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Three Areas Where Tax Reform is Needed

UK tax reform is badly needed...

THE CONTENT of the upcoming Budget has been the subject of intense speculation, writes former Bank of England Monetary Policy Committee member Andrew Sentance.

Most of the focus has been on short-term measures, with much less discussion of the medium-term tax agenda. Yet setting out a clearer direction for medium-term tax reform is one of the most useful things that the Chancellor could do in his Budget next week.

Why is this so important? There are three reasons. First of all, the Chancellor has limited room for maneuver in the short-term – so there is limited to scope for immediate tax giveaways. Second, a major overhaul of the tax system is long overdue. The last Chancellor who had a clear and comprehensive tax reform agenda was Nigel Lawson, who left office over two decades ago. In the meantime, successive Chancellors have made many piecemeal changes to the tax system – adding to complexity and spawning a wide array of tax reliefs and exemptions.

Third, tax reform is one of the levers which a government can use to support longer term growth and improving the climate for business, enterprise and employment. It is part of a broader "supply side" agenda - including lightening business regulation and measures to ensure that the labour market is working effectively – which was effective in supporting growth in the 1980s and 1990s.

So what should the Chancellor do next week? Three broad principles should underpin his tax reform agenda. First, keep tax rates low and limit the extent of tax reliefs – creating a broader tax base. Second, tax income and wealth when people spend it rather than when they earn or invest it. Third, tax and hence discourage activities which create problems for society – such as pollution, smoking and traffic congestion.

The government has already laid out a clear reform agenda for corporate taxation, which aims to cut the corporate tax rate to 23%. But three other areas of taxation also require attention. First, within the personal tax system, there are genuine concerns about the impact of high marginal rates and disincentives both at the top and the bottom of the income spectrum. Taking lower earners out of tax is a government priority. But so also should be ensuring that the UK does not appear to have a penal tax regime for successful entrepreneurs and business managers.

Second, at the heart of the taxation of spending is a VAT system in which a wide range of items is zero-rated. Can it make sense for caviar to be zero-rated for VAT (as a food) while toothpaste and soap carry the full 20% rate? Narrowing zero-rating to more basic items of expenditure could create greater scope for reductions in personal or corporate tax rates, benefiting the economy as a whole.

Third, the application of taxes to address environmental problems is very ad hoc and uneven, with individual sectors bearing a disproportionate burden – notably motorists and air travelers. A more even-handed approach could help both the economy and the environment.

The Chancellor should not rush to set out detailed measures in this Budget – he needs to prepare the ground first. But he can set out the direction of travel by publishing Green Papers (ie consultation papers) on tax reform in the three areas I have highlighted – personal taxation, expenditure taxes and the environment. He could also set out the principles which will underpin reform – lower tax rates on the creation of wealth, a broader revenue base and clearer economic principles to drive the tax agenda. This would be a strong signal that the government supports enterprise and wealth creation, which is much needed.

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Now senior economic advisor to PricewaterhouseCoopers and part-time professor of sustainable economics at the University of Warwick in England, Andrew Sentance is a British business economist who from 2006 to 2011 served on the Bank of England's Monetary Policy Committee. Consistently calling for higher interest rates to combat rising inflation during his last 12 months in the role – and overwhelmingly outvoted each time – Dr. Sentance today shares his views on macroeconomic and monetary developments in his weekly blog, The Hawk Talks. His previous roles include senior economist at the Confederation of British Industry (CBI), chief economic advisor to the British Retail Consortium, and chief economist at British Airways.

See full archive of Andrew Sentance articles

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