Taxes are often the subject of debate; that is as it should be. But those debates need to be well-informed to produce sensible policy outcomes. This will be even more important in coming years as we see debates on whether – and, if so, how – to raise taxes to pay, for example, for additional health and social care for an ageing population, and for the transition to net-zero carbon emissions. Any debates should start with a clear understanding of how taxes currently work, who pays them and what the options for reform are.
To help with this, IFS has recently launched a new website, Taxlab, aiming to provide a ‘one-stop shop’ for impartial explainers, answers and data on tax – including the information on which this article is based. Over time, we will be adding much more to the site.
UK income taxes
One area that would benefit from increased debate – and ideally substantial reform – is how we tax incomes.
The UK effectively has two income taxes – income tax and National Insurance contributions (NICs). They are the two biggest taxes and together raise almost half of all tax revenue. Getting income taxes right should not be a niche pursuit.
NICs are misunderstood and commonly overlooked
There are two common misconceptions about NICs. One is that higher NICs payments earn people rights to higher benefits. In fact, the link between the amount of NICs paid and the amount of benefits received is now vanishingly weak. The other misconception is that NICs revenues are hypothecated to fund the NHS. In reality, there is no meaningful link – NICs revenue doesn’t affect how much is spent on the NHS any more than other revenue sources do.
NICs are a second income tax in all but name. Yet while it is common to hear discussion of income tax rates – the 20% basic rate or the 45% top rate – it’s extremely rare to hear mention of the combined income tax and NICs rates, which can reach a top rate of 53.4% (including employer NICs). One effect of ignoring NICs is that the progressivity of income taxes is easily overstated, because at the higher-rate threshold income tax rates rise but NICs rates fall.
Another effect of ignoring NICs is that it is easy to forget that combined rates vary a lot across different forms of income. NICs are charged at substantially lower rates on income from self-employment than on employment income. They are not charged at all on income from savings, dividends, pensions or property. And there are no employee or self-employed NICs charged on the earnings of those above the state pension age. This variation in rates can lead to unfairness as similar people get very different tax bills. It also encourages more work to happen through self-employment and through people working for their own company (and paying themselves in dividends) than would be the case if purely commercial choices were being made.
UK raises less than other countries from NICs, but should think carefully before it raises more
Over the past two decades, the share of UK tax revenue coming from NICs has increased. Yet if we compare the UK with countries that raise more revenue overall, we see that this is almost entirely accounted for by the fact that the UK raises less in NICs than these other countries raise through their equivalent social security contributions, especially on the salaries of middle earners.
But if we chose to raise more from NICs (without changing their structure), we would be increasing taxes on earnings relative to taxes on capital incomes (i.e. incomes from savings, dividends, pensions and property). This would exacerbate the problems associated with having preferential rates on capital incomes.
Strong case for a single income tax and reforms to taxation of capital income
There is a strong case for reforming income taxes.
Simplicity and transparency would best be served by a single tax, merging income tax and NICs. This would be a good idea even if it were deemed desirable to keep lower rates on some forms of income: at least decisions over preferential rates would be made explicitly and their implications would be easier for people to see.
There is also a strong case for aligning overall marginal tax rates across labour and capital income while reforming the tax base (for example, the treatment of investment spending) to ensure that higher tax rates on capital incomes do not distort saving and investment decisions.
The case for reform is strong even if it is decided that the UK should not raise more tax revenue. Better-designed taxes allow us to raise any amount of revenue with less economic harm.
The politics of tax reform are difficult, but worth the fight
Reforming taxes can be difficult. Any meaningful reform, however beneficial overall, would create losers as well as winners – and attention tends to focus on the losers. But keeping the status quo is also a choice – one that unfairly penalises ordinary employees (who are taxed more than business owners in return for the same services), as well as creating significant economic inefficiency and administrative costs that make us all poorer. If more people knew what the status quo entailed, there would likely be more pressure for reform.
This article was first published in AT magazine and is reproduced here with kind permission.