CGT rate as their
income tax rate. To make this palatable, though, the top rates
of income tax should simultaneously be cut.

Another useful reform to CGT could be to modify the annual
tax-free allowance, currently 10,100 pounds. Oddly enough, this
is higher than the 6,475 pounds tax-free allowance under income
tax, which matters more to ordinary people. It wouldn’t be fair
to abolish the CGT tax allowance completely, as some people live
largely off capital gains. But one option would be to have a
single allowance of, say, 8,000 pounds, covering both income and
capital gains. Combine this with the equalisation of income and
capital gains taxes and the two taxes would essentially be
unified. Over time, it would also raise a significant sum of
money.

AN ENGLISHMAN’S HOME

The biggest middle-class perk of all is the generous fiscal
treatment of housing. The best element of this is that people do
not have to pay tax on the capital gains they make on their
homes. They are also no longer taxed on the imputed income they
receive from living in their homes. And there isn’t much of a
local property tax either. Local government rates used to be
roughly proportionate to the value of homes. But Margaret
Thatcher abolished those and replaced them with the poll tax.
Although that was ultimately killed off, the current council tax
is only loosely linked to property values.

The result of all this is the British love affair with
houses. Unfortunately, the infatuation is unhealthy. Young
people leverage themselves up to get on the housing ladder,
fearing that, if they don’t, they’ll find themselves priced out
of the property market. Not surprisingly, housing booms and
busts have featured prominently in each of the last two
recessions, with a knock-on effect on banks, which sometimes
have to be bailed out.

But the damage doesn’t stop at macro-economic instability.

The tax advantages of housing have distorted people’s savings
decisions. The bulk of the British people’s savings goes into
their homes. Not much is left over to recycle to investment in
industry.

What’s more, the whole system gives people a very odd idea
about the work ethic. During the last upswing, some homeowners
were regularly making more money from the annual capital gains
in their homes (which are untaxed) than from what they made at
work (which is taxed). This is unfair on those who either can’t
get onto the property ladder or don’t want to run up excessive
debts.

There are various ways in which housing’s fiscal
featherbedding could be mitigated. The government has just made
a modest move by raising stamp duty on properties worth one
million pounds or more from four percent to five percent. The Liberal
Democrats, the UK’s third largest party, have proposed an annual
mansion tax of one percent on properties worth more than two million
pounds. The best way of dealing with housing’s peculiar fiscal
advantage, however, would be to charge people CGT on future
gains made from property sales. This wouldn’t just remove a
major economic distortion; over time it would also generate
significant revenue.

VAT ATTACK

Another area ripe for reform is Value Added Tax. This is
currently levied at 17.5 percent. One of the top options for
raising money for the exchequer is to bump this up to 20
percent.

But this is not the best way forward. The only reason VAT
has to be even 17.5 percent is because swathes of goods and
services are tax-exempt — notably children’s clothing, most
food and books. A better alternative would be to sweep away the
tax-exempt categories and lower the rate.

Such a reform might provoke howls of protest from the
anti-poverty lobby on the grounds that it would be regressive.
After all, poorer people spend a greater proportion of their
income on food than rich people. However, it’s not going to be
possible to restore order to the public finances without some
sacrifice from poorer people. What’s more, most of the reforms
being advocated here would hit the middle classes and rich. Tax
reform packages need to be viewed in the round.

FAMILY VALUES

It is normally bad when the state tries to influence how
families are run. The Tories have a particularly wasteful idea.
They want to restore some version of the married person’s tax
allowance, hoping a tax break would give people an added
incentive to either get or stay married. Quite apart from
whether it is sensible to encourage what are presumably the most
borderline marriages, any money thrown at this pet scheme would
be better deployed either cutting income tax rates or the
deficit.

In a similar vein, the UK pays all mothers a weekly benefit
of 20 pounds for their first child and more for subsequent kids
– regardless of whether the mother is a Goldman Sachs managing
director or the dustman’s wife. This is barmy. By all means, be
even more generous to the dustman’s wife. But focus this benefit
on the really needy and recycle the savings to lower borrowing
and tax rates.

CORPORATE ACTION

Tax breaks and loopholes aren’t just a feature of the
personal tax system. Corporation tax is riddled with them. The
most important, and most damaging, is the tax-deductibility of
interest payments. This favours companies with hefty leverage –
most notably leveraged buyouts, commercial real estate
developers and banks.

The recession should have rammed home the dangers of
excessive debt. The solution is to phase out this corporate tax
perk over several years and to make countervailing cuts in the
rate of corporation tax. This would not raise any additional
revenue. But the tax system would no longer be distorted in
favour of debt rather than equity, and the whole economy would
be healthier. Ideally, such a reform would be introduced in
tandem with similar moves by other leading economies.

BANK BASHING

Banks are every politician’s favourite whipping boy. It’s
not surprising, therefore, that the main parties have backed the
idea of a levy on bank balance sheets.

In principle, this is an excellent proposal. The
justification is that banks relying on short-term hot money
endanger not just themselves but the taxpayer who has to bail
them out. It is therefore not only legitimate but sensible to
apply a levy proportionate to the size of their short-term
wholesale funding. After all, this would give them an incentive
to rely on safer retail deposits or long-term funding. Such a
levy could raise up to four billion pounds a year, according to
Reuters Breakingviews calculations.

That said, it is important that the UK doesn’t move
unilaterally. The International Monetary Fund is working on
proposals for a globally-coordinated tax of this nature. If the
big economies adopt some such tax, as seems increasingly likely,
Britain has nothing to fear. But the Tories have been unwise to
say they will go it alone if necessary.

CONCLUSION

None of the parties fighting May’s election has embraced
anything remotely as far-reaching as this package of proposals.
But, then again, neither Labour nor the Tories have said very
much about what they would do to tackle the deficit. One of the
two — or possibly a coalition with the LibDems if there is a
hung parliament — is going to have to decide. The parties
should remember that one of the advantages of a crisis is that
they will be able to push through changes which would otherwise
be deemed too radical. They shouldn’t waste the opportunity.

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