Options For Increasing Taxes As We Approach The UK Budget
23rd September 2024
The Institute for fiscal Studies looks at the taxation possibilities as the UK budget looms.
What taxes could the Chancellor increase in her first Budget on 30 October? And how could it be done in a way that improves tax design?
The ledgers of the public finances have rarely made for more dismal reading. Tax revenues are this year set to reach their highest level since the 1940s (and are forecast to rise further still). Nevertheless, spending plans pencilled in for future years imply big cuts to public investment and some public services. Merely avoiding spending cuts would - if debt is to fall - likely require raising tens of billions of additional revenue by 2028-29. Faced with such unenviable arithmetic, the Chancellor has indicated that tax increases are on the way - October's Budget, the Prime Minister has warned, will be ‘painful'.
The UK tax system offers a huge number of rate, threshold and base adjustments for a Chancellor in search of additional revenue. Ms Reeves, however, has not made life easy for herself. Labour's manifesto ruled out increases in VAT or National Insurance contributions (NICs) and increases to the main rates of either income tax or corporation tax - major restrictions to four big taxes that together comprise just shy of 75% of all tax revenues. The manifesto also pledged not to ‘increase taxes on working people', a phrase that could plausibly be interpreted as ruling out almost any increase in taxation.
Where, then, might the Chancellor turn to for revenue come October?
Income tax
Perhaps the simplest recourse would be to income tax. Labour's manifesto commits to not increasing the basic, higher or additional rates of income tax. But that still leaves the Chancellor with options. She could, for instance, lower the income thresholds at which those rates begin to apply. That could raise very substantial sums (although to do so it could not be confined to those with the highest incomes and it would clearly be a tax on ‘working people'). Reducing the personal allowance or the basic-rate limit (the thresholds at which the 20% and 40% rates of income tax begin to apply) by 10%, for example, would yield £10 billion and £6 billion a year in additional revenue respectively. But that would come on top of an £8 billion tax rise (in today's terms) that is already planned for the next four years as thresholds continue to be frozen in cash terms under plans bequeathed by the previous government.
Should the Chancellor be reluctant to reduce thresholds further, another option would be to adopt a less generous income tax treatment of pensions. Several aspects of the current system are poorly targeted and could be reformed to increase revenue. The maximum amount (currently £1,073,100) to which the 25% tax-free element applies could, for example, be reduced - though any such change would likely need to be phased in over time to avoid too much ‘retrospection’, and hence might not raise large sums in the short term. Ending the absurd exemption of some pension pots from both income tax and inheritance tax on the death of the owner would also be a positive step (though it would not raise large amounts).
Ms Reeves might also be tempted to limit the amount of up-front income tax relief provided on pension contributions (which are income tax exempt up to an annual limit, instead being taxed when withdrawn in retirement). Limiting relief to the basic rate could raise as much as £15 billion (although that figure does not account for any behavioural response by taxpayers). That is a tantalising sum for a cash-strapped Chancellor, but limiting relief to the basic rate would result in a less coherent tax system - not least because it would leave those expecting high incomes in retirement with a strong disincentive to contribute. A better option for raising substantial revenues from pensions taxation would be to impose some employer NICs on employer contributions to pensions, although this would be at odds with Labour’s manifesto commitment not to increase National Insurance. If levied at the full rate (13.8%), that would raise around £17 billion per year (before accounting for behavioural responses).
Capital taxes
Perhaps the area that has engendered the most media speculation about possible increases is capital gains tax (CGT), a tax on the increase in value of an asset between the points of purchase and sale that currently raises £15 billion a year. CGT suffers from poor design in several ways. Ending forgiveness of capital gains tax at death, for example, would both raise money (around £1½ billion before taking into account behavioural responses) and improve the design of the system.
More substantial revenue could perhaps be raised by increasing rates (although anticipating taxpayers’ responses to CGT changes is particularly challenging, making revenue projections uncertain). Taxing capital gains at lower rates than other forms of income creates various problems, but simply increasing CGT rates towards income tax rates – including by removing carve-outs such as business assets disposal (BAD) relief – would exacerbate the degree to which CGT discourages saving and investment. A much better approach would be to combine rate rises with a narrowing of the base on which the tax is levied – raising revenue while reducing distortions to savings incentives (these issues will be discussed further in a forthcoming chapter of the IFS Green Budget 2024). At a minimum, any increase in rates should be accompanied by an allowance for inflation. At present, purely inflationary gains in the value of assets are subject to tax.
Changes to inheritance tax (IHT) have also been the subject of significant speculation. IHT raises around half as much as CGT (£7.5 billion forecast in 2024–25) and only around 4% of deaths are subject to the tax – although projections by IFS researchers suggest that revenue will increase more sharply than forecast by the Office for Budget Responsibility (OBR) over the remainder of the decade as the scale of inherited wealth ramps up. IHT is ripe for reform in ways that could both raise revenues and make the tax fairer. A good start would be ending, or at least capping, the unjustified exemptions for pension wealth, business assets and agricultural land – a change that would raise around £2 billion a year assuming no behavioural response (a detailed discussion of IHT reform can be found here).
Property taxation
The part of the tax system that is arguably in the most advanced state of disrepair is council tax, a tax on domestic properties which partly funds local council services. Even in the absence of revenue pressures, there is a pressing case for reform (ludicrously, for example, properties in England and Scotland are still taxed on the basis of their estimated values as of April 1991). Bills are currently highly regressive with respect to property values and the Chancellor could sensibly choose to follow Scotland in making them more proportional. In 2017, the Scottish government increased rates on band E–H properties relative to less valuable properties. Applying these rate changes to England would raise around £1½ billion (assuming that councils did not use the change as an opportunity to reduce tax on lower-value properties). Going further and increasing rates by 50% on the highest-value properties (bands F–H) would bring in closer to £3½ billion. Without an accompanying adjustment to grants, any additional revenues would flow to local government rather than to the Treasury. Moreover, like income tax, current forecasts are already predicated on council tax going up – with average real-terms bill increases of 3% a year pencilled in for the remainder of the parliament.
Another aspect of property taxation to which the Chancellor might be tempted to turn for revenue is stamp duty land tax (SDLT), which already raises the sizeable sum of £13 billion a year. She should resist the temptation. For a start, an SDLT increase worth around £1½ billion is already pencilled in for April 2025, when increases to the thresholds at which SDLT begins to be charged introduced in Liz Truss’s ‘mini Budget’ are due to expire. More importantly, in a crowded field, SDLT has a claim to be the most economically damaging tax in the UK. It makes both housing and labour markets less efficient, acting as a drag on growth. It should be reduced or – even better – abolished, and certainly not increased.
Taxes on spending
With VAT increases off the table, by far the largest source of revenue from indirect taxation is fuel duties which are expected to raise £25 billion in 2024–25 (duties are also subject to VAT, raising a further £5 billion). While substantial, this is much less (in real terms) than they raised 15 years ago, thanks in part to the prolonged cash freeze in rates – the extension of which became an annual tradition for Conservative chancellors after 2011. Had fuel duties increased every year in line with the Retail Prices Index (the Treasury default), they would today raise an additional £19 billion per year. The OBR’s current forecast is predicated on the assumptions that fuel duties will increase by RPI inflation next year and that the ‘temporary’ 5p cut to duties introduced in 2022 (and retained ever since) will be reversed. On current inflation forecasts, cancelling those increases would, in today’s terms, cost the Chancellor £6 billion a year by 2029–30. Raising revenue relative to current forecasts would require rate increases above and beyond allowing the 5p cut and the cash freeze to expire. Doing so would raise around £¼ billion for each 1% increase in the rate of duty.
Other options
Were the Chancellor to find the strictures of her party’s manifesto too irksome, she could choose to create a new tax altogether. In 2024–25, more than £30 billion of revenue will be generated by new taxes created since 2001 – ranging from the tax on sugary drinks (£0.3 billion) to the various environmental levies charged on energy supplies (£11.5 billion). This option could either permit the Chancellor to tax a particular good or activity more heavily or to circumnavigate the letter (if perhaps not the spirit) of Labour’s manifesto by creating a facsimile of an existing tax under a new name. A recent example of this was the health and social care levy, whose design (before it was scrapped under the brief premiership of Liz Truss) was almost identical to that of National Insurance contributions (which the 2019 Conservative manifesto had pledged not to increase), with the exception that the earnings of those over state pension age were not exempt. Resurrecting this levy would raise around £15 billion a year if set at a rate of 1%.
A final possibility for Ms Reeves would be to wring more revenue from the UK’s many smaller, lower-profile taxes. This could add up to meaningful money, but reaching into the more obscure regions of the tax system for revenue has its drawbacks. A cautionary tale is the insurance premium tax (IPT), rates of which have been increased steeply since 2015 with the result that it now raises more revenue than inheritance tax. While that might sound to some like a success story, IPT rates are now set far too high – unjustifiably distorting spending decisions away from the purchase of insurance.
Conclusions
Even by the standards of an era when manifesto ‘tax locks’ have become increasingly common, the Chancellor has given herself little room for manoeuvre. Many of the tools best suited to the task of significant revenue-raising have been put out of reach. If that were not enough, substantial increases to income tax, fuel duties, council tax and stamp duty land tax are already pencilled in and factored into forecasts. Strengthening the public finances through additional taxation will demand tax increases on top of these already planned hikes.
Measures that raise big revenue are few and far between and (assuming Ms Reeves intends to stick to her party’s manifesto commitments) pensions taxation and capital gains tax are perhaps the most likely candidates. Both could be perilous. Restricting up-front income tax relief on pension contributions is superficially appealing but would make for an ever more jumbled tax system and add to economic distortions. Capital gains tax, meanwhile, would need to be carefully reformed or else tax rises would risk acting as an ever greater drag on saving and investment. These are not tidy-minded quibbles. Poorly designed taxes distort taxpayer behaviour in ways that hamper growth and, ultimately, damage living standards. Unlike the broad-based tax rises on income and spending that Labour has ruled out, raising large amounts of money from either pensions taxation or capital gains tax would also mean making a big change to a relatively narrow tax base. All else equal, that will tend to mean more uncertainty in how taxpayers will respond. While no reason to hold back from sensible reforms, this could make it harder for the government to estimate how much revenue it can expect to raise from any changes it makes.
A foray into the UK’s smaller taxes is another option – enough small changes could add up to significant money. But here too there are pitfalls; increases in stamp duty land tax and the insurance premium tax, for example, should both be avoided. On the other hand, there is no shortage of areas with defects (from inheritance tax exemptions to council tax rates) that, sensibly reformed, could raise revenue while enhancing efficiency. A path still exists for the Chancellor to raise revenue without exacerbating the worst features of the UK tax system, but Labour’s manifesto has made it a narrow one. With the government signalling that growth is one of its highest priorities, Ms Reeves would be well advised not to stray from it.
Appendix. Summary of potential revenue-raising measures
Table 1 provides a summary of the amount of revenue that could be raised through some of the measures discussed above. Unless otherwise stated, the figures below do not account for taxpayers’ behavioural responses. This is an important caveat. Were taxpayers to respond, for example, to an increase in inheritance tax by spending more of their resources during their lifetimes, this could substantially reduce the amount of revenue the measure would be expected to yield. The numbers below should therefore be taken as broadly indicative of magnitude rather than as a prediction of what a given change would yield.
Readers should note that the inclusion of policies in Table 1 does not constitute an endorsement. As this article has argued, for instance, capping up-front income tax relief for pension contributions at the basic rate would not be a desirable reform. Nevertheless, the measure is included in Table 1 to provide a more comprehensive picture of the options facing the Chancellor, however unwise some of those options might be.
Table 2 sets out the total revenue that is forecast to be raised in 2024–25 by the 15 largest taxes (by revenue) in the UK.
Read more with Table Two and notes HERE
