The UK may be planning to leave the EU, but before it does – if it does – it has to face a European Commission probe into a tax avoidance measure dreamed up by George Osborne when he was chancellor of the Exchequer.
The Commission is concerned that changes to the “controlled foreign company” rules Osborne made back in 2011 – they came into effect in 2013 – mean that some companies can shrug off anti-avoidance rules unless they’ve been applied to them by name. The Commission’s beef is that the rules could give the UK a competitive advantage.
It is impossible to say how this probe will turn out – or even whether it will matter when the UK leaves the EU. But it is yet another factor that raises concerns about the country’s shrinking tax base. In October 2017 HMRC revealed that multinational companies – the kind most favoured by Osborne’s measure – avoided £5.6bn of tax in 2016. That was twice as much as the government had estimated.
The problem of the shrinking tax base is especially acute in western countries that are used to enjoying high levels of state-provided public services. It is important to point out that the problems of a shrinking tax base and of tax avoidance are two separate but related issues.
The first focuses on the economic opportunities to collect tax while the second is about whether those opportunities were effectively carried out. So as the first becomes a bigger problem, more attention is focused on the second as a source of remedies.
By far the biggest threat to the tax base in most Western economies is that the proportion of older, non-tax or low-tax paying retirees is rising in comparison to the number of younger, higher-taxpaying workers. In Britain and some other countries, including the US, that threat has been partially mitigated by immigration. In others, such as France, state measures encourage larger families to redress the population imbalance.
But there are a host of other issues that make the tax base problem difficult to resolve. Not least is the political debate over how much tax governments should levy on citizens. The aim of some, but not all, Brexiteers is to extract Britain from the EU so they are able to create a low-tax, low-regulation economy free from European “interference”. If Britain pursued that policy, the theory goes, it would ease the tax base problem because the demand for spending on public services would fall. But that relies on people prepared to accept lower quality public services. Opinion polls suggest there is no widespread appetite for that (and the pressure on spending – hospitals, schools and infrastructure – will remain).
So the central policy issue for policymakers is how to squeeze more revenue out of the shrinking tax base. That won’t be easy, says Anita Monteith, senior policy adviser in the Tax Faculty at ICAEW. “Politicians have some very difficult decisions to make and will have a hard time selling them to a public that doesn’t understand what is happening.” So where should they start?
Three big taxes
How about with the three biggest revenue earners for the government: income tax (£175bn projected in the government’s Budget Red Book for 2017); VAT (£143bn); and National Insurance (£130bn)?
The big threat to both income tax and National Insurance is the growth of the “gig economy” and changing patterns of employment. Monteith points out that most workers in the gig economy are self-employed for tax purposes. Employers draft their contracts to enshrine this status, she says. The changing nature of the economy means that more workers will drift towards self-employment. The growth in the online proportion of the economy means that more work can be done overseas, escaping British income tax and NI completely.
Jonathan Riley, head of tax at Grant Thornton, believes the “massive gap” between the tax position of employed and self-employed encourages firms to favour more self-employment. In his report on the gig economy, Matthew Taylor, chief executive of the Royal Society of the Arts, pointed to some possible solutions. He suggested businesses should be more transparent about the status of their employees. He mooted creating a category of “dependent contractor” with new employment rights. But that would take time and new laws.
Toby Ryland, corporate tax partner at HW Fisher & Company, reckons all the anti-avoidance tools are in place to combat false self-employment claims. It would be politically tough to levy some form of NI payment on “dependent contractors” but might be possible if it were sold by the government as part of a review of the rights and benefits of self-employed people. If tax can be presented more as a payment for services received rather than just a levy on earnings, it may make it more acceptable.
Riley believes that labour is over-taxed in the UK. “When you compare an effective tax rate of around mid-40% to the taxation of capital at typically 20% for most assets, and a corporate tax rate of 19%, it is clear the government needs to radically consider what is taxed and how.”
Richard Murphy, director of Tax Research UK, believes the long-term solution may be to abolish National Insurance. “Replace it with a progressive consumption tax charged on the flows through a person’s bank account – having allowed for transfers between related accounts,” he argues. “This is green taxation and it does not penalise jobs, which is the last thing we need to do as we head for automation. Tinkering with National Insurance is pointless. We need a financial transactions tax for a new era.” And what about VAT? “The government can’t make rash decisions ahead of Brexit,” Monteith points out. But when the UK leaves the EU, it could increase or vary rates of VAT or extend the scope of the tax. Riley notes that across the world, the shift to transactional taxes is gathering pace. But he adds: “Transactional or sales taxes are regressive and tend to affect the poorer in society most.”
When it comes to the question of squeezing more tax from a shrinking tax base, no tax domain is an island. Unless, of course, it’s a tax haven. The OECD’s base erosion and profit shifting (BEPS) programme has made slow but useful progress. In a world of multinational companies, tax domains will need to co-operate more to staunch revenue leaks.
In the UK, the diverted profits tax has had a measurable effect on protecting revenues. Riley sees BEPS already having an impact on multinationals’ behaviour. He sees tax authorities and large corporates changing their tax models to take account of BEPS. “Our surveys have shown a consistent thread of opinion whereby corporates prefer stability in tax regimes over a reduction in rates,” he says. “Governments, including in the UK, would do well to consider fewer changes and aim to provide consistency instead.”
Miles Dean, managing partner at Milestone International Tax Partners, believes a tougher approach to transfer pricing would help protect the tax take from corporates. He notes that BEPS is taking a tougher line in linking profits to where value is created.
Yet Murphy wants to see more progress soon on BEPS. He says that public country-by-country reporting could embarrass multinational companies into complying. He wants the BEPS programme to co-operate with the EU on a common consolidated corporate tax base.
But government moves to protect or raise the revenue from the tax take are not likely to win voters over. “No one likes to pay tax and governments have never fully explained where they spend taxation,” says Ryland.
“A lot of the time the government talks about structural deficits and in terms of billions or trillions of pounds – and most of it goes over people’s heads.” He says the government needs a PR campaign to explain the role tax plays in providing services people want.
Monteith agrees. “Rarely do people think about where spending on NHS, education and infrastructure comes from,” she says. Adds Dean: “Governments and finance professionals must stress to the public the fact that we cannot live beyond our means.” But that will be a hard lesson for a country that’s been doing so for years.