Mr Sunak’s Challenge: How will we pay for coronavirus?

How will a government ideologically committed to low taxes and infrastructure spending manage the colossal deficit resulting from the coronavirus pandemic? And if taxes must rise in the UK, where will they fall? Victor Hill investigates.

The bill for Covid-19 is in the post…

Some weeks ago, I speculated in these pages that the UK fiscal deficit for 2020-21 will turn out at between £300 and £350 billion. This is colossal, representing around 14 percent of GDP – so much worse than the fiscal deficit of around 10 percent that Messrs Cameron and Osborne inherited from Messrs Brown and Darling in 2010. This arises from massively increased government spending together with a much-diminished tax-take.

Mr Sunak, the Chancellor of the Exchequer, almost alone in the Johnson cabinet, has survived the pandemic thus far with his reputation enhanced. His swift roll-out of the Job Retention Scheme prevented – or at least forestalled – a tsunami of job losses resulting from the hard lockdown which lasted from 23 March to 04 July. But everybody knows that his real challenge is yet to come.

That challenge is: how to address the deficit without throttling any prospective economic recovery. That there will have to be tax rises – even though the government fought an election ten months ago on a platform of lower personal taxes – is not in doubt. The question is: where, and how soon, will they fall?

On 30 August, the Sunday Telegraph led with a story entitled Bombshell tax hikes to pay for virus. The Westminster rumour mill was suggesting that capital gains tax would be raised; higher-rate pension tax relief would be scrapped; fuel duty would be hiked for the first time since 2011; inheritance tax would be simplified; and there would be a new sales tax on goods purchased online. The government has already tried and failed to introduce a digital services tax – that is a tax on the tech titan’s revenues. But a tax on online purchases would inevitably hit consumers.

On the other hand, it was reported that there was fierce resistance to such tax hikes in Downing Street. Number Ten, supposedly, prefers cutbacks in government spending – to be achieved via the old chestnut of efficiency savings. Messrs Johnson and Cummings know that Middle England, which now embraces the Blue Wall Labour-turned-Tory seats in the North of England, will cut up rough if it perceives that it is paying the bill for Covid-19. Any increase in headline income tax rates will be hugely unpopular.

That is why Tory backbenchers, already frustrated by the government’s handling of the pandemic, are in restive mood. Knights of the shires Sir John Redwood and Sir Graham Brady warned that tax increases would be a grave mistake. Some Tory MPs have even threatened to vote against the autumn budget. They would prefer tax cuts, even if temporary. They point out that the Chancellor’s suspension of stamp duty on the purchase of houses (in England and Northern Ireland) has turbo-charged the property market.

That said, Tories understand that the current deficit is unsustainable. The national debt is now above £2 trillion. If interest rates were to return to the historically abnormally low level of just one percent, then the interest charge on that national debt would begin to spiral higher. Current levels of expenditure have only been made possible by the monetary alchemy of the Bank of England. That cannot continue indefinitely.

Capital Gains Tax (CGT)

The proposal that capital gains tax should be aligned with income tax has been around for some time. It would mean that any profit arising from the sale of an asset would be taxed at 20 percent for basic rate taxpayers, as against just 10 percent currently. Profits on the sale of second homes would also be taxed at 20 percent, as against 18 percent now. For higher rate taxpayers (that is, people on taxable incomes of more than £50,000) taxes on profits on asset sales would rise from 20 percent to 40 percent, and from 28 percent to 40 percent on second homes. Such a move would be yet another blow to the buy-to-let market.

Then there is the schedule of reliefs on CGT which even some accountants find perplexing. Some tax reformers propose that these be replaced with indexation allowances with the result that only gains in excess of inflation (currently negligible, anyway) would be subject to tax. An increase in CGT is seen by some as a step away from reliance on income taxes in the direction of wealth taxes – beloved of the disciples of Thomas Piketty. Except that these measures would hit many people who do not regard themselves as wealthy.

Tax relief on pension contributions

At present standard-rate taxpayers can reclaim all income tax on contributions to their pension pots at a rate of 20 percent while high-rate taxpayers get a rebate of 40 percent. This rebate is claimed by the pension companies and is paid directly into the pension pot. Thus, pension contributions are deemed to be tax-free. Successive governments have incentivised citizens to make adequate provision for their retirement precisely because the state pension in the UK is not deemed sufficient to finance a comfortable retirement. In other European countries, the state pension is closer to the income to which a retiring employee has been accustomed.

When someone retires and draws on their pension, their pension receipts are deemed as income and taxed. Any reduction in pension relief would result in so-called double taxation: income is taxed; then it is invested; and then pension payments arising are taxed again. There would undoubtedly be much resentment about that.

Income tax relief on pension contributions costs the UK Treasury about £40 billion a year. If all relief were capped at 20 percent, then that would raise between £10 billion and £20 billion annually. But the current dispensation is so entrenched that it would be impossible to change overnight – it might require transitional arrangements for up to three years.

Corporation Tax

The Tories were once the party of low Corporation Tax. They cut the headline rate from 28 percent in 2010 to 19 percent by 2017 – with the stated intention of dropping it even further, possibly equalling the rate in the Republic of Ireland of 12.5 percent. In the election campaign last year, however, Mr Johnson said that a further cut to 17 percent would be abandoned so as to fund an increase in spending on the NHS.

Within the EU, only Hungary (9 percent), Ireland and Lithuania (15 percent) have lower headline rates of tax on company profits than the UK. Germany imposes tax at 29.9 percent and France at 32 percent. But the headline rate is only part of the story. What really matters in the calculation of tax payable are the reliefs or capital allowancesavailable to businesses – in accounting terms, how much capital expenditure can be classified as current year revenue expenditure. On this basis, according the OECD, Japan, Germany, Canada and Israel have more competitive business profit tax regimes than the UK.

Inheritance Tax

Sir John Major (PM 1990-1997) once mused that a future Tory government might abolish capital gains tax and inheritance tax altogether. That seems like a dream now. Rather, the word is that Mr Sunak may close a notorious loophole in this tax on assets passing from one generation to the next. That is that, hitherto, agricultural land has been exempt form inheritance tax so that farms can continue in business when the farmer dies. Even if investors acquire agricultural land and rent it out to farmers, the inheritance tax applicable is charged at 50 percent of the normal rate. (Nor do farmers require cumbersome planning permission for farm buildings.)

These inheritance tax privileges have pushed up the price of agricultural land beyond that justified by its return on capital (i.e. the value of food outputs per hectare). That is one reason why many wealthy investors have built up holdings in agricultural land – one being Sir James Dyson. (Though, to be fair, Sir James is a passionate advocate of British agriculture.)

Some reports suggest that Mr Sunak wants to impose a 10 percent inheritance tax on all agricultural land. This idea has already got farmers in my Norfolk village fuming behind their facemasks.

Investing in growth

Many Conservative commentators argue that no amount of tax hikes will close the deficit this year or next; and that the danger of damaging the recovery is severe. If the economy turns down again then unemployment will rise, tax revenues will fall, and welfare spending will balloon. The only way out of the fiscal hole, medium-term, they say, is to stimulate growth. This will lead to a bigger economy with higher tax revenues. But tax hikes imposed too soon will stymie investment, encourage flight of skilled labour and reduce consumption.

There has been a debate raging for years about how to stimulate Britain’s flagging long-term growth rate. Most economists agree that what is needed is to boost productivity. But that is not straightforward. Increases in productivity have stalled across the developed world even as technology has advanced. It will be interesting to see how productivity is impacted by the home-working revolution. But it is probably not where we work but how we work that is critical. I foresee that those returning to the office will continue to hold meetings on Zoom rather than in conference rooms – even if some colleagues are in the same building.

What Britain desperately needs in the decade ahead is to become a better place for tech start-ups to launch and grow. Expect lots of initiatives on that score in Mr Sunak’s budget.

…and the bill has got your name on it

For all his surefootedness, Mr Sunak, a Goldman Sachs alumnus, doesn’t seem to understand that wherever freebies are given out, there will be abuse. It now turns out that many people supporting the Eat Out to Help Out gimmick got a £30 discount from their meal – not a £10 one – because each course was booked as a separate meal. More importantly, Jim Harra, the Permanent Secretary at HMRC, speaking to the House of Commons Public Accounts Committee on Monday (07 September), said that between 5 and 10 percent of furlough cash might have gone astray. That amounts to about £3.5 billion.

Quite apart from the spending necessitated by the health crisis, the Johnson government has taken some dubious spending decisions. The purchase of a stake in satellite-launcher OneWeb for £400 million in early July was questionable. Why not just outsource our satellite launches to the likes of SpaceX?

The paradoxical conclusion is that the very government that finally took Britain out of the European Union will be the one that propelled the country in the direction of European social democracy. The US Federal government spends about 35 percent of GDP. Mr Osborne was determined to keep UK government spending below 40 of GDP. Most European states spend around 45 percent of GDP – and that is where Britain is likely to end up by the end of this parliament.

The UK government 2020 Comprehensive Spending Review will report before the end of the year. This may come up with some blinders. There is a potty idea afoot, advanced by people who don’t understand military matters, that the Army’s tanks should be decommissioned and replaced entirely by drones. (Of course, we need both – you cannot hold hostile territory with drones alone.)

We can expect another freeze on public sector salaries – though many civil servants will continue to work from home and thus save on commuting costs. The foreign aid budget may well be trimmed – though there is huge opposition to this across the liberal establishment. (I don’t see why its advocates shouldn’t be invited to pay additional voluntary taxes to finance it.)

The argument that we need more roads and fast trains has been undermined by the one-way shift away from the office towards home-working. And yet the bulldozers formally got going on the HS2 project at the end of August which will have a final price tag north of £100 billion. Then there is the £100 billion bill floated on Thursday (10 September) for a moonshot CV-19 testing regime. The enormous spending pledges just keep coming.

Philip Booth of the Institute of Economic Affairs thinks that unless public spending is reined in, then UK public debt will exceed that of Japan by 2060. He thinks that to establish fiscal rectitude two massive budgets will have to be trimmed which were privileged during the period of Cameron-Osborne austerity: healthcare and state pensions. The first is politically untouchable – especially given the pandemic. So, it will just have to be the second.

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Get ready for Byzantine customs procedures, certification regimes and costly visas to travel in Europe. Tariffs, quotas and non-tariff barriers (Do you ‘ave a licence for zat monkey?) – here we come. No doubt, there will be opportunities ahead; and the momentum for CANZUK is building. But these things will only happen medium-term. 2021 could be the year of living painfully.

The Europeans tell us that we can be lords of our own waters – but that they must have the right to take our fish. They did not ban Canada from aiding its own industries when they signed a trade deal with that country – they only required that information on state subsidies must be shared. In contrast, in the year that Lufthansa and Renault were granted gargantuan state subsidies in Germany and France respectively, any UK subsidies to its industries must be pre-authorised in Brussels.

There is an argument that the Withdrawal Agreement was predicated on there being a free trade (i.e. zero tariff) deal between the UK and the EU by the end of the transition period. Section 38 of the Withdrawal Agreement Bill is considered by hard-line Tory Brexiteers as a get-out-of-jail card. It states that nothing in this Act derogates from the Sovereignty of the Parliament of the United Kingdom. The proposed Internal Market Bill, if enacted, would ensure that the Northern Ireland Protocol (within the EU-UK Withdrawal Agreement) may not be used by the EU to impose tariffs on goods entering the UK from Northern Ireland. That does not seem unreasonable to me.

If it is to be a hard, WTO Brexit, then the Withdrawal Agreement is no longer fit for purpose. But expect one Hell of a row – with Frau von der Leyen denouncing Britain at the United Nations in an attempt to sink the pound.

It’s going to be a turbulent autumn.