A message to Reeves on tax increases

If the Chancellor hopes to raise large sums from tax increases at the Budget, she should consider reforms that would make any increases less damaging.

This is the message sent to Chancellor Rachel Reeves by the Institute of Fiscal Studies (IFS) ahead of her upcoming Budget.

The influential think tank notes that Reeves is likely to raise taxes in the upcoming Budget as her plans to save costs in other ways are now off the table.

“In the spring, she decided to meet her borrowing rule by just £10 billion. The subsequent dilution of planned reductions to the generosity of disability benefits, and the partial reversal of recent cuts to pensioners’ winter fuel payments, will reduce this slender margin. A downgrade to the Office for Budget Responsibility’s economic forecasts could easily eliminate it,” the group said.

If that happens, the IFS notes that the Chancellor will face three options:

• Borrow more in breach of her fiscal rules;
• Reduce spending;
• Increase taxation.

The IFS noted that the first of those options seems unlikely. “The Chancellor has (understandably and repeatedly) stated that she will not loosen the fiscal rules. As for spending reductions, unpicking detailed departmental spending plans up to 2028–29 set out in June’s Spending Review seems unlikely.”

Pencilling in cuts to total spending in 2029–30 (the year in which her fiscal rules bind) in order to meet the letter of her targets would be possible but would stretch credulity to breaking point, the IFS said. It noted that cutting benefits has also proven to be difficult politically.

“There is, therefore, a widespread expectation that tax rises will be the key feature of the Budget. For that reason, this chapter sets out the options for tax increases, but such increases are not inevitable. Any changes to tax policy should be done in a way that, ideally, improves the design of the tax system and that, at a minimum, does not worsen it.”

Key findings and recommendations

The key findings and recommendations from the IFS are as follows:

• Tax revenue as a share of national income is set to reach a UK record high of 37.4% in 2026–27. This is still lower than in many other Western European countries. It would be feasible for the Chancellor to raise more tax revenue if desired.
• Raising the rates of income tax, National Insurance contributions (NICs) or VAT – the three largest taxes – could straightforwardly raise large sums, but break Labour’s manifesto promise not to ‘increase National Insurance, the basic, higher, or additional rates of Income Tax, or VAT’. Extending the ongoing freeze in personal tax thresholds would also raise a significant amount but (if it included a freeze to NICs thresholds) would also break the manifesto pledge and would leave real-terms tax thresholds – and the size of the tax rise – to be determined by the vagaries of future inflation.
• A new tax on income, hypothecated to a particular spending stream, may be a more politically attractive way to increase tax on a large tax base, but would add unnecessary complexity to the tax system. Hypothecation would either be unjustifiably restrictive (such that spending on a particular item was tied to a specific revenue stream) or economically meaningless (in the sense that the amount raised from the tax bore no direct relation to the amount spent on an area).
• Restricting income tax relief on pension contributions would raise large sums but should be avoided. It would be unfair and distortionary to restrict up-front relief but continue to tax pension income at the taxpayer’s marginal rate. It would also be practically very difficult to attribute employer contributions to defined benefit arrangements to specific individuals so that they could be taxed. There are better options for increasing tax on pensions, including levying some NICs on employer pension contributions and/or reforming the 25% tax-free element of pension income.
• Labour’s pledge not to raise the biggest three taxes, if adhered to, seriously constrains options. Raising significantly more revenue from the next four largest taxes – corporation tax, council tax, business rates and fuel duties – would also bring challenges.
• The government has ruled out increasing the main or small profits rates of corporation tax or reducing the main corporation tax reliefs. It has previously stated its intention to shift some business rates from small retail properties to large properties, in the context of the Labour party manifesto’s intention to ‘raise the same revenue but in a fairer way’. Making tweaks to the current system rather than moving to a land value tax for commercial property is a missed opportunity.
• Council tax rates are already assumed to rise by 4.3% per year for the rest of the parliament; larger increases would be needed to bring in additional revenue. An alternative to raising all rates further would be to increase rates on homes in higher value bands. This would make council tax less regressive. But because council tax bands in England and Scotland are still based on 1991 valuations, the increases would not accurately target the properties that are most valuable today. A sensible goal would be to move to a tax that is proportional to up-to-date property valuations.
• Current forecasts assume that rates of fuel duties (which are lower in cash terms than they were in 2009) will in future keep pace with RPI inflation and that the current ‘temporary’ 5p per litre cut will come to an end – a combined cash increase of more than 20% by 2029–30 on current forecasts. Anything less than that would lose the government revenue relative to current forecasts.
• Higher tax rates on income from capital – including rental income, dividends, interest and self-employment profits – could raise money. So too could removing capital gains forgiveness at death. But simply raising rates would discourage saving and investment. The case for genuine reform is clear: improving the design of the tax base (entailing some giveaways) and then more closely aligning overall tax rates across different forms of income and gains would produce a fairer and more growth-friendly system.
• We caution against introducing an annual wealth tax, which would face huge practical challenges. It would also penalise saving and, the more it was concentrated on the very wealthy, the more it would incentivise them to leave (or not come to) the UK. It would not be a well-targeted way to tax the large returns that wealth can generate and, as such, would be no substitute for well-functioning taxes on capital income and gains. If the Chancellor wants to raise more from the better-off, a better approach would be to fix existing wealth-related taxes.
• The Chancellor should not increase stamp duties (because they lead to asset misallocation and lower labour mobility, dragging on growth in the process) or insurance premium tax (which creates damaging distortions to production decisions that weigh on productivity).
• The overall tax gap (between taxes owed and revenues collected) has fallen, but the tax gap for small companies has ballooned; reducing it should be a priority. The approach should include compliance activities and improving policy design.
• It would be difficult, but not impossible, for the Chancellor to raise tens of billions of pounds more revenue without breaking Labour’s manifesto promise not to increase National Insurance, the basic, higher or additional rates of income tax, or VAT. Just because large sums could be raised elsewhere does not mean it would be sensible. Many of the tax-raising options outside the ‘big three’ would have particularly damaging effects on growth and welfare.
• However much revenue she seeks to raise overall, the Chancellor could create a fairer, simpler, more growth-friendly tax system. That means grasping the nettle and pursuing genuine tax reform (property and capital taxes would both be good places to start). At a minimum, the Chancellor should avoid measures that worsen the design of the tax system.

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