Lord Willetts is President of the Resolution Foundation. He is a former Minister for Universities and Science, and his book A University Education is published by Oxford University Press.
Conservatives argue about the total burden of taxation. But it isn’t the whole story. For any given total of taxation, how it is raised really matters – especially now, since the Government is clearly hoping that an improving economy and some fiscal headroom will give it the opportunity to cut some taxes. I personally find the idea of cutting taxes when public borrowing is running at over £100 billion rather odd. But maybe that is just me unable to shake off Treasury orthodoxy.
The freezing of tax allowances is denounced as an underhand tax increase, but there could be more logic to it than that. There is a genuine question whether the aim should be to ease the tax burden by increasing tax allowances or cutting tax rates. The Coalition Government increased personal income tax allowances: it was a particular priority for the LibDems. This is always referred to as “taking people out of tax”.
Some people with very low incomes are indeed taken out of tax, but every taxpayer gains by their tax deductions starting at a higher threshold. This makes it very expensive indeed. To recoup these costs and retrieve the gains to high income taxpayers, George Osborne then introduced some extra tweaks and complexities into the system to try to recover money from higher earners.This created more complexity and also imposed high marginal tax rates on some high earners as their allowances were withdrawn.
There is a strong argument that what matters for behaviour and incentives is the marginal rate. That is what determines how much of your money you keep if you work an extra hour or save a bit more. There is also a strong case for believing that it is risky if you have almost half of adults not paying income tax – the position we were approaching by the end of the Coalition.
We can more effectively help people on low incomes by targeted public spending on benefits and services. So far, the freeze in the income tax allowance has reversed half the value of the real increase in personal allowances under the Coalition, and it could soon be at the level it would have been if simply indexed to RPI steadily since 2010. Freezing allowances and cutting rates may not just be an expedient response to a surge of inflation, but a conscious reversal policy with its own rationale.
These arguments apply not just to income tax but also to Inheritance Tax. The Government is in danger of being swayed by a campaign that Inheritance Tax is somehow illegitimate. But it is reasonable to tax different transactions: we pay VAT when we spend our earnings which have already born income tax.
Moreover, Inheritance Tax is actually a substitute for Capital Gains tax which would otherwise be payable on death. It may be that the reason why Inheritance Tax causes such unhappiness is that it is at quite a high 40 per cent. A lower rate band on part of an estate of say 20 per cent might help, perhaps funded by removing some other exemptions. The threshold for this lower rate could be frozen so gradually more estates make a contribution.
Both with income and capital taxes there are respectable arguments for a broader tax base with fewer exemptions and lower rates. Indeed many tax policy experts would argue that is a better model than a tax system with higher rates and high thresholds. There is a strategic case for what the Government is doing – maybe they just need to set it out.