Parties should avoid tax pledges they may come to regret

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is deputy director of the Institute for Fiscal Studies

This week, shadow chancellor Rachel Reeves told the public not to expect any tax announcements in the Labour manifesto — other than the few already set out. The Labour party has definitively ruled out future increases in income tax, national insurance contributions, VAT (other than on private school fees) and the main rate of corporation tax. The party is being pressed on whether it will rule out rises in other taxes, including on capital gains, if it wins the election.

The Conservative party has also ruled out raising income tax, NICs and VAT. But these pledges are a mistake.

The next chancellor will surely be at least tempted to raise taxes — given the difficult fiscal situation they will inherit. Both Reeves and the incumbent, Jeremy Hunt, have committed to having debt as a share of national income falling by the end of the five-year forecast horizon. It is this fiscal rule that will constrain their choices: meeting that target will mean cutting some areas of government spending or raising taxes.

The parties have been quick to rule out raising the major taxes — but far less forthcoming about which areas of spending they would cut. Higher economic growth would make everything easier and should be a key focus of policy for whoever is chancellor. But they shouldn’t bank on growth increasing by enough, or quickly enough, to avoid that difficult choice.

So ruling out changes to the big three taxes is a problem — even if the main parties genuinely have no current plans to raise more tax revenue.

If the last few years have taught us anything, it should be that the world can change in unexpected ways. And that can happen fast. By the time of the next Budget, the fiscal forecasts could be worse. None of us know what will happen over the next few years. Recessions, pandemics and cost of living crises can upend any government’s plans. It is unwise to take important policy levers off the table before knowing which problems will need fixing.

Income tax, NI and VAT collectively account for about two-thirds of total tax revenue. Ruling out increases in these biggest taxes doesn’t mean that extra revenue couldn’t be raised by other means. There are other taxes. But it’s a serious constraint. 

Another problem with ruling out specific rises during the election campaign is that it severely limits the next government’s options for tax reform. 

Our tax system creates large and unjustified distortions, including to how much people work, how much businesses invest and where people live. Ultimately, poor tax design makes us less productive and therefore poorer. And when poorly designed levies entail giving different rates to very similar people — as they often do — it also creates unfairness. 

Of course, when there’s money floating around, tax reform is politically easier because it can happen through cuts. We’re not in that world now. There are lots of worthwhile, pro-growth reforms that could be made “revenue neutral”. But that would necessarily imply tax rises for at least some people.

Take just one example. Tax rates on employment income are much higher than those on investment income, including capital gains. At the same time, the design of allowances means that, even when taxed at preferential rates, some forms of investment are discouraged. This is a poor way to incentivise entrepreneurship.

It also means that people doing similar things can be taxed very differently. Whatever your job, whether you’re a builder, lawyer, IT consultant or doctor, you’ll pay much higher taxes if you’re employed than if you do exactly the same work but through your own business. It would be better to raise tax rates on capital gains towards income tax rates, while giving more generous capital gains tax allowances on investment to improve incentives. This would be good for growth. And it would be fairer. Such a package need not change overall revenue. But it would require tax rises for some alongside tax cuts for others.

A new parliament should be an opportunity to tackle some of the major problems with our tax system. Economic growth really is the holy grail, with tax reform a key part of a serious growth strategy.

During the campaign, all parties should give voters as much clarity as possible about their intentions for tax. Where there is a clear plan for a specific tax, setting that out is good for transparency and can be good for the economy, too. Labour’s commitment not to raise the headline rate of corporation tax will have given businesses more certainty for long-run investment plans. 

But parties shouldn’t make pledges that they may come to regret if circumstances change. Nor should they shut down the possibility of serious tax reforms — especially not before the next parliament has even started.

Whether future taxes are higher or lower, they really must be better designed if we are serious about boosting growth.