Taxation in the UK. James Browne. Senior Research Economist Institute for Fiscal Studies

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1 Taxation in the UK James Browne Senior Research Economist Institute for Fiscal Studies

2 Outline Overview of the UK tax system in historical, international and theoretical contexts: 1. Level and composition of revenues 2. Structure of the major taxes 3. Economic aspects of the overall tax (and benefit) system: References Effect on the income distribution Effect on work incentives How close to an expenditure tax? Survey of the tax system (more on 1 & 2) Adam, Browne and Heady (2010), chapter 1 of Dimensions of Tax Design The Mirrlees Review, available from

3 % of GDP The tax burden in the UK 48% 46% 44% 42% 40% 38% 36% 34% 32% 30% Public sector total receipts Net taxes and SSCs Line 3 Line 4 Source: HMT

4 Tax to GDP ratios Taxes and social security contributions 60% 50% % 30% 20% 10% 0% UK EU15 OECD USA Fra Ger Jap Swe Ire Aus Can Ita Source: OECD

5 Breakdown of net taxes and NICs, VAT Other indirect taxes Other taxes Personal income tax Capital Taxes Recurrent buildings taxes Corporate Income Tax NI Source: HMT

6 Composition of revenues Net taxes and NICs 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: HMT Other taxes Other indirect taxes VAT Other capital taxes Rates/Poll Tax/Council Tax Corporation tax National Insurance Income tax + CGT

7 Composition of revenues, 2005 Taxes and social security contributions 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Other taxes Other capital taxes Recurrent buildings taxes Corporation tax Other indirect taxes VAT / GST SSCs + payroll tax Income tax + CGT 0% UK EU15 OECD USA Fra Ger Jap Swe Ire Aus Can Ita Source: OECD

8 Income tax liability Income tax schedule For earned income, 2010 prices 120, , ,000 60,000 40,000 20, ,000 50,000 75, , , , ,000 Gross income

9 Changes to income tax structure Big reduction in top rates (83/98% 40%) between 1978 and 1988 the start of an international trend partly reversed this year with 50% rate above 150,000 withdrawal of personal allowance above 100,000 creates small band where marginal income tax rate is 60% Reduction in basic rate (33% 20%) part of an international trend Large-scale fiscal drag some increase in no. of taxpayers massive increase in no. of higher-rate taxpayers

10 Income tax as % of gross earnings The income tax burden, 2007 For single worker at multiples of average full-time earnings 35% 167% of average 100% of average 67% of average earnings 25% 20% 15% 10% 5% 0% UK EU15 OECD USA Fra Ger Jap Swe Ire Aus Can Ita Source: OECD

11 Changes to treatment of families Shift from joint to independent taxation in 1990 part of an international trend away from family taxation Abolition of additional tax allowances for married people and those with children Shift towards providing support for children and low earners through tax credits

12 Weekly NICs National Insurance schedule Combined employer and employee NICs, 2010 prices ,000 Weekly earnings

13 Changes to National Insurance More like income tax: Abolition of entry fee Contributions now continue above the upper earnings limit Alignment of NI threshold with income tax personal allowance between 2001 and 2008 Upper earnings limit aligned with income tax higher rate threshold since 2009 Benefits in kind now subject to National Insurance Contributory principle undermined

14 Social insurance and the contributory principle In Britain, National Insurance was traditionally closer to a Beveridge system flat rate payments gave entitlements to flat rate benefits when out of work etc Link between contributions and payments has become less important over time, on both contributions and payments side Contrasts with Bismarckian system where insurance payments give entitlements to benefits that replace previous earnings This tends to require higher tax rates, but despite this may have smaller effect on work incentives

15 PIT + SSC as % of gross earnings Total burden of income tax and NI For single worker at multiples of average full-time earnings 60% 50% 40% 167% of average 100% of average 67% of average earnings 20% 10% 0% UK EU15 OECD USA Fra Ger Jap Swe Ire Aus Can Ita Source: OECD

16 Main corporation tax rate Main rate Small companies' rate

17 Changes to corporation tax Main and small companies rates cut (52% 24% by 2014, 40% 20% from next year), part of a continuing international trend Share of revenue kept up though This is partly because of reduced capital allowances aim is to tax profits = revenue expenses (includes capital consumption) allowances exist to compensate companies for depreciation difficult to know what the true economic rate of depreciation is though allowances may not adequately compensate companies for depreciation of capital therefore (will return to this later)

18 The corporate tax burden Effective average tax rates and capital allowances % 90% Capital allowances (p.d.v.), plant and machinery EATR, equity-financed plant and machinery 80% 70% 60% 50% 40% 30% 20% 10% 0% UK79 UK05 USA FRA GER JAP SWE IRE AUS CAN ITA Source: Klemm (2005)

19 VAT Main rate 8% 15% in 1979 and 17.5% in 1991 in both cases to pay for reductions in other taxes further increase to 20% in January 2011 as part of deficit reduction package part of international trend towards uniform VAT Atkinson and Stiglitz result from optimal tax theory if there is weak separability between leisure and all other goods, uniform sales tax optimal But the UK has lots of zero rated items

20 VAT rates and bases 110% 100% 90% 80% Main VAT rate, 2006 VAT Revenue Ratio, 2005 (= VAT revenue/(vat rate * national accounts consumption)) 70% 60% 50% 40% 30% 20% 10% 0% UK1980 UK EU15 OECD Fra Ger Jap Swe Ire Aus Ita NZ Source: OECD

21 VAT Zero rating of items often defended on grounds of redistribution Atkinson-Stiglitz result shows that this argument is flawed - always better to use other means of redistribution (assuming consumption and leisure separable and ignoring externalities/merit good arguments) So taxing all goods uniformly and increasing a universal grant will always bring the system closer to optimality Submission to the Mirrlees review shows that it is possible to make VAT uniform, compensate the poor and still have 11bn left over

22 Percentage change in net income Distributional effect of uniform VAT and compensation package 4% 2% 0% -2% -4% -6% -8% -10% Loss from uniform VAT (raises 23bn) Uniform VAT + compensation package (costs 12bn) Poorest Richest Income decile Source: Crawford I., M. Keen and S. Smith (2010), Value added tax and excises, chapter 4 of Dimensions of Tax Design the Mirrlees Review,

23 Excise duties Fuel, alcohol and tobacco Rates increased, yet share of revenues declined (as in most other countries) Fuel protests in 2000 led to lower rates of fuel duty Serious concerns about smuggling, especially with spirits Believed that raising rates would not increase revenue Rate frozen in cash terms But may have also be because taxed more highly than wine & beer per unit of alcohol

24 Environmental taxes Various new environmental taxes introduced: Air passenger duty (1994, reformed with more bands in 2009) Landfill tax (1996) Climate change levy (2001) Aggregates levy (2002) London congestion charge (2003) None of these raised more than 2bn in 2009 compared with 26bn (+ VAT) from fuel duty

25 Property / local taxes Council tax: Based on property values (banded, no revaluation) with discounts for 1-person households and low-income families UK s only local tax (councils set average rate only) Business rates: Proportion of estimated market rent (unbanded, revalued) with discounts for businesses with low rents Central government now sets the proportion Lyons enquiry into possible reforms to council tax in 2007 Suggested revaluation, more council tax bands, maybe allocating a proportion of income tax revenues to councils No sign of any of this being implemented though

26 Part of an international trend? YES: Cuts in top and basic rates of income tax Shift from duties on specific goods towards VAT Corporate tax rates cut, base broadened Shift from family to individual taxation In-work support through the tax system SSC rates up even as PIT rates down Introduction of environmental taxes NO: Unusual in removing mortgage interest relief Increasing centralisation not matched elsewhere

27 Distributional effect of the tax and benefit system, Excluding most business taxes 60% 40% Benefits - taxes as a percentage of original income Benefits - taxes as a percentage of disposable income 20% 0% -20% -40% -60% Poorest 2nd 3rd 4th 5th 6th 7th 8th 9th Richest Decile group of equivalised household disposable income Source: Barnard, (2010), The effect of taxes and benefits on household income, Economic and Labour Market Review vol.4 no.7.

28 Gini coefficient Effect of tax and benefit system on income inequality Excluding most business taxes Private income Private + benefits Private + benefits - direct taxes Private + benefits - all taxes Source: Barnard, (2010), The effect of taxes and benefits on household income, Economic and Labour Market Review vol.4 no.7.

29 Gini coefficient Effect of tax and benefit system on income inequality 2003, personal taxes and benefits only Private income Disposable income UK EU15 Aut Bel Den* Fin Fra* Ger Gre Ire* Ita* Lux Neth Por Spa Swe* Source: EUROMOD statistics:

30 Change in Gini Effect of tax and benefit changes on income inequality Personal direct taxes and benefits only, population Uprated in line with RPI Uprated in line with GDP Taxes RPI-uprated, benefits GDP-uprated Source: Adam and Browne (forthcoming), Redistribution, work incentives and thirty years of tax and benefit reform, IFS Working Paper

31 Mean participation tax rates Personal taxes and benefits only 70% RPI indexed GDP indexed 65% Benefits in line with GDP, tax thresholds in line with RPI 60% 55% 50% Note: In work incomes for non workers calculated as described in Adam and Browne (forthcoming)

32 Mean effective marginal tax rates Personal taxes and benefits only 58% 56% 54% 52% RPI indexed GDP indexed Benefits indexed with GDP, tax thresholds with RPI 50% 48% 46% 44% Note: Workers only. See Adam and Browne (forthcoming) for more details

33 Work incentives among workers 1998, personal taxes and benefits only 80% 75% 70% 65% 60% 55% 50% 45% 40% 35% Mean effective marginal tax rate Mean participation tax rate 30% UK EU15 Aus Bel Den Fin Fra Ger Gre Ire Ita Lux Neth Por Spa Swe Source: Immervol, Kleven, Kreiner and Saez (2005)

34 Taxation of savings Atkinson-Stiglitz result again uniform commodity taxation implies tax on consumption should be the same in both periods (again, if leisure and consumption weakly separable) This implies a zero net tax rate for savings This is called an expenditure tax Caveats ignores the fact that there is labour income in different periods no reason that leisure in different periods should have same tax schedule may be optimal to have age-specific schedules or make future tax schedule conditional on current decisions But even so, difficulty of taxing all forms of capital income equally may mean uniform rate of zero is desirable

35 Expenditure tax - implementation Not just a sales tax can be progressive Remember that C = Y S Two ways of implementing it EET treatment: e.g. pensions in the UK (almost) Contributions: Returns: Exempt from tax (or tax relief on contributions) Exempt from tax Withdrawals: Taxed (on whole amount) TEE treatment: e.g. ISAs Contributions made out of: Taxed income Returns: Exempt from tax Withdrawals: Exempt from tax Identical if investments zero net present value

36 Expenditure tax at the corporate level Various ways of operating it: 100% first year capital allowances (i.e. count all investment as an expense when first made, but no depreciation allowances) used to have this in the UK for plant and machinery capital allowances that reflect true economic depreciation Allowance for Corporate Equity allow dividends that represent the normal return to capital as an expense (but no capital allowances)

37 How close is the UK to an expenditure tax? ISAs, owner occupied housing, durables have TEE treatment Pensions have what is sometimes called EEt treatment (tax free lump sum of 25%) This covers almost everything for most people But other savings accounts and shares have TTE treatment This is just in income tax though: need to consider Council tax (taxing returns from housing) Stamp duty (transactions based tax) Inheritance Tax (if bequests not accidental) Means tested benefits effectively impose a high rate of tax on saving

38 Effective tax rates on different forms of saving over a 25 year period Asset Effective tax rate (%) for: Basic rate taxpayer Higher rate taxpayer ISA, owner occupied house 0 0 Other savings account Pension (own contribution) Pension (employer contribution) Buy to let housing Direct equity holdings 7 33 Note: various assumptions see Adam, Browne and Heady (2010) for details

39 But EET structure of pensions can make them very (un)attractive Rate in work Rate when retired Effective tax rate (%) for: Own contribution Employer contribution Basic rate Basic rate Higher rate Higher rate Higher rate Basic rate Basic rate Basic rate and tax credit taper Pension credit taper Basic rate

40 Tax rates on investments 100% 80% 60% Company-level EMTR, equity-financed plant and machinery Company-level EMTR, debt-financed plant and machinery Company-level EMTR, equity-financed industrial buildings Top net income tax rate on dividends Top income tax rate on interest 40% 20% 0% -20% -40% -60% -80% Source: Klemm (2005) UK1979 UK2005 USA FRANCE GERMANY JAPAN

41 Changes to treatment of savings Closer to uniform tax-free treatment at personal level: Uniform rate of zero for pensions, ISAs, durables Removal of tax relief on life assurance and mortgage interest (EEE treatment) The removal of mortgage interest relief is an achievement that few countries have been able to emulate Further away from expenditure tax at corporate level: 100% capital allowances for plant & machinery ended

42 Summary Some successful attempts to reform the tax system in recent years, but still many areas in need of reform Debatable to what extent tax and benefit reforms are responsible for increased inequality Tax and benefit changes have improved the incentive to work at all, but left effective marginal tax rates unchanged overall Closer to expenditure tax treatment at the personal level, further away at corporate level

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