Mind the Gap Between Tax Policy and Economic Reality

When Andy Burnham was asked about tax rises in the autumn Budget last week, he said “I won’t take risks with people's jobs or their livelihoods”.

His critics will argue that the last two Labour Budgets have done precisely that with measures including a national insurance rise for employers and inheritance tax changes for farmers.

Many businesses view the former as a tax on jobs while the latter raises doubts about the long-term viability of some family farms.  

The abolition of non-dom status last year also affected livelihoods. Those who left the UK no longer spend, invest or pay taxes here, with knock-on effects for the businesses they owned, the people they employed and the wider economy.

Focussing on the emotional appeal of a tax rather than anticipating its real-world consequences is clearly a flawed approach, but nothing suggests the new Prime Minister is about to change course.

Given the bond market won’t tolerate a notable rise in government spending, Labour backbenchers won’t sanction meaningful spending cuts, and the Labour manifesto has ruled out income tax, VAT or national insurance hikes, Chancellor John Healey is likely to increase taxes on assets and wealth to fund the government’s plans.

For example, he is reportedly looking at aligning rates of Capital Gains Tax with Income Tax, which would be a further disincentive for landlords, as we explored here.

Real World Outcomes

Listening to expert views is one way of anticipating the behavioural effects of a tax. For example, a relatively minor change would have made a big difference for many former non doms, as I discuss on the latest episode of Housing Unpacked with James Quarmby, head of private wealth at law firm Stephenson Harwood.

The fact pre-existing overseas trusts would not be protected from inheritance tax under the new non dom rules was the single biggest reason that so many left, said James.

“It was the final straw because it was the breaking of trust,” he said, noting how previous inheritance tax changes had not been applied retrospectively. He said former Chancellor Rachel Reeves had ignored warnings made to HMRC officials.

“They ended up doing exactly what we warned them not to and what happened afterwards was exactly what we warned them would happen,” he said on the podcast.

He estimates the non dom rule changes will cost the Exchequer up to £4 billion per year in lost tax revenue. That compares to a government estimate that it would raise close to £3 billion.

His calculation is based on the fact top taxpayers are more mobile and therefore likely to leave. Underlining the lop-sided nature of the tax base, the top 1% of income tax payers contribute 29% of total revenue, while the top 10% pay almost 60%.

The departure of non doms certainly had a noticeable impact on the prime London residential market, as we explored here.

The pain of tax rises can be better justified when there is an obvious gain, said James. His comments highlighted a story last week about the high-value council tax charge, which was announced in November’s Budget. While it aims to raise £400 million per year, that number will be virtually eclipsed by set-up costs and lost stamp duty revenue, according to the Treasury. 

It seems like a small gain for a policy that will also generate negative headlines about homeowners being fined for not allowing access to their properties.

Borrowing Cost Pressure

Healey’s financial room for manoeuvre will be further limited by higher borrowing costs due to the Middle East conflict, which will no doubt be the dominant justification for tax rises this autumn.

The SONIA five-year swap rate, which is used to price fixed rate mortgages of the same length, was 3.49% before the war broke out but was trading at 4.3% on Thursday. 

For mortgage costs, there is little prospect of a meaningful movement in either direction as the unpredictable conflict unfolds, as I discussed on an episode of Housing Unpacked last month with financial market analyst Michael Brown. 

The good news is that there are few signs yet of any second-round inflationary effects for the UK economy. While financial markets currently believe a rate hike is more likely than not this year, signals such as weak UK wage growth means the Bank of England may hold for the foreseeable future. 

A stable rate environment would certainly help underpin housing transactions, which HMRC said on Friday had continued their downwards trajectory since March and were marginally down in July compared to a year ago.

The less good news is that bond yields have been pushed higher in recent weeks as markets “increasingly fret over government debt burdens, higher energy prices, and the potential for a prolonged period of higher inflation,” said Michael this week.

“Initial ‘back of the envelope’ maths suggests that somewhere between £30bn and £40bn of revenue raising and spending cuts will have to be found, with the former considerably more likely than the latter given the Labour Party’s aversion to lowering government spending,” he said.

With the cost of 10-year government debt standing just above 5% this week compared to a figure below 4.7% in the US, the UK continues to pay higher borrowing costs than its American counterpart. It’s a clear sign that investors are yet to be persuaded about the government’s plans.