Opinion: Why we should all be 40% taxpayers!

With the Liberal Democrats now committed to raising the annual tax personal allowance to £10,000, thoughts must turn to ways and means of following through on this pledge.

As I see it, there are three principal areas to be fleshed out.

1. Should the benefit of this proposed £700 per person tax reduction be extended across the board or restricted to the approximately 4 million taxpayers earning below the level of the minimum wage?
2. Should we seek to eliminate both tax and national insurance payments for the taxpayers earning below the level of the minimum wage?
3. In light of a continuing projected structural budget deficit of circa 80 to 90 billion per year, how is the cost of this tax measure best absorbed while simultaneously seeking both tax increases and spending cuts?

National insurance is now purely an additional tax. There is no insurance scheme in the accepted sense. Only around one-half of social security and health service costs are financed by national insurance contributions. The link between benefits and contributions has been gradually diminished with the development of income support, pension credit and tax credits. While there is a National Insurance Fund as a notionally separate entity in the government accounts, it only ever contains enough money to pay out benefits for a few weeks or months.

Combining income tax and National Insurance

The Lib Dem proposal to increase the personal allowance should be funded by combining tax and national insurance into a single rate and redistributing the tax burden such that those on minimum wage would suffer no deductions; those with below average earnings would see an increase in take home pay. The cost of the measure would be borne by those with above average earnings accepting a greater share of responsibility for funding the system of social insurance i.e. benefits and the health service.

The advantages of such a restructuring lie in both its progressiveness and the economic incentives provided by eliminating the benefits trap when low paid workers are weighing up the advantages of work versus potential loss of social security benefits.

These are most clearly displayed in the table below, which is based on the following assumptions:

1. Personal allowance equivalent to minimum wage for a full-time employee working 35 hours per week at £5.80 per hour i.e. £203 per week or £10,500 per year.
2. Average weekly earnings of £490 or £25,500 per year.
3. Tapered reduction of personal allowance of 21p per £1 on taxable incomes (after personal allowance relief) between £50,001 and £100,000
4. 50% tax rate to start on taxable income from £100.001

To ensure that a taxpayer on average earnings pays no more than he pays currently, if we increase the personal allowance threshold to £10,500, we need to set the combined marginal rate of tax at 40% over this level. (This compares with a current combined rate pf 31.5% and a personal allowance of £6475).

The tax and national insurance deductions for a worker on a minimum wage of £203 per week reduces from £26 to zero. The worker on average earnings will see a small increase in net pay of £80 per year. Those on above average earnings would pay a more equitable contribution towards the costs of providing public services, starting at around £1 per week extra for earnings of £27k per year and peaking at around £150 per week for those on incomes over £125,000.

(i) Deductions are based on personal allowance relief of £6475 (phased out on incomes between £100,001 and £140,000, tax rates of 20%, 40% and 50% on income over £150k and employees NIC of 11.5% on income between £5715 and £40,040 and 1% thereafter.

The proposed restructuring does not impact on the budget deficit as the overall tax take to the exchequer is increased by approx £1.5 billion as a consequence of phasing out personal allowance relief earlier on incomes from £50,001 upwards and applying the 50% rate to taxable income over £100,000.

Tackling the deficit

Turning now to takling the deficit, with the government’s budget projecting a halving of the budget deficit over four years from 2010/2011, it would appear that some £80 to £90 billion a year is required to fund the structural deficit by the end of the next parliament. As it is likely that this will need to come from both tax increases and spending cuts, we need to turn our attention to addressing these matters concurrently with any proposed tax restructuring.

The thrust of the Lib Dems’ policy for raising taxes has been a withdrawal of exemptions that typically benefit larger companies and very wealthy individuals with higher rate tax relief on pensions contributions being specifically targeted.

The last budget has addressed in part the limiting of pensions relief on those earning over £150k per year. Limiting deductions for pensions contributions to half of the contributions made or a maximum tax reduction of 20% of contributions has the potential for generating £10 billion plus of additional tax. See HMRC statistics for an analysis of the cost of tax reliefs.

Bringing capital gains tax rates in line with income tax rates has been mooted previously. With a single combined rate of 40%, capital gains tax would increase from the present level of 18% to 40% or 50% on net gains over £100,000 in the model presented here.

VAT exemptions on food, books, energy costs and other items are a likely area for review. Universal tax reliefs and benefits do not take into account the ability to pay. Once the economic recovery is well established a VAT hike from 17.5% to 20% may well come into play.

Vince Cable in a recent Daily Mail Column article has advised as follows:
Business taxes – “they are passed on as higher prices and reduced dividends that affect our pensions and lead to job losses. Also, these days, many companies can move abroad easily, costing more jobs.”
Employers’ National Insurance – “it has the potential to add thousands to the dole queue.”
VAT – “a big, sudden jump in VAT would stall any early recovery and hit shops hard. Also, some companies have learnt how to dodge VAT.”
Income tax / NI – “What we pay should reflect our ability to pay. That means progressive taxes with high earners not just paying more tax but a higher rate. This can’t, however, sensibly be pushed further.”

There is little there to disagree with. I would however, advocate increasing the lower earnings limit from which Employers’ National Insurance payments start to the minimum wage level of £10,500 annually, from its current level of £5,715, and paying for this measure by redistributing the costs to wages above the average earnings level. The purpose would be to reduce the costs of employing workers at or below the median pay level i.e. the earnings group where the bulk of the unemployed sit. Employers’ national insurance is due to increase from 12.8% to 13.3% next year. An increase in the lower earnings limit to £10,500 would require a rate of 17.5% to be applied to wages above this level to maintain a revenue neutral position for both the exchequer and UK business generally.

There is not space in this piece to consider the detail of potential spending cuts. However, the Institute for fiscal studies handily provides a DIY spending review here, while we await the Chancellor’s pre-budget report and Vince Cable gets us started with his Reform pamphlet here.

* Joe Bourke is a prospective Lib Dem council candidate for Brentford in West London and runs an accountancy practice serving small- and medium-size business in the area.

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8 Comments

  • David Boycott 18th Oct '09 - 11:37am

    The most serious failing of this government is the absence of any real job creation, despite 16 consecutive years of economic growth.

    The most effective means of job creation would be to make employment cheaper. For this reason, we must ensure that those earning below a minimum amount (say 10k) are not liable to pay income tax nor to pay NICs.

    I would therefor remove the personal allowance and the starting point for both employee and employer NICs to 10k. However, I would do so only in the private sector – there is no need for the deadweight losses to be gifted to those working in the public sector.

    To help finance this, I would suggest extending VAT to zero-rated items, such as food. This would again increase the incentives to work and it would make the tax tae much less cyclical, making future deficits less of an issue. I would have a compensatory increase in the state pension, but no associated increase in other benefits.

  • Cllr Patrick Smith 18th Oct '09 - 4:39pm

    In view of pending revaluations of business rates, by as much as as 26%-30% in some London Boroughs, can I ask what is the latest plan to bring into Election campaigning the democratic `Localism’ implicit in LIT and Local Business Rates powers to set?

    At present the Governmnet has the powers to determine all Small Business Rates, when the bulk of small companies only operate in the local community and provide important `life-blood’ local services for local people but the Local Council still has no say in setting the business rates tariffs.

    Why is this stiil the case at this critical time of `downturn’ in business for so many small retailers that they now must stump up 30% more in business rates, in some London Boroughs without having a say in setting their own tariff?

    Many shops and small firms are already going to the wall and further lists of empty unrentable business shop lets in the High Street will not stimulate either business growth and development as we approach a Christmas blighted by postal strikes and lost business mail items.

    I ask Vince Cable to tell Local Councils how he sees reform to a fairer and local means of calculating both Local Income and Business Rates so that small business traders are saved before it too late to help them?

  • The proposals look good to me and very similar to my own thinking on the subject of income tax especially that no one on the minimum wage should be paying any form of income or NI.

  • Tom Papworth 19th Oct '09 - 12:59pm

    I’m hugely in favour of raising the personal allowance to £10,000 a year, and I am intrigued by Jock’s (okay, Friedman’s) suggestion that we eliminate the minimum wage but introduce an Negative Income Tax (though I would remind you that Friedman was emphatic that this should replace, and not supplement, other benefits).

    However, your suggestion that “Those on above average earnings would pay a more equitable contribution towards the costs of providing public services, starting at around £1 per week extra for earnings of £27k per year ” – that is to say, that everybody earning over £27,000pa would be taxed more (even if only slightly) – would be political suicide. “Middle England” feels aggrieved enough already at the enormous tax increases that have squeezed them over the past decade. They want to see their taxes fall, not rise.

    I believe that we ought to raise the personal allowance to £10,000 and pay for it by reducing spending. Sadly, that may not be possible in the short term because of the massive debt with which Labour has saddled us. But we could commit to doing so as soon as the debt was paid off, perhaps by implementing Joe’s changes in the short term but announcing that as soon as the debt is back under control we will reduce the taxes that have been raised on middle and higher wage earners. (The proposal for a specific “Labour Tax” was mine, btw).

    This latter is very important, as there is some evidence that people respond as much to the direction taxation is moving in as its actual level. While we know that increased taxation reduces productivity (the IFS have calculated that Brown will gain very little from the 50% rate Darling announced because high paid labour will relocate abroad or opt for more leisure time instead), knowledge that the pain will be reversed as soon as the debt is paid off may encourage high-earning, high-contributing individuals to stay in the UK and to keep working.

  • Tom,

    I would not disagree with your comments and indeed many economists may consider that the UK has already reached the apex of the so called ‘laffer curve’ whereby further increasing the overall tax burden may actually diminish tax yields.

    I like your suggestion of flagging up a committment to reduce higher rate taxes as the deficit is brought under control. I would prefer to see a combined flat rate of 40% with progressiveness being maintained by keeping the personal allowance at the level of minimum wage for a full time worker (with an additional age allowance for pensioners) and withdrawing the relief gradually on higher incomes such that no taxpayer would ever pay more than a combined 40% effective rate.

    Equity, like beauty, is in the eye of the beholder. If we accept the premise that the broad sweep of public opinion is reconciled to both tax increases and spending cuts after the next election, it may be neither pragmatic nor credible to campaign on a platform of tax reduction or real increases in investment in public services during the course of the next parliament.

    In my view tackling unemployment, by targeting tax reductions in the hands of below median wage earners (where it is most likely to be recirculated as consumer spending) offers the best short term prospect of restoring aggregate demand levels in the economy, containing the exponential growth in the level of benefit spend and putting us back on a path to where reduction in the tax burden across the board may actually become a realistic prospect.

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