How tax distorts everything – people respond to price signals which harms intergenerational fairness argues Angus Hanton, IF Co-founder.
Tax reliefs
At the end of January 2024 the government’s spending watchdog, the National Audit Office (NAO) outlined the vast scale of tax reliefs which the government offers: there are about 250 different reliefs in total. Their report raises questions about why these reliefs are offered at all and if they are effective in promoting economic growth. The NAO is critical of how the government often underestimates how tax breaks lead to behavioural change: in the case of the Research & Development (R&D) tax credit scheme for small and medium sized companies (SMEs), claims have ballooned to almost three times the Treasury’s original estimates. As a result, this tax relief for SMEs now costs the government about £5 billion a year of which £1 billion is lost in error or fraud. Although these R&D tax credits were intended to boost R&D investment, many people feel they just led to the reclassification of existing spending as well as motivating widespread fraud.
In total, tax reliefs amount to over £200 billion each year – which is about a fifth of the government’s tax take – so they do really matter. Two-thirds of the total relief is in the form of the three biggest: zero VAT on food; tax-advantaged pension saving; and tax-free sales of homes. There can be little doubt that the last two of these have massively distorted the economy, and have contributed towards intergenerational unfairness. Whilst some people find discussions of fiscal policy arcane, indirectly these tax reliefs contribute to house price increases, overcrowding, under-occupation and homelessness.
Housing
Because they know that their home is growing in value tax-free, many homeowners regard their home as an investment even if they have several unused bedrooms. Two other aspects of the tax system contribute: Council Tax and Stamp Duty. Owners of larger homes are helped by fairly low Council Tax charges: whereas the Council tax on a modest flat might be about £1,000 a year, a large house of three times as much square footage will only be about £1,500. Furthermore, homeowners are discouraged from downsizing from their larger homes because of the Stamp Duty cost of buying a new property which can amount to around 10% capital cost. So there are two carrots and one stick when it comes to downsizing: the carrots are tax free capital gains and modest Council Tax, and the stick is the painful stamp duty for buying a new property even though downsizing comes with an inheritance tax (IHT) relief equivalent to the residential nil rate band (RNRB) on death if passed on to a relative. We have seen how these tax-drivers have led to the “hoarding of housing” response where many older people are under-occupying, in contrast to younger people who are often overcrowded and paying high rents. One rational response by younger people is to buy or rent in cheaper areas remote from their place of work, but this leaves them with long and expensive commutes.
Pensions
In the case of pensions, the very generous tax reliefs offered have recently been widened. In 2023, the Chancellor announced an increase in the annual amount that could be put into pensions. He also abolished the lifetime allowance. These “reforms” have become even more valuable to savers because as tax rates have risen, tax exempt saving becomes more attractive. Of course this only helps those with enough money to put aside significant sums. Whatever the intention, the main beneficiaries of these tax breaks are older wealthier generations, because they are more likely to have higher incomes and have the cash to save.
Review and reform tax reliefs with a price signal
The effects of all these tax reliefs should be radically reviewed by the government with a particular effort to reduce some of the current intergenerational unfairnesses. In the area of housing, one simple measure – which would free up a lot of underused housing – would be to announce the introduction of Capital Gains Tax on gains on the sale of all housing, BUT to delay its introduction for 5-7 years. Such action would create a period of downsizing and freeing up of the housing market, improving the way we use our housing stock and helping young people with more housing stock availability for renting and buying. Such a tax change would likely lead to a huge response to a clear price signal.
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