Ryan Bourne: We need simpler tax system to cut barriers to growth

AS the UK’s economic clouds darken, it is clear George Osborne needs a sharper plan for growth. But not by reversing on planned spending cuts – the failed Obama stimulus package has shown that deficit spending is futile in a deleveraging recession. Instead, George Osborne should seek at every opportunity to remove barriers to growth.

Evidently, some regulation and employment legislation is necessary – but small and medium-sized enterprises are forever lamenting excessive red tape and bureaucracy. The deregulatory agenda of the 1980s showed that you don’t need to teach the grass to grow; you must simply remove the concrete from the lawn preventing it from doing so. An equally important area is the UK’s tax system, which influences the incentives to consume, produce and work. Adam Smith explained that a tax system conducive to growth should abide by four key principles: proportionality, transparency, convenience and efficiency.

Last week, the Centre for Policy Studies examined marginal rates of tax at the personal level, and found that our current system is failing on all fronts.

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Ask someone how much they pay in tax, and the usual retort will simply be to highlight which income tax band they happen to fall into: 20 per cent for basic rate payers, 40 per cent for higher rate payers and 50 per cent for the “mega-rich”.

But this does not tell the whole story. The contributory principle behind employee NICs has been eroded and they can now be regarded as simply an additional income tax. And public finance theory suggests the long-run effect on take-home pay of employer NICs is exactly the same as that of employee NICs.

These observations allow us to calculate people’s marginal effective tax rates (METRs). The METR represents the incentive to increase your earnings – i.e. the incentive to move into work from benefits, or to work more – and is calculated as the proportion of each extra pound it costs an employer to employ you that ends up in the hands of the Treasury. A high METR therefore represents a low incentive to increase your work time.

Our research shows the METRs faced by people across the income spectrum. And the results aren’t good. Even basic rate income tax payers face an METR of 40.2 per cent after income tax and both sets of NICs are accounted for. That means that for each extra pound an employer invests in employing you, 40.2p goes to the Treasury.

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In reality, the situation is worse. Those at the lower end of the income scale face significantly higher METRs than this because benefits and tax credits are withdrawn with relatively high taper rates as income improves. In some cases, the marginal deduction rate (METR extended to incorporate benefit withdrawal) has been calculated to be as high as 96 per cent – a gain of just 4p for every additional £1 earned.

The welfare reforms undertaken by Iain Duncan Smith seek to reduce this shocking figure and are predicated to always making work pay. But as part of strategy for growth, a supply-side revolution should seek to reduce marginal tax rates across all levels of income.

Take the 50p income tax band. George Osborne has said that evidence suggests this band is actually losing the Treasury revenue – high-earning individuals either move abroad or arrange their finances differently to avoid paying it.

Its existence is therefore an economic distortion with no obvious benefit. More could be extracted from the rich, as a group, by reducing the rate and incentivising inward investment. Those higher earners in the 40/50 per cent income tax bands face overall METRs of 49/58 per cent. And for those earning between £100,000 and £114,950, the METR is 66 per cent due to the withdrawal of the income tax personal allowance.

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Our personal tax system thus clearly distorts incentives. It is disproportional, with those on low incomes often facing higher marginal rates. It is not transparent, with extra taxes hidden away as NICs and a complicated interaction with the benefits system. And is not efficient – the 50p income tax rate actually reduces government revenue and harms economic incentives.

Simplifying tax and easing the tax burden should therefore be key aims for this government. While the priority must remain deficit reduction, targeted tax cuts and easing of regulations would in themselves be growth inducing.

So here are some suggestions for the Chancellor.

Set a firmer commitment to merging NICs and income tax. Abolish the 50p rate to increase the tax base and reduce the incentive for avoidance. Commit to always making work pay in any welfare reforms. Finally, set out a clear path to eradicate the personal allowance withdrawal for those earning £100,000 and above.

These would be small first steps to creating a simpler and fairer tax system.

* Ryan Bourne is the Economic and Statistical Researcher at the Centre for Policy Studies, and has written the factsheet: How much tax do you really pay?