We need a radical reform of the tax system

The Conservatives want to fight the next election as the party of low taxes and fiscal rectitude. Labour, on the other hand, is determined to show it will safeguard public services, making “fairer” cuts that protect the vulnerable while tackling the “cost of living crisis” for those on middle incomes. David Axelrod’s appointment as senior Labour election strategist is a tactical coup for the party, but cannot be a distraction from resolving policy fundamentals.

In truth, both parties are conspiring to make implausible promises: the British political class is avoiding an honest debate about taxing and spending. The danger is that neither party will have the mandate to take tough decisions, yet it is vital that politicians open up a more serious conversation with the public about future choices.

Despite the prospect of economic recovery, the 2010s will prove to be a “nasty” decade. The UK public finances are in a mess. The central cause of the ballooning deficit is the collapse in tax revenues, the result of over-reliance since the 1980s on financial sector growth and a booming housing market. In a more volatile globalised economy, Britain lacks a resilient tax base; moreover, long-term trends are further eroding tax revenues. The Office for Budgetary Responsibility (OBR) reports that revenues from fuel duty, oil and gas and tobacco are declining rapidly. George Osborne’s unfunded pre-election spending spree, raising ISA limits and reducing alcohol duty, will make the tax system even more precarious.

As a consequence, “non-protected” government departments –those other than health, schools and international development —will be slashed by more than a third up to 2020 on top of cuts already imposed, a scale of fiscal retrenchment widely regarded as undeliverable in Whitehall. This predicament could be avoided by imposing further reductions in the welfare budget, but that would mean penalising children and pensioners – a step too far for most voters. In the meantime, structural pressures on spending are rising exponentially.

Part of the answer, of course, lies in reprioritisation. Ending pension tax relief for high earners and increasing investment in the early years will boost female employment, widening the tax base and advancing social mobility. Redirecting benefits from the affluent over-65s towards a comprehensive social care system, as the IPPR think-tank recommends, is a rational prospective choice.

But reallocating spending won’t plug the gap on its own. Neither will economic growth: despite optimism about the UK’s recent upturn, the IMF warns that the world faces years of low growth, from which Britain is not immune. As such, it appears certain that after 2015, taxes will have to rise. The priority is to identify new sources of revenue, alongside radical reform of the tax system.

Frank Field, Labour’s former Minister for Welfare Reform, recommends an earmarked 1 per cent rise in national insurance contributions to pay for health and care costs – an admirably bold proposal, but politically risky unless voters can be convinced that the money will be spent wisely. Restoring the 50p rate of tax might be good politics distributing the pain of the fiscal squeeze more equitably, but won’t raise sufficient revenue on its own. The UK needs comprehensive tax reform, not endless tinkering with income tax rates and allowances.

One way forward is set out in the landmark Mirrlees review for the Institute for Fiscal Studies, which recommends “taxing income from all sources equally”: applying the same tax rates to employment, property, dividends, inheritance, capital gains and so on. This has intuitive appeal, simplifying the tax system while strengthening equity. Progressives should focus on shifting the burden of tax from incomes to land values, unearned capital receipts, and property. Either way, the political parties’ reticence about taxing and spending is no longer sustainable.

Patrick Diamond, a former Downing Street adviser to Tony Blair and Gordon Brown, is Lecturer in Public Policy at Queen Mary, University of London