Sunak and Truss should replace tax pledges with tax reform plans

Tax policy has dominated the Conservative leadership contest. Liz Truss has proposed reversing or cancelling the two big tax rises Rishi Sunak announced as chancellor: the health and social care levy and the planned hike in the corporation tax rate. Meanwhile, Sunak has argued against immediate tax cuts but committed to further tax cuts in future, including an ambition to reduce the basic rate of income tax to 16% (it is currently 20% and is due to fall to 19% in April 2024).  

Both candidates have said their proposals would boost economic growth, but that is unlikely with these uninspiring – and expensive – pledges to tinker with tax rates.  

Reforming the tax system is more complicated than cutting headline rates and harder to turn into a campaign soundbite, but whoever wins this contest will very quickly switch from campaigning to governing. To avoid being hamstrung  by hasty commitments made on the campaign trail, both candidates should set out what they want the tax system to achieve and commit to a review to find the tax reforms that will best meet those goals. 

There are real problems with the tax system that act as barriers to growth 

As the Institute for Government and others have argued, flaws in the current tax system arbitrarily distorts people’s and businesses’ decisions, encouraging them to choose less efficient options that ultimately hold the economy back. Arbitrary cliff-edges also encourage people to pour time and effort into ensuring they are classified in a particular way by the tax system when they could be focusing on productive activities.  

Perhaps the clearest distortion in the tax system is the bias towards self-employment and away from employment. National Insurance Contributions (NICs) are much higher for an employer-employee relationship (with both employer and employee NICs charged) than for the self-employed (where only a reduced rate is charged, with no equivalent of employer NICs). This can lead to unfair situations, where two similar people doing similar jobs are being taxed differently. But it also biases businesses and workers towards contracting relationships rather than employment relationships, even though the latter might be a more efficient fit.  

Pledges on headline rates would neither fix the tax system’s flaws nor pay for themselves 

The candidates’ plans for permanent tax cuts have exclusively involved cutting the headline rates of taxes. Rate changes are the easiest tax policies to announce and are politically the most salient. But it leaves the flawed structure of the system in place – and might even exacerbate it further. A lower corporation tax rate will leave in place the bias towards debt financing, for example, and the system will continue to disincentivise some capital investments.  

Headline rate cuts are also expensive. Truss’s two tax cuts combined would cost almost £30 billion per year, while Sunak’s income tax cut would cost £19 billion per year. ^[1] Truss in particular has argued that her tax cuts would stimulate future economic growth and so pay for themselves. But the evidence suggests that headline corporation tax cuts alone are unlikely to provide a big boost to growth, and the costing already allows for some additional investment in the short-term. ^[2] Even models that embed optimistic assumptions about the relationship between corporation tax rates and growth find that a rate cut will not pay for itself. ^[3]

Given the current fiscal position, and future spending pressures that the Office for Budget Responsibility (OBR) has identified for the coming decades, it will be difficult to maintain permanently lower taxes and the quality of public services that the public demands. ^[4] Permanently cutting headline rates is therefore unlikely to be a viable fiscal strategy even if it were to lead to a small boost in economic growth. The candidates should instead be looking for smart reforms to the system that might provide better “bang for your buck” in growth terms.   

Sunak and Truss should commit to a review of the system rather than erratic pledges 

Tax policy will be made most effectively when politicians set out their objectives from the system and then consider, based on the advice of civil servants and external consultation, which measures will best meet those aims within broader fiscal constraints. To generate the best ideas and bring the public onside, the IfG has previously recommended that a chancellor serious about tax reform should launch a review of the tax system.  

Liz Truss has proposed a review of how the tax system could be reformed to ensure it does not unduly penalise those with caring responsibilities. ^[5] But that stands in contrast to the way both candidates have used tax policy announcements to reveal expensive policies in isolation. 

It is encouraging that our next prime minister will be looking for tax policies to deliver growth, but unless Liz Truss and Risi Sunak take a more considered approach and explore tax reforms rather than easier tax cuts, then they are unlikely to succeed. 

_________________________

1. https://www.gov.uk/government/statistics/direct-effects-of-illustrative-tax-changes 
2. https://www.epi.org/publication/ib364-corporate-tax-rates-and-economic-growth/ 
3. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/263560/4069_CT_Dynamic_effects_paper_20130312_IW_v2.p…;
4. https://obr.uk/frs/fiscal-risks-and-sustainability-july-2022/ 
5. https://perspectivemag.co.uk/liz-truss-pledges-tax-reforms-to-help-with-childcare/