Tax and pensions: Facing reality

He often makes it hard, but you have to feel at least a little sorry for Alistair Darling. Even in better times, Chancellor to Prime Minister Brown had the makings of being one of the worst jobs in the world. Now Mr Darling finds himself neck deep in red ink, much of his boss's making. Like any of us in an unprecedented situation, he has theories but cannot be sure what to do.

This background makes it all the more important that policy decisions are explained properly. Ideally, the Government should set out an objective, and then describe the policy measures designed to reach it. The voting public, and, perhaps more importantly given the necessary levels of borrowing, the gilt markets, can then make informed judgements.

It is worth examining the quality of reasoning offered to support the key tax-raising measures in this year's Budget. These tax rises, along with the National Insurance (NI) rises announced in the 2008 pre-Budget report (PBR), are expected to play the key role in restoring the public finances over the next decade. Given that increasing income tax rates within this Parliament is a breach of a highly important manifesto commitment, some governments might have felt honour-bound to go to the country to seek endorsement of their changed position. At the very least we are entitled to a credible explanation of the policy.

So how did Mr Darling fare? First, we should look at the stated objectives most relevant to the tax rises. These can be summarised as follows:

• restore the public finances over the medium term;
• retain a world-leading financial services industry;
• encourage people to save more; and
• encourage employers to retain staff and then resume hiring as soon as possible.

Mr Darling also stated that it was right that those who had done well out of the boom should pay more in tax to help fix the bust; this line has been reinforced by Government spokesmen since, and it appears to be seen as an important part of the justification for the tax rises.

Let us look at the tax measures which have been implemented ostensibly with these aims in mind.

Restoring the public finances

Self-evidently, if the measures are to assist materially, they must raise a significant amount of cash. The Government's estimates, since challenged by the independent Institute for Fiscal Studies (IFS), show only £7bn a year eventually being raised by all the high earner tax increases (of which the 50% income tax rate accounts for £2.4bn). By contrast, the IFS believes there may actually be a reduction in revenue as a result, due to a combination of high earners moving away and spending less - although this is hard to prove.

It is worth putting these numbers in some context. The temporary 2.5% cut in VAT announced in the 2008 PBR cost £12.4bn a year. The 2% cut in the basic rate of income tax announced in the 2007 Budget was then expected to cost £8bn-£9bn a year (in fact it will have been less; events have overtaken the financial assumptions underpinning that Budget to such an extent that merely calling them completely wrong does not really do the situation justice). Meanwhile, the national debt burden is expected to rise to somewhere in the region of £200bn.

It is abundantly obvious that these taxes on the wealthy cannot make a significant contribution to restoring the public finances, even if one accepts the Government's numbers are correct. On the other hand, as will be apparent from the figures above, broader-based tax rises can raise vastly more money while only increasing individual taxpayers' liabilities by relatively small amounts.

Retaining a world-leading financial services industry

Here the analysis is rather simpler. Many individuals in the financial services industry earn more than £150,000 a year, and, in particular, almost all the key decision-makers do. The industry is highly mobile. The Budget measures will lead to a material increase in tax for individuals who take strategic decisions on business location, and will cause the UK to have one of the highest top income tax rates in the Organisation for Economic Co-operation and Development (OECD). So what do we think will happen?

Encouraging saving

Again, the analysis need not detain us long. Relief for pension contributions has been slashed for high earners, with obvious results (apparently the old position was 'anomalous', in that it meant the relief was worth more to higher earners; my view is that it is anomalous that a category of payment is fully deductible for one type of taxpayer but not another).

Encouraging employment

Unemployment is what economists call a "lagging indicator" - because employers are initially reluctant to make redundancies, and then later cautious about increasing staff until it is clear an upturn is real. It tends to take some time to respond to economic conditions. On the Government's (questionable) assumption that the economy will begin to recover at the end of this year, one might expect unemployment to begin to fall in late 2010. However, we have an increase in employer's NI (to 13.3%) taking effect from April 2011, which will provide a direct extra cost to hiring new staff.

Taxing those who have done well out

It is undoubtedly the case that many people who are currently high earners will have done well out of the boom. However, prospective changes to income tax do not tax those historic profits. Those who have made themselves seriously wealthy might even withdraw from active work, faced with future lower incomes and higher taxes. Meanwhile, the disincentive of higher rates will bite on younger, hungrier entrepreneurs who have not yet achieved the happy state of life-long financial security.

It is worth remembering that this Government cut inheritance tax in 2007, in a panic response to opposition proposals. Surely if the desire was to address excessive profits taken in the boom, inheritance tax would have been the place to start?

What to do?

Arguments can be made to support the Government's approach. The problem is that none of these arguments have been advanced by the Government, presumably since they involve unpalatable truths and/or pronounced policy u-turns.

There is a perfectly respectable case for increasing tax rates for the well off. Most recently it has been consistently advanced in the Guardian newspaper, but it goes back to JK Galbraith and before. In summary: inequality of wealth is socially damaging and economically dangerous, and so should be limited, even at the price of reducing overall growth. Higher taxes for the wealthy will reduce the wealth gap for those who stay, or drive away the richest. Either way, the economy is left smaller overall but with less inequality. An intellectually coherent left-wing government might advance this case, rather than wrongly asserting that taxes on future income penalise those who have already made their millions (and overstating the revenue raising potential of such taxes).

Even the employer's NI increase might be justified as an unfortunate but necessary imposition given the severity of the situation. However, it is impossible to resist the suspicion that the attraction of this particular tax is that it is not borne by any particular voter: there will be people out there who are out of work who would be in jobs if employers' NI were lower, but nobody, least of all the individuals themselves, can identify them and respond accordingly at the ballot box.

It is obvious from this article that I do not agree with Mr Darling's measures, but my greatest frustration is how the national intelligence is insulted by the abject failure to properly justify them. There is a profound disconnect between stated policy objectives and measures. Nonetheless, I am conscious of begging the question, "But what would you do?". So, to finish, some ideas:

• increase basic rate income tax by 2% a year from 2011 to 2013, resulting in an eventual 26% rate: it hurts, it may not be that fair, but it is the only way to generate enough cash without printing it instead;
• cut employer's NI to 11% from 2011 to stimulate hiring (the first year's basic rate income tax increase would fund this);
• restore the previously announced new 45% top rate for incomes over £150,000, from 2010 and drop the 50% rate: 45% will raise little money, but will be seen to be fair;
• restore personal allowances for all: it is not anomalous that they are available to everyone; it is, however, extremely odd that as a result of Mr Darling's changes a higher marginal tax rate applies to people earning £100,000 than £150,000;
• reverse the proposed limit on relief for pension contributions: again, the old position is less anomalous than the new;
• reduce the inheritance tax nil rate band to £250,000, reverse the measures allowing its transferability and introduce a new higher rate of IHT of 50% for estates over £500,000: this addresses the generational transfer of wealth caused by the boom and bust;
• look to increase VAT to 20% at a point in the next three years when the economy (and in particular the inflation rate) can stand it; and
• cut SDLT to a flat rate of 1% temporarily to stimulate the property market; and
• commend this Budget to the readers of Legal Week as painful but necessary in these difficult times. Living standards will unfortunately fall for all in the short- to medium-term, and those fortunate enough to be in work must all bear extra tax costs to pull the country through. Although a bitter pill, the only alternative to extra tax for all is to devalue our debts with a period of high inflation, which hurts the entire economy, but particularly penalises those who have been wise enough to save. We cannot go on pretending otherwise.

Simon Yates is a tax partner at Travers Smith.