Reduced economic activity under lockdown means that the tax revenues received by HMRC have plummeted, at the same time as the government has been picking up the tab for the NHS, furloughed staff and self-employed income support.
By some estimates, the public finances may be around £300 billion worse off in 2020, that being about 15% of gross domestic product (GDP). In the short term, this has been funded by a surge of government borrowing. But attention will soon be turning to who foots the bill in the longer term: will taxes have to rise despite previous Conservative tax freeze promises, will we see further public spending austerity rather than ‘levelling up’, or will higher levels of UK government debt become part of the new normal?
The answer, particularly when it comes to taxes, could have an impact on the financial planning of many clients, so we consider below some of the wider political and economic considerations likely to steer the thinking of Chancellor Rishi Sunak.
At the last election, the Conservatives explicitly promised a ‘triple tax lock’: no increases in the rates of Income Tax, National Insurance or VAT. With those raising about two thirds of all tax, and tinker as they might with other taxes (or with reliefs, allowances and exemptions), the overall burden of tax (about 37% of GDP) looked unlikely to rise much over the Parliament.
The Coronavirus almost certainly changes things. Not many will hold the government to tax promises made in the different world before COVID-19. Some tax rises feel inevitable. Importantly, however, there will be no need to raise anywhere near £300 billion per year in new taxes (which would increase taxes to Scandinavian levels). The deficit should fall sharply in future years as economic activity returns, tax revenues naturally recover, and exceptional public expenditures abate.
Having issued short-term debt at negative yields (meaning the government will pay back less than it borrowed) and borrowed longer term at well below 1% per year, the interest on the extra debt is probably less than £3 billion a year (much of that being paid to the Bank of England, which is buying gilts as part of its monetary stimulus). That kind of a tax increase (about £60 per adult) might go largely unnoticed.
The government may increase taxes more if the deficit does not fall as hoped (if the coronavirus causes lasting damage to the economy) or to help pay down the debt. However, the UK has only run a surplus in six of the last 50 years, and the government would need to thread the needle to sharply increase taxes without killing off any economic recovery, particularly as Brexit looms (again) on the horizon.
Potential Tax Changes
One tax change has already been clearly signposted. Announcing the Self-Employment Income Support Scheme, the Chancellor hinted that tax rates for the self-employed may be aligned with those for employees in the future. The self-employed currently pay lower rates of National Insurance (a main rate of 9%, relative to 12% for employees), and previous plans to increase that 9% rate (briefly explored in 2017) appear likely to be revived.
Wider National Insurance changes might also be politically palatable, given the association in the public imagination between National Insurance and the NHS. Higher rates could be branded by government as an extra ‘NHS contribution’. Other fairly straight-forward changes could include increasing the other rates (such as the reduced 2% rate for higher and additional rate taxpayers) or extending the tax to the earnings of those who carry on working past state pension age.
Such changes to National Insurance would reduce take home pay, but could be focused mainly among groups more likely to reduce their saving rather than spending, potentially limiting the short-term economic impact. Changes could also be pre-announced, to encourage the ‘bringing forward’ of income before higher rates kick in, helping to fill the coffers sooner rather than later.
The downside of higher National Insurance contributions would be an even wider disparity between the taxes paid on earnings and those on other forms of income, unless other income taxes rise too.
Jeremy Corbyn felt that the ‘rich’ should pay more income tax. However, by international (OECD) standards, the UK is already disproportionately reliant on high earners for its Income Tax revenues. Repeated increases to the personal allowance mean that around 42% of adults now pay no Income Tax at all. Among those that do, the top 10% receive about 34% of taxable income but pay about 61% of all Income Tax (for the top 1%, those figures are 13% and 30% respectively).
HMRC’s own numbers suggest that increasing the basic rate of income tax by 1% would raise nearly £5 billion per year, whereas increasing the additional rate by 1% would generate a paltry £105 million. In short, raising meaningful sums of tax would require broad changes, such as increasing the basic rate or scaling back the personal allowance (going against the recent direction of travel).
The government has, however, already raised taxes on dividends in recent years, and could do so again if it wants to discourage incorporation purely to gain a tax advantage. It is still usually more tax efficient for business owners to pay themselves mostly dividends rather than salary. A minority of taxpayers receive taxable dividends from investment portfolios of more than the £2,000 dividend allowance, so might be deemed acceptable collateral damage.
The tax advantages of pensions are estimated to ‘cost’ the Exchequer around £35 billion a year, and were already under the spotlight. Annual Allowance limits on pension contributions that have already shrivelled over the last decade might be reduced further, though the government will want to take care not to revisit the problems that previous cuts (only recently relaxed) caused senior medical professionals.
A number of more radical proposals have been talked about, including moving to a flat rate of tax relief on pension contributions (that might save £10 billion a year if limited just to 20%), or restricting the tax-free lump sum at retirement. However, these are fraught with practical difficulties and political risks.
The majority of pension tax relief relates to employer contributions, particularly to defined benefit schemes. Taxing these more heavily could be the final nail in the coffin for many struggling employers (and disproportionately affect public services, including health and education). But focusing changes just on employee contributions, particularly to defined contribution schemes, could exacerbate intergenerational inequality, as well as introduce arbitrage opportunities.
Meanwhile, tax-free cash has been a feature of the pensions landscape since 1909, and millions have contributed to pensions over the decades and planned their retirements based on this. And tax-free cash is already restricted by the Lifetime Allowance. Further restricting this element of ‘the pension promise’ could destroy public faith in pensions, undermining the recent progress made via auto-enrolment. A more plausible (but still radical) change would be to review the generous tax treatment of pensions on death, which has only been in place since 2015.
The state pension triple lock (which sees most state pensions rise by the higher of national average earnings growth, inflation or 2.5% per year) seems almost certain to be at least temporarily suspended, so that state pensions unaffected by the slump in earnings this year do not permanently increase in line with a surge in earnings over the coming years.
Finally, the widespread popularity of ISAs and much lower ‘cost’ to the Exchequer (compared to pensions) probably mean that material changes to ISAs remain unlikely.
Compared to income and especially compared to earnings, capital is taxed fairly lightly. As a result, Capital Gains Tax (CGT) and Inheritance Tax (IHT) currently raise relatively small amounts in the grand scheme of things, around £14 billion per year (2% of all taxes). Only a few hundred thousand (generally wealthier) taxpayers pay these taxes in a typical year.
Consequently, changes to these taxes are more likely to be symbolic than meaningful tax grabs, even if they might have a very large impact on some individuals. Changes may be unpopular amongst backbench Conservative MPs, many natural Conservative supporters and those who rail against ‘death taxes’. But being seen to increase taxes on wealthier individuals could play well politically in others areas (among new Conservative voters in Labour’s red wall, for example), and other changes might be obscure enough to evade widespread controversy (such as the recent changes to Entrepreneur’s Relief). Reversing the 2016 cuts to CGT rates and reviewing the scope of Business Relief (particularly in relation to AIM shares and trusts) cannot be ruled out, for example.
The government is also still due to respond to the Office of Tax Simplification’s recommendations relating to IHT (and in some cases the interaction between CGT and IHT), which most expect the Chancellor to do at the next Budget.
There has been talk of unprecedented wealth taxes being used to pay for the crisis. However, much wealth is hard to value or illiquid, or both (take defined benefit pensions, for example), and some liquid wealth is internationally mobile.
It is also an open question as to whether HMRC could actually implement such radical new taxes at this time. Whereas established tax infrastructures support the collection of taxes on income and on capital transactions, infrastructures to support the ongoing (or one-off) taxation of the stock of wealth would need to be developed more or less from scratch.
The international experience suggests that wealth taxes are not effective in raising particularly meaningful sums of money. Often assets (such as main residences) have been exempted to limit political controversy, valuation issues and cash flow problems, rates have been set at low levels so as not to provoke capital flight, and tax collection and enforcement have proven relatively costly.
With the country on the brink of Brexit, a Conservative government in charge that has always previously opposed wealth taxes, and a strong link between an already fragile property market and UK consumer confidence, meaningful changes to the level of taxes levied on property (particularly main residences) and wider wealth are unlikely.
All else being equal, higher taxes will typically mean that funding the same objectives (after tax) will require a higher level of savings. And they may also restrict the ability to save in the first place. For example, higher rates of National Insurance and Income Tax would reduce take home pay, and higher Income Tax would also have a wider impact on portfolios, reducing net investment growth outside of pensions and ISAs, and impacting upon net pension withdrawals.
Fully using your ISA allowance, wherever possible, should therefore be of paramount importance, and very likely to be good planning come what may. Similarly, though certain reforms could make pensions less attractive in the future, it is unlikely that pensions will ever lose their place at the heart of sensible retirement planning. Pensions offer very significant tax advantages today, particularly for higher earners, and those who have not already maximised their pension contributions should certainly consider doing so sooner rather than later (in many cases even before using ISAs), before any drawbridge is pulled up behind.
If taxes on dividends and capital gains increase, offshore bonds – and the tax-deferred environment these offer – would likely become a bigger part of the financial planning for many with assets besides just pensions and ISAs, and the short-term consequences of higher rates of CGT may be mitigated by many asset values now being lower than just a few months ago.
While the word ‘offshore’ for some is a dirty word, and for others a source of interest as they look to protect their assets, offshore bonds are widely accepted by HMRC as standard tax planning. However, other offshore arrangements should be approached with great caution. These can involve very significant costs and unclear benefits, as the scope of potential future tax changes is always uncertain. Many who transferred assets to other offshore arrangements due to fears of higher taxes and capital controls under a Corbyn government are ruing such decisions now. We would advise similar restraint in the face of fears of higher taxes now, and wealth taxes in particular.
Finally, with regard to IHT, we would encourage reviewing your estate planning sooner rather than later if this is a concern for you. There may be steps that you can take today to pass on your wealth in a tax-efficient manner, taking advantage of the current known environment. Examples include making regular gifts out of surplus income that are immediately exempt, or large gifts of capital that become exempt after seven years.
Any government wishing to meaningfully raise taxes faces plenty of political and economic constraints on their ability to do so at the best of times. This is all the more so the case in the current environment, as the UK aims to transition into post-pandemic economic recovery, as well as to reset its relationships with the European Union and the rest of the world.
The Conservatives now have a sizeable majority in the House of Commons and plenty of time until the next election, factors that might make tax rises easier in more normal times. However, the Chancellor will surely be aware that ill-timed and ill-targeted tax rises could derail the economy and hurt Britain’s standing in the world as a place to do business post-Brexit. Taxes may have to rise to some extent, but perhaps more slowly and less sharply than some might fear.
We would urge against rash decisions based on fears of potential future tax rises, and instead focus on what you can control. Even if taxes do rise, taking steps today to maximise your income and align your expenses with what is important to you (and cut back on what is not) will only stand you in good stead. Similarly, being clear on your financial objectives and having a plan and a portfolio to get you there will still bear fruit, even if the plan needs course adjustments along the way. And maximising all of the tax advantages available (and diversifying across tax wrappers) using sensible tax planning today is still very likely to be sensible tax planning tomorrow, given governments rarely engage in retrospective taxation.
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