To make the UK’s public finances sustainable again will require higher taxes – among other steps, says Gemma Tetlow, who sets out the policies and taxes Rishi Sunak should consider
Despite having only been in post for nine months and having presented only one formal Budget, chancellor Rishi Sunak has made more major fiscal announcements than most chancellors would in their whole careers: 14 separate announcements, averaging £20 billion of giveaways each.
The one task he has not yet faced is telling the public that they need to start paying more. But as Sunak said in the Commons when setting out his spending review, at some point that is likely to be unavoidable: “we have a responsibility, once the economy recovers, to return to a sustainable fiscal position”. 
Three options are on the table: spending cuts, tax rises or a combination of the two. With Boris Johnson having pledged not to return to ‘austerity’ for public services, with working age benefits having already been sharply pared back after the financial crisis, and with the current government showing little inclination to cut payments to pensioners, it seems likely that the chancellor will need to focus his attention on how to raise money from taxes.
There is more than usual uncertainty about how the UK economy will fare over the next few years and beyond. But if the Office for Budget Responsibility’s (OBR’s) latest official central forecast is correct, the pandemic will leave the UK economy permanently 3% smaller than was predicted pre-crisis, with knock-on implications for tax revenues. As a result, the OBR projects that – without further spending cuts or tax rises – public borrowing will remain at around 4% of GDP (£100bn a year) even once the pandemic has passed and the economy has recovered.
The need for tax rises is not wholly new. The pandemic has merely added impetus to pressures that already faced the UK’s public finances from the country’s ageing population, which creates growing demands on public spending.
If the government wants to be on track to borrow only for investment by 2025/26, as last year’s Conservative manifesto pledged, the chancellor will need to announce tax rises or spending cuts worth 1% of GDP (or around £25bn a year in today’s terms). If he wants to restore the headroom against that target that he had in March, he would need to find more like £40bn a year. That is equivalent to roughly a 7p increase in the basic rate of income tax. Given the prime minister’s resistance to a second round of austerity, tax rises seem inevitable.
But tax rises do not have to happen immediately. Despite being on course to borrow nearly £400bn this year (19% of GDP), the government has ready access to financing at very low interest rates. The best course of action for the long-term health of the UK economy and public finances is for the chancellor to keep borrowing and spending to help tide things over until Covid ceases to be a threat and the economic recovery is secured.
But at some point, the chancellor will need to reduce ongoing annual borrowing in order to put the UK’s public finances on a sustainable footing.
One major concern when raising taxes in order to reduce public borrowing is that doing so will discourage economic activity. By taking money away from people, all taxes impose some discouragement and distortions on the private sector. A well-designed tax system will minimise these distortions – but the UK tax system is currently far from well-designed, meaning there are numerous areas that create inefficient distortions that could likely be addressed in such a way as to raise revenue without dragging substantially on growth.
Those who are self-employed or who work for their own company are taxed far less heavily than employees. Aligning the tax treatment of these groups more closely could raise revenue while reducing the incentives that individuals and businesses currently face to expend time and energy ensuring that they contract with people in such a way that it can be claimed to be ‘self-employment’ rather than ‘employment’.
Another option that could be considered – highlighted in a recent report from the Office of Tax Simplification, as part of a review commissioned by Sunak – is aligning rates of capital gains tax more closely with those of income tax and reducing the capital gains tax annual allowance. Capital gains are currently taxed more lightly than income, which – as the review concluded – creates “odd incentives” for people to structure their income as capital gains instead. Aligning the rates would return to the approach introduced by Nigel Lawson in 1988, when he argued there was “little economic difference between income and capital gains… And in so far as there is a difference, it is by no means clear why one should be taxed more heavily than the other. Taxing them at different rates distorts investment decisions and inevitably creates a major tax avoidance industry.” 
Beyond addressing existing distortions, it would be sensible to focus on broad-based tax rises – that is, ones that apply to a wide range of income, spending or assets. Doing so would allow the chancellor to raise large sums of money, while minimising additional economic distortions and disincentives. In this respect, Sunak is unhelpfully constrained by the Conservative party manifesto, which ruled out increases in the rates of the three largest taxes – income tax, National Insurance contributions and VAT – although he refused to repeat this pledge when pressed last week. Having already abandoned one manifesto pledge – when he cut overseas aid spending from 0.7% to 0.5% of gross national income – Sunak has set a precedent for reassessing those commitments in the light of the huge changes that coronavirus has wrought.
These distortions in the tax system – and others discussed in an Institute for Government report last year – are not new. Previous governments have struggled to implement significant tax reforms or significant net tax rises – with the exception of those like the increase in VAT to 20%, implemented in the immediate aftermath of the financial crisis. Sunak is already facing pushback against the mere suggestion that he might be considering tax rises. 
To reform and increase taxes the chancellor will need to build public understanding and acceptance of the need for change. The coronavirus crisis offers the opportunity to create a persuasive narrative about the need to do things differently. As we laid out in a report earlier this year, there are many ways he could do this – including by being clear about the government’s objectives for the future UK tax system, ensuring more and better evidence on taxes is produced and shared publicly and leveraging the interest that has been shown by the Treasury Select Committee in their ongoing inquiry on tax reform to build a broader consensus.
Rishi Sunak does not need to raise taxes immediately. That gives him time to lay the groundwork – presenting evidence and raising public understanding of the need for change – that will be necessary to get enduring tax reforms through parliament.