In recent years the focus of fiscal policy in the UK, as in many industrialised countries in the wake of the financial crisis, has been on reducing the overall rate of public expenditure. However, despite a series of reforms to reduce tax avoidance and fraud, the tax system has largely remained unchanged since 2008, despite major concerns about its underlying resilience. Under the coalition government after 2010, the policy priority was radically curtailing spending rather than improving the sustainability of UK tax revenues. This was a major policy error reflecting a basic misunderstanding of what caused the financial crash and the ensuing fiscal crisis, no doubt encouraged by Conservative politicians after 2008.
Britain’s weak public finances and rising levels of public debt were not primarily created by profligacy and overspending in the New Labour years. Instead it was the absence of a more resilient tax system and an over-reliance on tax revenues generated from the deregulated financial services sector. As the crisis struck and financial services’ activity was squeezed, tax revenues fell dramatically, leaving the UK among the most exposed of the advanced economies. Although the Labour governments between 1997 and 2010 simplified the tax system and reduced the burden of corporate taxation as a means of promoting global competitiveness, too little consideration had been given to the likely impact of external macro-economic shocks on the UK’s tax base. This was unquestionably a serious failing of Labour’s macro-economic policy regime.
These events are a reminder that progressive centre-left parties have a variety of tax reform principles that they ought to achieve. The tax system is not only a means of raising resources to pay for vital public services while redistributing income between those on higher and lower incomes: it is also concerned with maximising stability and resilience in revenues, avoiding the ‘boom and bust’ scenario which ensued after the financial crash in the UK. As such, an important political challenge is to strengthen public legitimacy and confidence in the tax state after a long period in which tax resistance among UK voters has apparently been growing. There is a particular need to broaden the scope of taxation beyond ‘earned’ income to property, consumption, and activities which have a negative impact on the environment. Indeed, Britain can learn much from the reforms introduced by other European countries since the financial crisis.
Tax reform across EU member-states
According to the European Commission, taxation policies in EU member-states since 2010 have focused on advancing three broad public policy objectives: ensuring more sustainable public finances in the wake of the crash; promoting rather than inhibiting economic growth and employment after a prolonged recession and contraction of aggregate demand; and shaping fairer distributional outcomes as a countervailing force against rising market-based inequalities over recent decades. European countries have generally been effective since the 1990s at using tax and benefits systems to contain the rise in income inequalities, but there has been considerable reluctance to use the tax system to constrain the inexorable increase in top incomes. In 2011, the Organisation for Economic Co-operation and Development (OECD) warned that, “from the mid-1990s to 2005, the reduced redistributive capacity of tax-benefit systems was sometimes the main source of widening household-income gaps”.
There are a number of discernible trends in tax reform across the EU since 2010, outlined in a recent survey report by the European Commission. First, the tax burden has been rising across Europe as member-states seek to consolidate their public finances in the wake of the financial crash, although the Commission expects this to stabilise in the years ahead. The UK’s tax burden is lower than most other European countries: here, tax revenues are 32.9 per cent of national income, whereas the average across Western Europe is currently 38.9 per cent.
Secondly, there has been a sustained effort to reduce the burden of taxation on employment and labour. Measures have been targeted on low income groups, in particular in the more vulnerable sectors of the labour market. The Commission notes that there has historically been a “relatively high” tax burden on labour in Europe: reducing taxes on workers is designed not only to promote employment and job creation but to ease the pressures on low income households in the wake of the financial crisis. According to the Commission’s study, a small number of member-states such as Belgium and Slovakia have reduced taxes on employers, encouraging them to hire workers ‘on the margins’ of the labour market, notably disabled people and the long-term unemployed. Measures have not only lessened the cumulative burden of taxation on labour, but have been used to cut taxes for the lowest paid through tax credits and higher allowances. Moreover, in the wake of the financial crisis, a number of measures were taken to increase the tax burden for high earners particularly in the financial sector. However, this wave of reforms has now, the Commission says, “run its course” and further tax increases on the rich have been rare, not only in the UK. A number of countries have sought to identify alternative sources of revenue, enabling them to cut labour taxes without having a detrimental impact on public finances.
The third trend has therefore been a willingness to increase taxes on consumption either by increasing tax rates or by broadening the tax base. Consumption taxes tend to be favoured because they have less discernible impact on economic growth, and usually provide a more stable source of revenue. Understandably, there has also been a focus on taxing ‘bads’ such as alcohol and tobacco consumption, not only to increase revenues but to alter consumer behaviour and to promote public health objectives: countries from Poland to the Netherlands, as well as the UK, are increasing excise duties on these goods.
Fourth, a number of member-states have increased environmental taxes, although the impact of these additional revenues on the public finances has so far been modest. The aim of environmental taxes is to meet stated EU objectives relating to carbon use and climate change, such as reducing the use of fossil fuels by altering the behaviour of businesses and consumers.
Fifth, there has been some willingness to increase taxes on property, although this is by no means common to all member-states. Taxes on ‘immoveable property’ are considered to be least harmful to growth and produce fewer distortions than taxes on property transactions, but such taxes presently account for only 3.8 per cent of tax revenues across the EU, as the Commission notes. A number of member-states have continued to offer tax relief on mortgage interest payments, but many are reviewing these arrangements given the tendency to increase household indebtedness and to inflate the housing market increasing the risk of financial instability, as well as the regressive nature of such tax deductions. In the UK, for example, the housing market continues to be distorted by tax reliefs on ‘buy-to-let’ properties.
Sixth, member-states including France and Spain have used the tax system in order to stimulate ‘entrepreneurial activity’, for example by increasing incentives for equity investment in unquoted companies, as well as offering tax deductions on capital gains for individuals purchasing shares in start-up SMEs, such as the reforms recently introduced in Sweden. The UK has taken further steps to increase investment allowances for business.
Finally, all countries have been making sustained efforts to improve ‘tax governance’, strengthening tax compliance and reducing tax evasion, balancing these measures to encourage voluntary compliance with policies to strengthen enforcement. The European Commission emphasises that one of the most important steps in improving the resilience of the tax system in member-states has been to broaden the tax base, while reducing the number of tax exemptions which tend to have distortive effects on economic decision-making by households and firms. What these various tax reform principles illustrate, as Tony Atkinson notes in his recent book, Inequality: What can be done?, is that despite the constraints imposed by globalisation, national governments can, and do, continue to make discretionary choices about the structure of the tax system with major implications for equity and efficiency in their respective countries.
Principles of tax reform
After 2010, the coalition government in the UK focused on the following priorities for tax reform: raising VAT rates, extending the tax free personal allowance, cutting income tax for the highest earners, reducing business taxes, increasing taxes on property transactions at the upper end of the housing market, and strengthening measures to tackle tax evasion and avoidance. As can be seen from the discussion above, this direction of travel was broadly consistent with tax reforms across numerous EU member-states. However, George Osborne has continued the process of weakening the tax base by raising the threshold for the starting rate of tax. This is very costly and does not help the low paid as much as the better off. At the same time, the chancellor has cut corporation tax, believing that a national strategy of tax competition is right for the UK. This is somewhat at odds with the much bolder efforts by the previous Labour government to curb tax avoidance and build support for co-ordinated international action.
After 2015, it appears likely that a number of tax reform principles will continue to have salience across Europe. The first will be improving the resilience of tax systems in order to complete the task of fiscal consolidation. Second, we are likely to see a further shift away from taxing labour by increasing taxes on consumption and ‘immoveable property’. Third, the tax system will be used to stimulate entrepreneurial activity and small business formation. And, fourth, will be the use of environmental taxes to alter the long-term behaviour of citizens, businesses and key actors throughout the economy.
These general principles of tax reform appear at first sight to be broadly sensible and consistent with a progressive framework of fiscal policy and macro-economic management. In particular, the emphasis on reducing the taxation burden on labour is consistent both with promoting employment and raising living standards across the income distribution. What is striking, nonetheless, is the relatively low salience of reform principles relating to the distributional objectives of the tax system. Writing several decades ago, economists Richard and Peggy Musgrave concluded that the distributive purposes of the tax structure in the industrialised countries had progressively weakened:
“Attention appears to be shifting from the traditional concern with relative income positions, with the overall state of equality, and with excessive income at the top scale, to adequacy of income at the lower end. Thus the current discussion emphasizes prevention of poverty, setting what is considered a tolerable cut-off line or floor at the lower end rather than putting a ceiling at the top, as was once a major concern”.
The tax and benefit system was still designed to reduce inequality at the ‘lower end’, but was no longer envisaged as a mechanism for containing the rise in inequalities at the top of the distribution. The 2008 financial crisis raised the salience of income inequality as an issue in most western societies, as acknowledged by the OECD, the International Monetary Fund (IMF), and the Governor of the Bank of England, Mark Carney. However, this trend does not appear to have been reversed over the last decade either in the United Kingdom or across the European Union, although there are still considerable differences between member-states. Short-term measures to increase taxes on high earners and the wealthy in the wake of the crash have been gradually phased out. In the meantime, there is growing concern about whether the tax and benefit system can continue to perform the limited function of constraining the growth of inequality at the lower end of the distribution, especially given the rise of absolute and relative poverty rates across the EU in recent decades.
Among the most influential UK analyses of tax reform in recent years has been the Mirrlees Review undertaken by the Institute for Fiscal Studies. This outlined three broad principles: the tax system ought to be integrated closely with social security and the benefits system while ensuring financial stability and resilience; it should not distort consumer behaviour, avoiding taxing economic activities differently without good reason; and it should, ‘achieve progressivity as efficiently as possible’ by setting tax rates and allowances judiciously.
The evidence from this comparative survey is that tax and benefits systems, including in Britain, are partially achieving the final objective of ‘progressivity’ by promoting employment and reducing the taxation burden on labour. Nonetheless, governments across Europe are less willing to use tax rates to constrain the increase in high incomes, even in the wake of the financial crisis. In part, this reflects ongoing issues of tax resistance, as vested interests opposed to higher taxes have been able to foment growing public antipathy towards the tax state. In an era where concern about economic inequality among electorates has been rising, this raises major political challenges for social democrats in the decade ahead if the tax system is to achieve the progressive goal of constraining the increase in relative differences between the top and bottom of the income distribution.
Returning to the three broad objectives outlined by the European Commission, the UK, like other European member-states, has reformed the tax system to stabilise its public finances (although resilience remains a major concern), and to promote employment and growth in the wake of the recession. The third objective, achieving equity and fairness, appears to have been significantly downplayed. However, in a climate where popular concern about inequality is growing, this may well prove unsustainable in the long-term.
This is a chapter from Tax for our Times: how the left can reinvent taxation, edited by Daisy-Rose Srblin. You can read the full pamphlet here.