It's fair to say Labour's first budget did not go down well with businesses. Neither has it delivered the economic growth and investment that the Government hoped would buy it time against further tax rises.
The problem with the last budget is that it was a fudge. How can we raise taxes without seeming to raise taxes? This Labour government is not unique in that respect. Budgets over the last 30 years have all taken this approach, and the result is an increasingly complex tax system that actively encourages people to find legal ways to avoid tax. Rather than fundamentally changing or fixing the tax system, successive governments have just applied sticking plasters to cover the widening fiscal cracks.
These cracks have been baked into the economy for years: ageing population, declining labour participation, wealth inequality, regional decline, consumer spending collapse, asset inflation, offshoring of both production and profits, asset hoarding and asset sweating.
I don’t think it’s a coincidence that budget fudging has become the norm ever since Gordon Brown announced his Golden Rule in 1997. This is the hair shirt Gordon Brown and his successors have been forced to wear ever since.
The Golden Rule has no real economic basis, nor does it provide any useful framework or doctrine for monetary and fiscal policy. Yet every Chancellor since has lived under a fear of breaking the Golden Rule. Changes to tax and spend policies have not been based on fundamental economic principles or future returns, but on fudging the numbers to ensure the OBR forecast meets the Golden Rule, along with some political sleight of hand to wrangle at least a few positive headlines.
It’s no coincidence that, ever since the Golden Rule became a political doctrine of faith, government debt has ballooned and the economy has flatlined. The problem is this: almost every policy that would correct the current tax imbalances and skewed incentives, to create a sustainable, balanced system over the long term, would involve forgoing short-term tax revenues. Any tax reform that creates short-term pain in return for long-term gain breaks the Golden Rule, so it is off the table.
The Golden Rule has not just put a straitjacket on successive Chancellors, but it has given the Bond Markets a stick with which to beat them. It gives Bond traders a made-up marker around which to position and profit without having to do the hard work of broader economic analysis. I’m sure every Chancellor since has contemplated loudly, “won’t someone rid me of this turbulent Golden Rule” in the hope of an errant knight overhearing them. Liz Truss is still muttering it in her sleep.
So will Rachel Reeves just stick to what she knows and plaster over the budgetary cracks to keep the Golden Rule intact, or will she twist and do the hard work to rewrite the tax system fundamentally?
The reception to her last budget was so overwhelmingly negative that it has made the Treasury very wary of just repeating the same trick. The constant leaks and noises over the past few months, testing the water for potential tax changes in the budget, are a window into the fact that there is a debate taking place within the Government, which recognises the need for fundamental tax change.
My guess is that the Treasury is pushing for fundamental reform, while the political apparatchiks around Kier are nervous about taking any radical steps. The budget will probably end up coming out somewhere in between.
From the musings I have heard, this is where the internal debate is focused:
NI versus Income Tax
Most of us know NI is a con job, and if it were being run by anyone other than the Government, it would be shut down as a Ponzi Scheme. It’s an income and payroll tax just by another name. Introduced to give the impression that we are paying into something that, over time, will pay us back, it was always just a way of increasing income tax without people realising it. Any sane government would abolish it and just roll it into the Income Tax rates. With retirees generating an increasing proportion of wealth and income and “passive income” falling outside the scope of NI, the case for reform is too loud to ignore. We will probably see some “offsetting” changes to NI and Income Tax in the budget.
Cash Hoarding Incentives
A record £100bn of cash was poured into ISAs last year. The vast majority of UK household non-property wealth is stored in tax wrappers – ISAs and pensions. These tax incentives were designed and introduced when governments’ biggest fiscal fear was that people would not have enough retirement savings, as we moved away from defined benefit schemes.
The reality is that all these tax incentives have achieved is to encourage those who already have good retirement provisions to hoard their excess cash in unproductive and low-risk assets. They have done little to increase savings rates among those already struggling to save for retirement. The “tax gains” achieved by stuffing ISAs and pensions far outweigh any incentive to invest in higher-return, riskier assets. One of the major differences between the US and UK tax systems is that in the US, people can invest in small businesses through the wrapper of their 401(k)s. Reform of tax-incentive-based savings to unlock some of this cash is long overdue, especially as these schemes actively disincentivise small-business capital investment and spending, two of the biggest drags on economic growth. There have been too many leaked proposals around ISAs and Pensions to keep track, and the political pushback has been fierce, but I expect something to give.
Property Taxes
The political poisoned chalice. Every Chancellor for 40 years has known two things: 1) the current property tax regime has driven house price inflation and made the economy too reliant on property values; 2) doing anything about it is political suicide.
The rise of populism around the world is being driven by a coalition of those who want governments to protect their property wealth, and the disenfranchised who have been left behind by property-driven wealth creation. These two groups should not be electoral bedfellows, but that’s the trick of populism.
Property as an asset is taxed far less than every other economic activity. The big one is no tax on gains from your main asset, and historically gaping loopholes that reduce or avoid a host of other taxes. For the past 40 years, everyone who has made a few quid has turned themselves into a property investor. Even at a lower level, the incentive is for everyone to plough as much as they can afford from their income into owning property. For some, this has facilitated large gains in wealth (on paper) through asset price inflation, which has become self-reinforcing. This has been a huge disincentive to investing in more productive economic activity and assets. Just look at the banking system. Before banking deregulation, mortgages were provided by building societies, and almost all bank lending was commercial. Now, almost all bank lending is property-based, and banks are all but reluctant to lend to small businesses. Why risk investing in start-ups when you can just park your capital in property and trust that successive governments will do everything to keep inflating the bubble? Breaking this cycle without crashing the economy or having mobs form in the streets will take a lot of hard work and time. We have seen the beginning of this shift with changes to taxes on landlords, and we might see more changes, such as CGT being charged on primary residences above a certain value and a commitment to reform council tax and stamp duty. If it were me, I would gradually allow changes to pension schemes regulations to both increase new home supply and broaden property ownership through collective savings and investments.
Productive Versus Unproductive Business Investment
The current tax code favours asset sweating over asset creation. The incentives to start and grow your own business or invest in risky start-ups are far outweighed by the rewards of hoarding and sweating existing assets. Small businesses are swamped by a complex array of taxes while at the same time constrained in their ability to borrow or raise capital. In contrast, private equity funds can borrow cheaply and structure their investments to reduce their tax liability, sweat the assets and pocket the fees and profits. This has facilitated a huge boom in shadow banking and unregulated investment funds. Public capital markets, where everyone can own a stake in a business, have withered, with the exception of the Magnificent 7 in the US. You just need to look at the high street to see the economic results of this. Liquidation and bankruptcy risk doesn’t matter once you’ve extracted your millions in management fees, and your investors’ losses are offset by the “greater fool” gains from your other investments. This is a difficult one to tackle, but if current market rumours and musings about a private equity and shadow banking bubble are correct, governments may be forced to act. I only hope that action doesn’t include massive government borrowing to prop up asset prices and protect the makers of their own demise, as they did after the 2008 financial crisis.
Income Tax versus Asset Tax
Noise about a wealth tax is growing louder and louder. Regardless of individual political views on this, the gap between incomes and asset wealth has ballooned over the last 20 years. The current tax system was designed for an economy where the vast majority of the country’s economic activity was captured through payroll income, and that’s no longer the case. Some form of levelling up between the tax burdens on Labour-based and asset-based income is inevitable to avoid a complete economic breakdown as the proportion of the population in salaried employment continues to decline rapidly. This can’t be done through a simple wealth tax or putting up CGT rates. A scalpel needs to be taken to the tax system to shift the tax burden from one that penalises small business productivity and incentivises asset price inflation to one that rewards genuine wealth creation, not wealth extraction.
There is no doubt that the Treasury is actively exploring all of these issues. What businesses want most from the budget is a clear statement of intent and a long-term fiscal reform path to support small business investment and confidence. Will we get it? Probably not. It’s too much like hard work. It’s easier just to bump income tax up a few pence and hope for the best.
