Tax and the long road to Brexit

Now that article 50 has been triggered by Theresa May, just before her self-imposed end of March deadline, and the formal process of leaving the European Union has begun, a few of the big picture themes are becoming clearer, even amid the huge uncertainty. There will, as we know, be no pot of gold for the exchequer at the end of the Brexit rainbow, £350m a week or otherwise. As the Brexit process unwinds, money will continue to be very tight for the chancellor. The underlying deterioration in the public finances since last year, roughly £100bn over the next five years, means budget deficits as far as the eye can see. Meanwhile, we wait to see how much the higher inflation, which is mainly the result of sterling’s post-referendum slump, constrains consumer spending.

 

What, however, about the detail? To what extent has Britain’s tax system, and the decisions taken by successive chancellors over the past four decades, been shaped by Britain’s membership of the EU? And to what extent will Brexit provide liberation for the Treasury and a new sovereignty for tax policy?

 

In the first of two Budgets in 1993, which sounds familiar, Norman Lamont announced that VAT would be imposed on domestic gas and electricity bills at a rate of 8% in April 1994, rising to 17.5% (then the standard rate) in April 1995. In the event, the second of the two VAT hikes did not happen – it was defeated in Parliament in December 1994 – but the 8% rate did. As such, it was firmly in the sights of Gordon Brown, as he headed for the Treasury in May 1997. He pledged to abolish it.

 

But Brown, in the first of his battles with the EU (the second was over whether Britain should join the euro) was unable to do so. EU VAT rules allowed a minimum reduced rate of 5%. So, to comply with these, the chancellor was only able to trim the rate from 8% to 5%, where it remains.

This was not the only occasion when the 5% reduced rate of VAT became an issue for the British government. In 2000, following a campaign led by Dawn Primarolo, a Labour MP and one-time Treasury minister, VAT on sanitary products, the so-called tampon tax, was reduced from 17.5% to 5%. In 2015, after a petition to abolish the tax attracted more than 100,000 signatures, George Osborne thought he had secured a deal with the EU to do so. He was wrong: 5% was the minimum permitted under EU law and it had to stay, though these days the proceeds are directed towards women’s charities. Whether or not the episode contributed to Britain’s vote to leave in June 2016 can be speculated about.

 

These episodes suggest that EU membership has reached deep into Britain’s tax system and that Brexit will provide liberation for future chancellors. In the case of VAT, that is true. EU law specifies a minimum standard rate of 15% and, as noted, a minimum reduced rate of 5%. It permitted zero-rating in the UK, though items which were taken out of zero-rating could not be returned there.

 

Leaving the EU will not mean the abolition of VAT and the return to purchase tax, its predecessor. It is unlikely that any chancellor will take the opportunity to reduce the standard rate below 15%, given the cost and the state of the public finances, though a symbolic post-Brexit abolition of the tampon tax is highly likely.

 

How typical is VAT, and how much freedom will Brexit bring to tax setting in the UK? As a general rule, indirect taxes have been most affected by membership. There are constraints on excise duties, including EU minimum rates on most but not all alcoholic drinks and on cigarettes.

 

Rates of direct taxation are not, however, the subject of EU rules, often to the frustration of Brussels. Ireland’s super-competitive 12.5% corporation tax rate survives, despite coming under a lot of pressure, particularly during the eurozone crisis; so too does the reduction in the rate in Britain to a targeted 17% from April 2020. There was no EU constraint on the coalition government’s ambition to reduce Britain’s corporation tax rate to the lowest in the G20, or on Philip Hammond’s determination to continue with that process.

 

Even more clearly than corporation tax, personal direct taxation across the EU is a hotchpotch of different schemes. Tax competition works. Many EU countries followed Britain in reducing higher rates of income tax after the Thatcher reforms of the 1980s. Not all did, and France very recently raised higher rates of income tax to close to the UK levels of the 1970s, before reining back.

 

But there is nothing quite like Britain’s system of income tax and national insurance, and each country has its own method of taxing wealth. Harmonisation of direct taxation and wealth taxes is one piece of unfinished business for the EU. Whether it will still be in the future remains to be seen; Britain was always a voice against it. The great unknown is whether there will be post-Brexit tariffs on imports from the EU, or some other form of border tax. The government’s intention is a continuation of tariff-free trade with the EU, although achieving that ambition may be easier said than done. Even here, however, the government would not be able to do exactly what it wants. A failure to strike a trade deal with the EU would result in tariffs being set according to the rules of the World Trade Organisation (WTO).

 

One thing is, however, very clear. In future, chancellors will have greater freedom to vary indirect taxes than they have been able to do while in the EU. They may see this as a mixed blessing. As in other areas of political life, not being able to blame the EU for things they did not want to do anyway may come to be a handicap.