Wargaming Labour’s tax options
Labour is promising change. That includes 6,500 more teachers (half a teacher per school!), 13,000 more police officers and PCSOs, and 2 million more NHS appointments. In the longer term, it is also promising to set up a publicly-owned energy provider (transforming Great British Nuclear) to steadily nationalising rail and to creating a ‘National Wealth Fund’ amongst a host of smaller commitments.
But Labour has also ruled out increases to the three big financial levers: income tax, National Insurance and VAT, which account for 57% of all tax receipts. Rachel Reeves also ruled out raising corporation tax (9% of tax receipts). This means ruling out raising headline rates of 66% of all taxes by value. They have also not proposed any spending cuts to close the gap.
This has resulted in widespread speculation about other taxes, which Labour has recently attempted to quell more explicitly than might be expected given the state of public finances. Carefully-worded statements about having “no plans” on capital gains and “no tax rises for working people” abound - and most of the time, only result in further speculation. Things also appear to be not quite settled: commitment to not add council tax bands seems to have been upgraded from “no plans” to “we’re not changing council tax banding”, only to be back to “no plans”.
As well as this, they have (for the time being) stuck to essentially the same ‘fiscal rules’ as the Conservatives which will limit borrowing: in both cases, it is the requirement to have debt falling as percentage of GDP by the end of the 5 year fiscal event forecast period which is the constraining factor.
In theory, a key plank of their agenda is a pro-growth reform package which they hope will dramatically boost economic growth so the UK has the best performance in the G7. If this happens it would ease the need for major tax rises or spending cuts, at least in the long term. (We will get into the details of Reevesonomics and fiscal rules in the next post… stay tuned!).
But in the shorter term, Labour will likely use its first fiscal event to search every corner of the Treasury for additional revenue that does not break its fiscal rules or existing commitments. We think the following measures are the ones to watch:
HEALTH WARNING: Educated speculation ahead! These have been compiled, in no particular order, using our collective judgement about the balance or risk and rewards facing the next Chancellor, taking into account prospective revenue raised, distributional impacts, prior commitments, and other considerations deemed relevant. We think it’s a decent guess at the time it was compiled - but it remains just that!
Extending freeze in thresholds
As confirmed at this year’s March Budget, all major personal tax thresholds (i.e. income tax and NICs) have been frozen until 2027-28, effectively making the 2pp cut in the NICs main rate fictional due to the effects of inflation known as ‘fiscal drag.’ This way of taxing “by stealth” will appear attractive to Labour, who will be likely to interpret the commitment to not raise major taxes as applying to the headline rate only, rather than thresholds.
History tells us that even when inflation is low, uprating thresholds is very irregular and does not happen automatically - it has to be a conscious decision by the Chancellor at a fiscal event. It seems likely that should Labour win power, thresholds won’t be uprated throughout the parliament.
REVENUE POTENTIAL: High
SIZE OF TAX BASE: Large
COMPLEXITY: Low
SHORT-TERM LIKELIHOOD: High
LONG-TERM LIKELIHOOD: Medium
Pensions tax relief
Pension contributions are subject to 100% relief from income tax and employer component of National Insurance, a policy which in 2021-22 was estimated to ‘cost’ the Exchequer around £48 billion. This number has been growing fast: in 2019-20 it was £41 billion, while in 2016-17 it was £31.7 billion. As automatic enrolment progresses, the number will keep growing.
Since a relief from a progressive tax will be regressive - in other words, the more tax you would have paid, the more of it you can claim back - the majority of it accrues to higher earners. In 2021-22 60% went to higher and additional rate payers, which constitute around 14% of income tax payers.
This week, Labour has explicitly dropped their policy of reinstating the Lifetime Allowance - the cap on the total amount which can be put into a pension tax-free - citing administrative difficulties and concerns about the retention of NHS consultants. But this has only fuelled further speculation on whether other tweaks to this relief are on the horizon.
As a result, arguments for reform abound. The simplest option is abolishing or reforming the right to withdraw 25% of any pot free of income tax, for which it is difficult to see a justification. Most talked about is setting a flat rate of relief at or above the basic rate of income tax (20%) which the Pensions and Lifetime Savings Association estimate would initially raise £8-10 billion a year.
The most complex is a root-and-branch reform of the system to align it with the ISA system, where contributions are taxed but drawings are exempt. Since most people’s income tax liabilities are lower in retirement, shifting relief to that stage is likely to result in savings. This was attempted by George Osborne but then dropped as opposition in Parliament mounted.
Then there is the issue of employer National Insurance Contributions (NICs) which are not charged on pension contributions. Since pensioners do not pay NICs, this money is never subject to it, giving rise to arbitrage opportunities like salary sacrifice schemes.
But all of these options have drawbacks: higher-rate taxpayers might be disincentivised from saving, which will reduce the revenue generated and weaken investment in pension funds. Economists also point to the problem of double taxation where contributions will be taxed once, and then again when withdrawn. The politics of it are difficult too - a small group of big, vocal losers, and a large group of small, quiet winners.
The plethora of options available makes it difficult to predict where Labour may land, if anywhere. But most importantly, Reeves’ clearest commitment in pensions policy is to launch a ‘wholesale review’ of the sector - it is there where any reform of this area is likely to start.
REVENUE POTENTIAL: High (depending on exact measures)
SIZE OF TAX BASE: Medium (depending on exact measures)
COMPLEXITY: High
SHORT-TERM LIKELIHOOD: Low
LONG-TERM LIKELIHOOD: High
Bank of England Reserve Account
Quantitative Easing involved creating central bank reserves used to purchase government bonds. The reserves are then held at the Bank of England by private banks who are paid interest at the Bank of England base rate.
Initially, the interest the Bank received on the bonds was higher than the base rate it paid on the reserves. This meant it made profits that it could pump into the Treasury. But now the rates have switched and, in effect, what we see is a direct transfer from the Treasury to private banks, since the base rate is higher than the interest being earned on the bonds.
It’s argued that by removing incentives to hold reserves banks will hold less, and some minimum level will therefore have to be mandated. This could clog the financial system given the role that reserves play in facilitating transactions. It could also make the banking system less robust against liquidity shocks. And if the Government was minded to raise revenue by taxing banks, a straightforward tax on the sector would be a better way to do it.
The ex-Bank of England Rachel Reeves has poured cold water on the speculation, not only filing it under “no plans” but warning of the financial stability implications. But the idea increasingly commands a broad coalition of supporters, from the left-wing New Economics Foundation to the FT’s Chris Giles, former Deputy Governor of the Bank of England Sir Charlie Bean, and even the centre-right challenger party Reform.
REVENUE POTENTIAL: High
SIZE OF TAX BASE: N/A
COMPLEXITY: Medium
SHORT-TERM LIKELIHOOD: Medium
LONG-TERM LIKELIHOOD: High (in some form)
Curbing Capital Gains Tax reliefs
An oft-repeated watch phrase is that Labour “will not raise taxes on working people.” Since the opposite of labour is capital, this gives rise to the possibility Labour is eyeing capital gains tax as a potential revenue raiser, especially as they refused to rule it out. It’s not a particularly big revenue source accounting for 1.5% or £15 billion in 2023-24. We should also not be surprised if these changes come unannounced - doing so would only give potential players time to rearrange their affairs to avoid it.
In committing to closing the ‘carried interest loophole’, Labour has already shown a willingness to align the taxation of income and capital. But should they want to go further, they will also be looking to do two things: firstly, shield what little capital is owned by lower and middle earners from the changes, and secondly, ensure the agenda does not work against increasing private sector investment in the UK (another one of their key commitments).
For that reason, the thing to watch are the reliefs and rates for higher and additional income taxpayers, especially since that is where most of the capital gains tax base is concentrated.
REVENUE POTENTIAL: Low
SIZE OF TAX BASE: Small
COMPLEXITY: Low
SHORT-TERM LIKELIHOOD: Medium
LONG-TERM LIKELIHOOD: High
Adding council tax bands
Staying with the theme of taxing capital rather than labour, another major revenue raiser - this time for beleaguered local government - is council tax, levied in bands on the value of a residential property based on valuations - if you can believe it - from 1991. In 2023-24, receipts totalled £44.5 billion, i.e. significantly less than ‘big ticket’ taxes which raise triple figure billions but also much more than various ‘duties’ which tend to raise single figure billions.
That this has not been updated since speaks to the difficulty and toxicity of doing so - it would mean a uniform tax rise which would disproportionately impact poorer areas. It also isn’t a tax based on income or savings meaning potential difficulties for ‘cash poor, asset rich’ households.
The disastrous attempt to introduce a flat ‘Community Charge’ (AKA Poll Tax) being slated as the first piece of domino which eventually brought down Margaret Thatcher does not encourage political tinkering of this tax. Local taxation is very salient, and generally unpopular.
A tempting halfway measure between status quo and full-fat revaluation may be to simply add bands to the top of the scale, hence concentrating increases at the top. Despite widespread speculation on this in the early weeks of July, Labour has been keen to put a stop to it, this week telling Times Radio they are “not changing council tax banding.”
REVENUE POTENTIAL: Medium
SIZE OF TAX BASE: Small
COMPLEXITY: Low/Medium
SHORT-TERM LIKELIHOOD: Low
LONG-TERM LIKELIHOOD: Low-Medium
Inheritance tax reliefs
In 2023-24, inheritance tax receipts stood at £7.5 billion (less than most excise duties like alcohol or tobacco). This is perhaps unsurprising given only 3.73% of all deaths in the UK attracted IHT liability in 2020-21, while £15.7 billion is estimated to have been “protected” by transferring assets to a spouse. This is in addition to £4.2 billion foregone to agricultural and business assets relief, and £6.2 billion in protections on passing on residential property.
Labour already said it wants to bring foreign assets held in trusts under the purview of the tax, but there is speculation over whether it will go further, with curbing reliefs on passing businesses, agricultural assets and pension wealth in particular being discussed.
There has been no shortage of expert voices calling for reform over the years, with much of it concentrating on the issue of higher income estates seemingly able to better avoid the tax (e.g. due to assets held in securities rather than real estate) which is the opposite of the intended effect of the tax.
One option would be to lower the headline rate (which in the UK is relatively high) but also curb reliefs, which is in line with the speculation on Labour’s plans, which should reduce scope for avoidance while making the tax less punishing. Another, suggested by the IFS, would be to curb the most widely used relief - spousal transfers - by setting a cap just enough to ensure a death of a spouse does not cause financial hardship.
But ultimately, the most significant statistic is likely to be consistent polling finding IHT to be extremely unpopular, not just due to somewhat haphazard application of it but because it is seen as the Government taking advantage of a familial tragedy.
REVENUE POTENTIAL: Medium
SIZE OF TAX BASE: Small-Medium
COMPLEXITY: High
SHORT-TERM LIKELIHOOD: Low
LONG-TERM LIKELIHOOD: Medium
And that's not all…
A combination of slow growth, an ageing population, increasing levels of people on out of work benefits and under-investment makes eventual tax rises look inevitable.
In the long-run, it’s arguably better to focus on Labour’s broader economic strategy, the role of fiscal rules within it, and what ‘economic credibility’ really means in 2024.
Part two to follow.