What’s Wrong with Our UK Tax System ?

In short – it stifles incentive and enterprise.....

Let me try to explain.

The Covid pandemic, Brexit, and more recently the worldwide ‘cost of living crisis’ have undoubtedly put a huge strain on many western economies since the start of the decade, and ours in UK is no exception. 

The many billions gobbled up by pandemic costs and the furlough scheme in particular were but one example of the financial challenges we faced, and these will still have to be paid for somehow. 

Raising taxes was a logical response during the first years of the pandemic in an attempt to pay down some of our mounting debt. Maintenance of ultra-low interest rates and effectively ‘printing money’ via quantitative easing was another means adopted to try and soften the immediate economic blow in the late 2010s, but unfortunately had the effect of making the economy appear more robust than it actually was....and building up our debt mountain alarmingly.

These policies, which were in any case out of kilter with conventional capitalist economics, were never going to be a long term solution to our economic ills, however, and could be likened to ‘sticking plaster’ to prevent the financial ‘wounds’ the economy had sustained over the last 10 years from getting infected. The sticking plaster is definitely passed its best now, and like all sticking plasters, needs to come off if we want the old wound to heal. Maintaining the old policies for too long, as we have done, has arguably already proved to be injurious in stoking debt and helping drive inflation, and we need a rapid re-think before the damage progresses too far and the ‘wounds’ start to get re-infected.

Our main economic problem in the UK at present is lack of growth and chronic low productivity, coupled with a measure of worldwide post-pandemic over-expansion and consequent supply-demand mismatch. These are closely interconnected, and are the end product of two decades of aberrant tax and financial policies, a worldwide financial crisis, and nearly a decade of consequent austerity - and of course a new war in Europe. We are also a rapidly ageing society, and this major demographic change, along with our historic attitudes to employing older workers, and, of course, Brexit have all created a major imbalance in the working population and acute shortages of workers in some sectors. This, in turn, has caused a chronic and seemingly perpetual series of crises, and more recently an upward trend in industrial unrest, all of which threatens to bring our normal daily life inexorably to a halt.

How has the tax system contributed to this, and how could we change it to reverse the trend ?

Although the previous chancellor but one (now our PM) did make some early tax and benefit concessions in an attempt to alleviate the worst effects of the cost of living crisis, these were few and far between, and the trend since the start of the pandemic has so far been toward an ever-increasing total tax burden. Both personal and business finances are affected by this. 

The decision to freeze personal tax thresholds was a particularly perverse and regressive one, and its effect has been to stifle any incentive middle-earners might otherwise have had to progress onwards and upwards, without actually helping those lower down the earnings scale. Imposing a hefty increase in NI contributions earlier this year, just as prices started to rise precipitately, was another major disincentive, this time for both employees and employers, who quite reasonably reacted by cutting their recruiting plans to save the extra employment costs, thereby worsening the employment crisis.

Why does freezing tax thresholds provide such a strong disincentive to self-advancement ?

To explain this I’ll provide a fictitious, but I think perfectly plausible, example.

Edward is a young middle-manager in his mid-30s based in the North of England, and is married with two young children. He currently earns just under £50,000 p.a. His wife Mary is still working part time, but with two young pre-school children she prefers to keep her hours to a minimum, so her net financial contribution to the household budget is small. The burgeoning cost of childcare isn’t helping things and she anticipates having to reduce her hours further and perhaps even stop working altogether, to keep childcare costs down.

Edward has had an offer of a promotion to a regional manager post to fill a key position which recently fell vacant due to an unexpected early retirement. He feels encouraged by this offer, but is also a little daunted by it, since the new post carries a lot more responsibility and involves a move to a different (and more expensive) area of the country. His new salary would be ca £70,000 including use of a company car, but his hours would be longer and he would need to spend more hours away from home and his young family. 

Should he take the promotion ?

Being a prudent soul, Edward takes a good look at the figures before making a decision, and finds that, quite apart from any detrimental effects on family life, he would actually end up significantly worse off, and with a much higher level of mortgage debt, if he took on the new job.  

His main problem is tax – the extra £20,000 he earns will all be taxed at 40%, and by moving into the 40% tax bracket he loses another £500 allowance on any savings income he might receive. His family’s child benefit entitlement is also likely to be affected by his becoming a higher-rate taxpayer. Last but not least, he will have a hefty additional tax charge on the use of his company car as a ‘benefit in kind’ to reckon with. 

Then there is the question of moving – as we all know, moving house is an expensive and traumatic process even if you move between areas with comparable house prices, and the relocation package he’s been offered isn’t that generous. Edward would unfortunately be faced with a move from North to South, where house prices for 3- and 4-bedroomed homes are ca 2-3 times as high, and would also need to take on a much higher mortgage to buy a comparable property or be faced with the prospect of downgrading to a much smaller one. This is equally daunting at a time when mortgage interest rates are already shooting up from their historic and artificially-engineered lows. Quite apart from the deleterious effect on his finances and or living accommodation, the move would leave him less quality time with his young family, and arguably a lower 'quality of life'. 

A 'no-brainer', you might say, and unfortunately you’d be right…

Edward also faces another, and arguably more pernicious, dilemma - by not taking the promotion, he will also mark himself out as someone who ‘lacks incentive’, and is therefore unlikely to progress any further, and as a result he may even end up being a prime target for any compulsory redundancies in the future. Unfortunately, middle managers are particularly vulnerable as targets for corporate 'economies' at present, so this is not an issue he can safely ignore. 

Mary will also lose the opportunity to take on more work, which might otherwise have been possible if Edward's salary had increased, thereby depriving the economy of another valuable and much needed worker.

Last, but not least, there is an important financial consequence for the treasury itself. By not taking up the new position, Edward will deprive HMRC of a significant amount of additional tax revenue every year. If the 40% tax threshold had been raised to £80,000 (as promised by our last prime minister but one during his 2019 leadership campaign), Edward might well have come to a different conclusion and taken the new job. His additional salary, even when taxed at only 20%, would then have raised an extra £4000 p.a. HMRC will also lose any tax which Mary might have paid on her increased earnings, had she and Edward been able to afford childcare and enable her to return to full time work........

This example is not untypical of the dilemma many UK middle-earners are facing. Apart from the blow to their own self-esteem that their inability to progress their careers delivers, and the likely consequent effect on their individual job satisfaction and productiveness, this type of problem stifles growth in the economy as a whole. As the example shows, it also has the potential to decrease significantly the overall net tax-take,thereby reducing the Treasury's ability to fund important infrastructure and other projects. Last but not least, the personal frustration involved may lead Edward and Mary to reconsider their 'verdicts' on the competence of the current government when it comes to polling day...

Those with a more politically leftward-leaning ideology might argue that anyone earning £50k is already 'quite well-enough off, thank you very much', and we shouldn't worry too much about their financial 'woes', given the arguably greater needs of those lower down the earnings scale. 

However, there is a serious flaw in this argument - £50k nowadays is certainly not the 'princely' salary it once was, given excessive house prices and the soaring cost of living, particularly for single-earner families. More importantly, it is workers and small business entrepreneurs in the private sector such as Edward who are best-placed to lift us out of our current economic trough through their own enterprise. Neither Government, nor indeed the public sector as a whole, can do this effectively without their help.

Further up the age scale, older workers in their 50s and early 60s in particular, when faced with similar disincentives, will be tempted to leave the job market altogether earlier than they might otherwise, especially if they have already managed to accumulate sufficient pension income and savings to get by in retirement, their children have all ‘flown the nest’ and their mortgages have been largely repaid. Rapidly increasing interest rates (at long last!) will also serve to boost their unearned income from any savings they might have managed to accumulate. 

We know that this 'flight from the workplace' has already started to happen, with recent reports suggesting that upwards of a million workers have gone AWOL from the job market since the start of the pandemic. This is often blamed on the Covid 'event', but is more likely to be driven by a marked lack of incentive to work. The exodus is likely to gather pace in 2023, given the dramatic effect a bank rate rise from 0.1% to the 4.0% just announced by BoE over less than a year can have on savings income (despite the fact that the banks are so laggardly in raising their rates to savers in line with bank rate hikes). 

The skills  and expertise of these early retirees, accumulated over a working lifetime, are desperately needed just now to help us 'work smarter' and enhance our productivity. In a recent blog I’ve put forward specific arguments as to why we should entice some of these early leavers and the over 65s back into the job market....and how we might do it.

In short, we need a radical re-think on tax policy in order to release the stranglehold on growth and enterprise that ill-conceived historic and existing policies have engineered. 

We should remember, however, that many of our older pensioners are simply too frail and infirm to return to work. They will need society's help to get through the cost of living crisis, and we should not simply abandon them to their fate. 

There are all too many reports of pensioners terrified of the consequences of the latest energy price cap uplift, who are fully expecting to go through this winter and next without being able to heat their homes, and / or eat properly. Even with the government help which limited the cap uplift to £2500 for the 'average' consumer, this fear is not by any means limited to the poorest - many pensioners with at least some savings they have put by to provide care in their old age have been hit particularly hard over the past few years by punishingly low interest rates, and have seen the value of their increasingly meagre savings income and pensions eroded by increased costs. They should at least now be able to take some comfort from the rises in interest rates. We should also remember that the recent 'anti-mini-budget' as I like to call it has not only abolished most of Kwarteng's tax cuts, but has also limited the fuel bill assistance to 6 months. Come April, we will be back to square one, with the Ofgem energy cap rising to £3000 and a strong likelihood of further help thereafter being limited to those actually on benefits. 

We urgently need to provide additional help for pensioners, many of whom have little or no savings and are dependent on the State pension and whatever occupational pension pots they may have accrued during their working lifetimes. Those who retired after 2010 and took out annuities will have suffered from particularly poor annuity returns (due to the excessively low gilt yields caused by central banks' quantitative easing policies) which they will remain locked into. An uplift in their incomes could easily be achieved by a simple modification of the tax system. 

Currently, although the basic state pension is not taxed 'at source', it is taken into account by HMRC in assessing tax liability. For anyone lucky enough to have additional earnings from an occupational pension and/or savings which exceed the personal tax threshold  (currently a meagre £12.5k for a single person), part or all of their State pension income will taxed at 20% or more. This makes no sense, given that they have already 'bought' their state pension 'pot' from HMG through their lifetime compulsory NI contributions, and are now being asked to pay for it again through tax on the income it generates. The State Pension should be theirs by right in its entirety, and not 'raided' in this way by HMRC. We should therefore exempt the state pension from the tax assessment process altogether. Any additional income through occupational pensions should only be taxed at a flat rate of 20%, and excluded from total income calculations.

Let's now look at the other side of the debate regarding taxation. The argument currently put forward for not reducing the tax burden is that lowering taxes will involve excessive additional borrowing, and we need to pay down our debt before we embark on any tax cuts. 

This unfortunately was always a shortsighted and potentially very damaging approach (but sadly endorsed by the Markets in September (largely due to the unbelievably incompetent way in which the costings were ignored). The key assumption that the current policy  makes is that maintaining or even increasing tax levels will enable us to bring inflation under control and pay off some of our accumulated national debt relatively quickly, and we should wait until we've done this before lowering the tax burden. 

This assumption is fundamentally flawed – the size of the debt mountain (currently running well into the £trillions) is now so large that worldwide cost increases and the resulting rapid interest rate rises alone will ensure both personal and Government debt continues to increase whatever we do in the short term. It is only by increasing our national productivity and engineering consistent medium- and long-term growth that we stand any chance of escaping the ‘debt vortex’ that we’re currently stuck in. The recent doom and gloom announcement from the BoE of a 4-quarter recession to come only serves to confirm the existing strategy has failed, and emphasise the need for a significant policy change.

If we don’t take action to escape this pervasive economic trap, we will leave our kids the very debt legacy that proponents of ‘tax and spend’ from both ends of the political spectrum claim will be avoided.

As we have seen, the Markets have put a stop to any excessive and uncosted borrowing. Their caution, though understandable, doesn't alter our need to escape the debt vortex. I have suggested an alternative approach in a recent blog, focusing on enhancing our productivity, which we might take pending an improvement in the world economy. 

Let's hope this improvement in world fortunes comes sooner rather and later, and the chancellor doesn't manage to introduce yet another increase the personal tax burden again in the forthcoming budget. With Sunak and Hunt now firmly in the financial driving seat, though, I don't hold out much hope of much financial 'good cheer', in the short term at least.

Viv

Version Date 4.2.23