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We must seize the chance to rewrite Britain’s tax rules

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Being in the EU places constraints on government policy. When we leave we will take back control. That gives us the chance to do things better. It also gives us the chance to do things worse.

In some areas it’s hard, though sadly not impossible, to believe that we could do much worse. It would take a special kind of stupidity to replace the common agricultural policy with something more damaging. In other areas the dangers should be obvious. EU state aid rules provide the sort of constraints on government intervention that, while frustrating in individual cases, can prevent long term economic damage.

All new government policy should be assessed against these dangers and opportunities. Some areas will need careful thought. Tax is a case in point.

Most parts of the tax system have relatively little impact from the EU. We have plenty of freedom over the design of income tax. The Commission wants to extend its reach over corporation tax but we will have broader multilateral obligations whether inside the EU or not. When it comes to indirect taxes, essentially VAT and excise duties, though, the EU does place some pretty severe restrictions.

Here we have our legal relationship with the EU in microcosm. Some of those restrictions force us to do silly and damaging things; some prevent us from creating a mess.

It is EU law, for example, that forbids us to tax some types of drinks according to their alcohol content. Strong cider is taxed less per unit of alcohol than any other drink. Very heavy drinkers are rational to the extent of consuming a large fraction of their alcohol in the form of strong cider. The EU is not rational since it is EU law which forbids us from changing the structure of alcohol taxation to address this. I hope the Treasury is thinking harder than ever about how to reform alcohol taxation.

On the other hand, being in the EU makes it difficult to really mess up parts of the VAT system. We can’t simply decide to offer special treatment and lower rates of VAT on consumption of whatever is the current flavour of the month. As with the state aid rules, the EU offers a bulwark against corporate lobbying and pork-barrel politics.

One of the most far-reaching and damaging aspects of EU tax law relates to VAT exemptions, and in particular the exemption of financial services from VAT. This is a vitally important part of the tax system which we now have a chance to rethink. It is with this in mind that, as the dust settles from the autumn statement, I have become increasingly surprised and disappointed by the chancellor’s decision to increase insurance premium tax (IPT) to 12 per cent — double what it was at last year’s election.

As a financial service, insurance is exempt from VAT. The EU gives us no choice on that. That means that there is no VAT on the purchase of insurance but also that insurance providers cannot reclaim VAT paid on any inputs they buy in the normal way — a cost they will largely pass on to their customers. That’s why exemption (as opposed to zero rating, where VAT on inputs can be reclaimed) is so damaging. Exemption distorts commercial decisions, such as whether to purchase inputs or produce them in-house, and often creates phenomenal levels of complexity. Exemption also means that financial services are cheaper than they should be for households, relative to a world in which VAT is applied at the normal rate, and more expensive than they should be for firms, which ought to be able to claim back any VAT incurred in the production of the service. Anything produced by firms that use financial services will have irrecoverable input VAT built into the price on top of the usual 20 per cent VAT.

IPT was introduced to compensate for the VAT exemption of insurance. Without IPT households would be paying too little for insurance and firms too much. Broadly, the “correct” tax on insurance for households would be 20 per cent of the difference between premiums and payouts. Since IPT is levied on premiums alone, that would roughly equate to a low single-digit tax rate. So a 12 per cent tax on premiums is much higher than the appropriate rate on households, let alone on businesses which were being overtaxed on their use of insurance even before IPT was introduced.

All of that would have been true even in the absence of Brexit but what makes it so much worse is that freed of the constraints imposed by membership of the European Union we actually have an opportunity for a fundamental reappraisal of the way in which we tax financial services, including insurance. This is not an easy task. It is hard to apply VAT, or something that does same job as VAT, to services whose value is not measured by how much you actually pay for them, as is the case with bank accounts and loans, for example. But it is not impossible to design an appropriate system, and a number of options do exist.

Now is the time for the Treasury to be working and consulting on how to tax financial services. That will take two years and more. There is an opportunity to do better. Making moves in the wrong direction now does not augur well. Let’s use the control we are about to regain wisely and not throw it away on short term opportunism.

Paul Johnson is director of the Institute for Fiscal Studies. Follow him on @PJTheEconomist

This article first appeared in The Times and is reproduced with permission.

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