Reforming the UK tax system

The UK tax system is out of control. Last week I had to advise on the application of the ‘worldwide debt cap’. This required me to read draft legislation published in December 2010 which amends lengthy and complex rules enacted in 2009 into a different version of the same law, the 2009 provisions having already been repealed and ‘re-written’ in 2010 before the draft changes were published. When that draft legislation is finished it will have retrospective effect so that what we currently see in our statute books (in two different versions which are substantively identical) will never have been in force. Meanwhile, with the Jaffa-cake dilemma long since solved, the courts have been grappling with the important question of whether a ferret is a pet.

Perhaps the only certainties in life are death, taxes, and calls for tax reform. The interim report of the Office of Tax Simplification (OTS) published in December quotes Edward VI bemoaning ‘superfluous and tedious statutes’ back in 1551. In 1995, when the tax code was about half the length it is today, the Inland Revenue (as it then was) was required to publish a report into tax simplification. Unfortunately all we got as a result of that was the Tax Law Rewrite, which is largely responsible for the additional length of the ‘yellow books’. The current climate of cuts and austerity coincided with the end of the Tax Law Rewrite, but taxpayers' money is still being spent ironing out the bugs it introduced.

Real progress on the way?

It feels as if we may be about to enter a period of progress, however. The Mirrlees Review launched its findings in November, arguing for a comprehensive and radical set of reforms. The report looks back on ‘the experience of the 1997 to 2010 Labour government, which went through a series of poorly thought-out changes and reforms that were later reversed at considerable political cost.’ The current government appears to have seized upon the opportunity to make some political capital out of making a clean break with that approach. The consultation on a new approach to tax policy making, of which establishing the OTS is only part, is a promising start in that regard. As well as Mirrlees and the OTS report referred to above, the Treasury Select Committee, which questioned senior tax officials in November over their handling of the PAYE fiasco that resulted in millions of people paying too much tax, announced that it would investigate the principles which should underpin the tax system.

At first I was alarmed by the obvious gulf between the OTS interim report into tax reliefs and the Mirrlees Review. For example the OTS report suggested abolishing a particular tax relief for late-night taxis whilst the Mirrlees review considered the fundamental question of what tax deductions should be allowed and whether travel to and from work should be one of them. Whilst the Mirrlees Review was trying to design a better tax system from the ground up based on sound economic principles and then suggest how to get there, the OTS was making a list of 1,042 tax reliefs and thinking about which ones to abolish.
However having heard John Whiting, the Director of the OTS, speaking at the London School of Economics in January, I can appreciate the method in what may look like madness. The OTS is only six core people with a very limited budget and they have a lot of rather bad tax law to simplify. They have to start somewhere. Tackling the reliefs before the taxes they're relieving may look like putting the cart before the horse but there is a need to produce a practical work product. I expect the assumption is that amongst the 1,042 reliefs there must be quite a bit of rubbish that can easily be deleted. Two such crusty barnacles on the hull of HMS taxation are identified amongst the 13 reliefs considered in the interim report; Millennium Gift Aid (which expired ten years ago) and tax relief for the first 15p on Luncheon vouchers (which was introduced in 1946 and hasn't been adjusted for inflation since).

Different aims

The Mirrlees Review and the OTS have overlapping but fundamentally different aims. The OTS was created to make the tax system ‘simpler’ whereas Mirrlees sets out what makes a ‘good’ tax system. One of the features of a good tax system must be simplicity, but ‘simple’ is not one of the three words chosen to describe the core of the Mirrlees proposal. Those are ‘progressive’, ‘neutral’ and ‘system.’ In a nutshell the core proposal is to have higher tax rates for higher earners (‘progressive’), treat similar economic activities in similar ways (‘neutral’) and to consider the system as a whole (‘system’).

Elements of the Mirrlees proposals would clearly be simplifications (such as abolishing stamp duty, merging national insurance contributions with income tax and removing most categories of VAT zero-rating). Neutrality and simplicity coincide, and the Mirrlees proposal is to have a single, simple set of tax rates which apply to income from all sources and capital gains (referred to in the report somewhat oxymoronically as ‘capital income’).

Other proposals in the report, however, are more complicated than what we already have. A key weapon in the Mirrlees arsenal to achieve ‘neutrality’ is to give companies an ‘Allowance for Corporate Equity’ – a tax deduction for equity investments to put them on the same footing as debt-financed investments. Individuals would get an equivalent ‘Rate of Return Allowance’ (RRA) on equity investments. Capital gains would be measured annually and taxed along with dividends but because of the RRA only the excess over the ‘normal return’ on savings would be taxed. Even as a tax specialist, this all sounds complicated to me on every level – in principle, in terms of what the legislation would look like and in administrative terms.

The impact on practitioners

Do these reform projects mean anything to us today as practitioners? Maybe the OTS will just delete a few obsolete reliefs we've never heard of and Mirrlees is just pie in the sky? I think to take such a position would be short sighted. As well as the full report on reliefs, the OTS is due to report on small business taxation (including IR35) in advance of the Budget this year and whilst neither of these reports is likely to make our tax system perfect overnight, they are expected to result in real, tangible changes which could come into effect in the next legislative round. The interim report didn't give much away but hinted at amendments to the principal private residence relief from capital gains – perhaps reducing the 'last three years' relief’ and introducing a minimum period of residence to qualify. The interim report lists 74 reliefs which will be included in the final report before the Budget. They range from the obscure (relief in respect of Angostura bitters under the Alcoholic Liquor Duties Act 1979) to the mainstream (Entrepreneurs' relief, exempt Demergers and the Enterprise Investment Scheme). A further list of 75 reliefs the OTS will consider if time permits includes the withholding tax exemption for interest on quoted Eurobonds (ITA 2007 s 882). As far as Mirrlees is concerned, the report itself recognises that it is a project for the long term. Even so, some of its recommendations (for example the widening of the VAT base) don't seem far fetched in the current climate of tax increases and spending cuts. The report's recommendation to replace the current multitude of welfare benefits (which the report sees as an integral part of the tax ‘system’) with one simplified benefit is in line with the ‘Universal Credit’ which work Secretary Iain Duncan Smith has already announced as government policy.

Directions of travel

Reassuringly, the OTS report acknowledges that the frequency of change is one of the biggest contributors to complexity. However the sheer volume of change has not slowed. Some of the changes in the pipeline have had a ‘simplification’ label attached (for example the significant changes to chargeable gains rules for companies) although the legislation looks like it will become longer and more complicated. There must also be a concern that in this flurry of activity, different groups within government may be looking to reform overlapping areas of taxation at the same time from different angles. For example before the OTS has had the chance to make its report on tax issues for small businesses, including IR35, draft legislation to implement a widely drawn anti-avoidance regime dealing with disguised remuneration has already been published in advance of the Finance Bill 2011. Meanwhile, consultation on a potential general anti-avoidance rule (GAAR) is going on in parallel. The Mirrlees report sees the annual barrage of new anti-avoidance legislation as a symptom of the underlying lack of clarity or consistency in the tax base.

The gap between the highest personal and corporate tax rates is currently growing each year, favouring small businesses being carried on through corporate entities. This represents a direction of travel away from the Mirrlees recommendations and raises the spectre of further anti-avoidance rules. We can only hope that this government is able to build on the positive start it has made to bring together the disparate strands of reform and avoid making the same tax policy mistakes as the last one.