UK TAX SYSTEM

Identification of the key issues which have resulted in the need to rationalise the current tax system of United Kingdom

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TABLE OF CONTENTS

1. INTRODUCTION -------------------------------------------------------------------------------------------2. KEY ISSUES IN CURRENT TAX SYSTEM --------------------------------------------------------------3. REFORM SCENARIO --------------------------------------------------------------------------------------3.1 AREAS OF CONCERN ---------------------------------------------------------------------------3.2 EVALUATION OF ISSUES -----------------------------------------------------------------------3.3 IMPACTS ON INCENTIVE TO WORK -----------------------------------------------------------

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4. RECOMMENDATIONS & CONCLUSION -------------------------------------------------------------REFERENCES --------------------------------------------------------------------------------------------------APPENDIX I:

TABLE1: DISTRIBUTION OF VAT AMONG VARIOUS PRODUCTS -----------------------------TABLE2: MEAN PTR FOR DIFFERENT DEMOGRAPHIC GROUPS (1997 2010) -------------TABLE3: MEAN EMTR FOR DIFFERENT DEMOGRAPHIC GROUPS (1997 2010) -----------

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1- INTRODUCTION The tax system of every country is based on its national income. The tax rate also vary from country to country; for example, some countries charge 30% taxes and some impose nearly 50% overall taxes. Basically, it depends on how the tax system of a particular country has been designed. It is very rare that policy makers consider redesigning the whole tax system, but improvements and tax reforms are regular actions performed by every government. At present, UK government wish to reduce inequality in the tax system and for that purpose the Government has established an Office of Tax Simplification to provide government an independent advice on simplifying current taxation system in UK. This particular paper aims to contribute the discussion for simplification and rationalisation of taxes and also to review new approaches to tax policy making. The report is based on three significant sections. Section I provides the insights to identify key issues which have resulted in the need to rationalise the current tax system. In section II, the attempt has been made to identify areas which focus on the reform of income taxation and its impact on the incentive to work by evaluating the issues. Finally, section III consists of a set of recommendations to policy makers and points for further consideration to ensure the success of any further changes by the Government. 2- KEY ISSUES IN CURRENT TAX SYSTEM The current tax system of UK is designed for the improvement and welfare of Britains people and economy but according to Mirrlees review, the present tax systems is costly and inequitable because it dejects saving and investment (Mirrlees et al., 2010). The major issues which have resulted in the need to rationalise the current tax system can be classified into 6 types of taxes: income taxes, indirect taxes, housing taxes, environmental taxes, saving taxes, and business taxes. The current income tax system in UK is confusing and gratuitously multifaceted that divides earning tax into two separate taxes: Income Tax and National Insurance Contribution; and both taxes are intensifying year-by-year. According to recent changes in income tax rates and taxable bands for 2010-11, the marginal rate has increased on incomes between 37,401 and 150,000, and it will go up again during 2012-13 (HMRC,
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2010). National Insurance Contribution (NIC) is another form of Income Tax which entitles individuals to contribute social security benefits (Jin et al., 2010). According to the survey studies, from 1979 to 2011, National Insurance contribution increased from 6.5% to 12.8% (Adam and Browne, 2011). Many changes can be seen in Value Added Tax (VAT) from past three decades. In the context of implications of VAT as an indirect tax, two common issues are incentives and redistribution. Adam and Browne (2011) state that rationalizing income tax will not take effect until the prices of commodities and services will go down due to cut in consumption tax because if the prices will remain same or increase with equal percentages, the tax burden will transfer from one end to another end. The redistribution of VAT is another issue which was raised in Mirrlees launch in 2010. As compare to other developed countries, UK applies zero rates to few items such as foods, books, and children clothing in order to give relief to people with low incomes, but according to Mirrlees review (Mirrlees et al., 2010) it is an inefficient and expensive approach of tax distribution because VAT cannot detached from the entire tax system. Similarly, the VAT rate of domestic fuel and power has also diminished from 8% to 5% recently to cover multiple women and children related products. This redistribution of VAT among zero-rated, reduce-rated, and exempted products brought many inconsistencies in entire tax system. Table 1 is showing the estimated costs of VAT distribution from 2010 to 2011.
[TABLE 1]

The taxation system for housing market is also designed badly with no clear economic rationale for stamp duty, and the threshold system is subject to create inefficiencies in housing market (Mirrlees et al., 2011). The band system of stamp duty identifies the liability of buyers to pay higher rates of duty on the total value of their properties once the thresholds of rates are increased (Crawshaw, 2009). This causes a quick rise in duty amount payable at each threshold. Similarly, many people with low and high incomes pay council tax on regular basis. The council rate is determined on the basis of 20 years old system when housing market was entirely different (Crawshaw, 2009; IFS, 2010). In UK, 90% environmental taxes are concerned with motoring including high fuel tax and vehicle excise duty and after 1994, three additional environmental taxes have been
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imposed on landfill, industrial energy use, and extraction of aggregates (Adam and Browne, 2011). The major problem with environmental taxes is to determine the rate at which the tax is charged especially in case of carbon emissions because of its complexity and uncertainty (The Treasury Committee, 2008). According to Mirrlees et al. (2010), the taxation on saving and wealth is also inequitable and inefficient because of absence of any reliable tax base. In addition, different forms of savings such as dividends, shares, foreign savings, and bank & building society accounts, are taxed at different rates. Another issue in the current tax system of UK belongs to corporate tax which favours debt financing and discourages the investment by equity (Mirrlees et al., 2011). One of the major problems in corporate taxes is that the rate at which the profits are taxed is not uniform and also not properly allied with personal tax system (Mirrlees et al., 2011). This inconsistency in corporate tax system is creating more complexities and avoidance opportunities in the whole tax system. 3- REFORM SCENARIO
3.1 AREAS OF CONCERN

Since 1997, few changes to income tax have occurred. For example, the lower rate of 20% was replaced with 10% starting rate in April 1999 and then was abolished in April 2008 (Browne and Phillips, 2010). Another change occurred recently when new additional rate of 50% has introduced by the Government applicable on income over 150,000 (HMRC, 2010). On the other hand, in past two decades, two momentous taxes, mortgage interest and married couples allowance were abolished (Browne and Phillips, 2010). In 1997, there was no NIC on earnings of less than 62 per week but later on 2% NIC was imposed on employees and 3% on employers. One of the first major changes in National Insurance Contribution was the abolition of entry rate for both employers and employees in 1999. In 2003, NIC was announced as second tax on earnings that made tax system more opaque, difficult, and expensive (Browne and Phillips, 2010). According to Adam and Browne (2011), since 1997, NIC increased from 10% to 12.8%.

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From 1997 to 2002, the corporation tax reduced from 33% to 30% for big enterprises and for small firms/business it fell from 24% to 19% (HM Treasury, 2003). In the budget of 2007, the main corporate tax rate was again condensed to 28% with a decrease in the rate of capital and machinery from 25% to 20% (Browne and Phillips, 2010). Not just in UK but other OECD countries are also practicing corporate tax reforms from past three decades. Such reforms include the establishment of allowances for corporate equity in Italy and Austria and elimination of split rate in Japan and Germany (Griffith and Klemm, 2004).
3.2 EVALUATION OF ISSUES

It is clearly evident, that income tax and NIC are two important elements of taxation on earnings, but both have different sources and objectives. In 2010/2011, the total receipts from income tax were 153.5 billion whereas total receipts of National Insurance Contribution were 96.5 billion (Office of National Statistics, 2011). In order to simplify and rationalise the current tax system, the Government wants to identify the proposals that will: reduce burdens on employers, remove distortions in the economy, improve transparency, deliver fairer outcomes, and reduce administrative cost of government (HM Treasury, 2011). By following the simplification and rationalization policy of Government, Mirrlees review recommends to merge NIC with income tax in order to avoid confusion and complexity (Mirrlees et al., 2011). According to Mirrlees et al. (2010), there is a need to introduce single integrated benefit in order to replace most of the current and previous multiplicity benefits by rationalising the way in which total support varies with income and other characteristics. Merging these two taxes is a major issue that will bring many challenges for the government and will also carry various impacts on incentive to work. In order to reduce the burdens for employers, the government is working on to introduce Real Time Information to make PAYE simpler and efficient. In addition, call for evidence also emphasized on the issue of different assessment periods for income tax and NIC (HM Treasury, 2011). In this context, the government is already taken few steps to facilitate employers. For example, now P11 form is covering earning taxes, income tax and National Insurance Contribution.

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In removing distortion in the economy and to improve transparency, the reformation of NIC and income tax may play an imperative role. The integration of earning taxes may stop employers to pay employees in certain ways and it could be easier for employers and employees to understand the way how to calculate income tax liabilities (Mirrlees et al., 2011). Similarly, individuals will also have clear understanding about benefits entitlements. Mirrlees et al. (2010) highlight the fact that current tax system is not fair for employees who work for multiple employers. Working on this issue is a great challenge for the government because it can create tension between the principles. According to stakeholders and Mirrlees et al. (2010), the impacts of operation on NIC and income tax may have adverse effects on employees and employers if not designed carefully.
3.3 IMPACTS ON INCENTIVE TO WORK

The changes in NIC to match income tax structure on annual, semi-annual, and collective basis will end up with different liabilities to different individuals. According to the survey of Office of National Statistics (2011), nearly 9 million people work less than a whole year and roughly 3 million people work for more than one employer at the same time. In addition, the earnings of over 7 million individuals are not uniform. Therefore, some of these people will pay less and others will pay more NIC tax if one threshold of National Insurance Contribution will be applicable. The impacts of changes in NIC and income tax can be determined in two ways: Participation Tax Rate (PTR) where the proportion of total incomes taken in tax and withdrawn benefits, and Effective Marginal Tax Rate (EMTR) where proportion of a small increase in incomes taken in the tax and withdrawn benefits (Mirrlees et al., 2010). In calculating both formulas, higher figures indicate weaker incentives. For example, the higher figures of PTR means unemployment trap and similarly higher EMTR represents low income families (poverty trap). To see the impact of reforms on work to incentives, Browne and Phillips (2010) calculated PTR for each demographic group from 1997 to 2010. Table2 is representing the means of PTR.
[TABLE 2]

In table 2, it is shown that PTRs for individuals without kids have not been affected from tax and benefit reforms. The work to incentive of Lone parent (whose partner does not work) is strengthening and the means PTR of couples with children (whose partner does
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work) are rising as a result of tax reforms. From the calculation of PTR it is clear that tax reforms are affecting the demographic groups. Table 3 is demonstrating the means of EMTR of each group from 1997 to 2010. As a whole, tax and benefit reforms cause to weaken the incentive to work for all demographic groups with small variations. One important variation in the EMTR average can be seen for parents without kids when EMTR increased little as a result of tax reforms in 2005, but this average reduced with the reform in April 2008 when there was a cut in basic rate of income tax.
[TABLE 3]

In summarizing the whole fact, it can be said that tax reforms in the past have slightly weaken the incentive to work for people with low incomes, and on the other hand, small reliefs in income tax caused a slight increase in earnings of the workers. Specifically, the incentives to work for both partners (working couples) has been weaken, and in contrast, big rise in the number of workers with high EMTR as a result of extension of in-work benefits and tax credits in 1997 (Adam et al., 2010). Conclusively, the impact of tax reforms is different on each demographic group. For example, the incentive to work for those who had weakest incentive to work, such as lone parents, has strengthened. Alternatively, single adults with no kids faced strongest incentives. 4- RECOMMENDATIONS AND CONCLUSION In the previous sections, some major issues and improvements in tax system have been discussed to critically evaluate the steps the coalition government is taking. In addition, in this research the attempt has been made to identify areas which focus on reform of income taxation and its impacts on the incentive to work. In this section, the attempt will be made to formulate a set of recommendations by considering contemporary and proposed developments in taxation. A number of proposals have been given to the Government to reform the tax system but the proposal of Mirrlees et al. (2010) in November has great significance. In this review, numbers of recommendations were made to the policy makers for the simplification of tax system. The following set of key recommendations is based on Mirrlees review of 2010:

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1. Integration of income tax and National Insurance Contribution to avoid confusion and complexity 2. VAT should be applicable on all products and services including financial services 3. The policy makers may consider to abolish stamp duty and reform council tax based on present value of the property 4. The tax on standard bank and building society should be abolished 5. The attempt should be made to associate corporate tax with personal taxes 6. The introduction of allowance for corporate equity may result to increase 1.4% (approximately 20 billion) in the national income 7. The treatment of three types of tax systems should bring into line; employment, self-employment, and corporate-source income
Mirrlees et al. (2010)

The above proposal looks ambitious that may cause to eradicate many tax confusions. In fact, the Government is currently undertaking careful consideration for merging NIC with income tax. In order to proceed with any further reform, the Government needs to ensure the effects of reforms on stakeholders. In addition, the Government should need to work with stakeholders in assessing the costs and benefits of any further reforms in the taxation system, to ensure the affordability.

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REFERENCES

Adam, S. and Browne, J., (2011). A survey of UK tax system, IFS briefing note 9, [online], available from: http://www.ifs.org.uk/bns/bn09.pdf [Accessed: 04 Feb 2012]

Adam, S., Brewer, M. and Shephard, A., (2006). The poverty trade-off: work incentives and income distribution in Britain, Institute of Fiscal Studies, [online], available from: http://www.jrf.org.uk/sites/files/jrf/1590-poverty-benefits-taxation.pdf [Accessed: 08 Feb 2012]

Adam, S., Brewer, M. and Shephard, A., (2010). Financial work incentives in Britain comparisons overtime and between family types, Institute of Fiscal Studies, [online], available from: http://www.jrf.org.uk/sites/files/jrf/1590-poverty-benefits-taxation.pdf [Accessed: 08 Feb 2012]

Blundell, R., (2000). Work incentives and in-work benefit reforms: a review, Oxford University Press, 16(1), pp. 27-44

Browne, J. and Phillips, D., (2010). Tax and benefits reforms under labour, IFS briefing note 88, [online], available from: http://www.ifs.org.uk/bns/bn88.pdf [Accessed: 07 Feb 2012]

Crawshaw, T., (2009). Rethinking housing taxation: options for reform, Shelter policy discussion paper, [online], available from: http://england.shelter.org.uk/__data/assets/pdf_file/0003/224472/Rethinking_Housing_Taxa tion.pdf [Accessed: 04 Feb 2012]

Griffith, R. and Klemm, A., (2004). What has been the tax competition experience of the last 20 years? Institute of Fiscal Studies, [online], available from: http://eprints.ucl.ac.uk/2900/1/2900.pdf [Accessed: 09 Feb 2012]

HM Revenue and Customs, (2010). Income tax rates and taxable bands, [online], available from: http://www.hmrc.gov.uk/rates/it.htm#2 [Accessed: 04 Feb 2012]

HM Treasury, (2003). Corporation tax reform: a consultation document, HM Revenue and Customs [online], available from: http://www.hmrc.gov.uk/consult_new/corp-tax-reform.pdf [Accessed: 07 Feb 2012]

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HM Treasury, (2010). Tax policy making: a new approach, HM Revenue and Customs, [online], available from: http://www.hmtreasury.gov.uk/d/junebudget_tax_policy_making.pdf [Accessed: 07 Feb 2012]

HM Treasury, (2011). Integrating the operation of Income Tax and National Insurance contributions, HM Revenue and Customs, [online], available from: http://www.hmtreasury.gov.uk/d/condoc_integration_it_nics_contributions.pdf [Accessed: 07 Feb 2012]

Jin, W., Levell, P. and Phillips, D., (2010). A survey of UK benefit system, IFS briefing note 13, [online], available from: http://www.ifs.org.uk/bns/bn13.pdf [Accessed: 05 Feb 2012]

Mirrlees, J. Adam, S., Besley, T., Blundell, R., Bond, S., Chote, R., Gammie, M., Johnson, P., Myles, G., and Poterba, J., (2010). Tax by Design - The Mirrlees Review, Institute of Fiscal Studies, [online], available from: http://www.ifs.org.uk/mirrleesreview/design/taxbydesign.pdf [Accessed: 03 Feb 2012]

Mirrlees, J. Adam, S., Besley, T., Blundell, R., Bond, S., Chote, R., Gammie, M., Johnson, P., Myles, G., and Poterba, J., (2011). Mirrlees review of tax system, Institute of Fiscal Studies, [online], available from: http://www.ifs.org.uk/pr/mirrlees_sept11.pdf [Accessed: 03 Feb 2012]

Office of National Statistics (ONS), (2011). Labour marketing statistics December 2011, Statistical Bulletin, [online], available from: http://www.ons.gov.uk/ons/dcp171778_247485.pdf [Accessed: 08 Feb 2012]

Office of National Statistics (ONS), (2011). Public sector finances November 2011, Statistical Bulletin, [online], available from: http://www.ons.gov.uk/ons/dcp171778_247485.pdf [Accessed: 08 Feb 2012]

The Treasury Committee, (2008). Treasury Fourth Report, House of Commons, [online], available from: http://www.publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/231/23102.htm [Accessed: 06 Feb 2012]

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APPENDIX I
TABLE 1: Distribution of VAT among various products

Source: Adam and Browne (2011, p. 16) 11 | P a g e

TABLE 2: Mean PTR for different demographic groups (1997 2010)

Source: Browne and Phillips (2010) TABLE 3: Mean EMTR for different demographic groups (1997 2010)

Source: Browne and Phillips (2010)

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