the cost of complexity

The Costof Complexity

How Britain’s tax system strangles theeconomy and reduces British competitiveness

Nicholas Boys Smith, David Martinand Lawrence Kay

Edited by Natalie EvansThe

Cost

ofComplexity

Nicho

lasBoys

Smith,D

avidMartin

andLaw

renceKay

edited

byNatalie

Evans

Policy

Exchang

e

£10.00ISBN: 978-1-906097-34-9

Policy ExchangeClutha House

10 Storey’s GateLondon SW1P 3AY

www.policyexchange.org.uk

This report argues that the Government must make the UK taxsystem fundamentally simpler. To be economically competitive,Britain needs to reduce the burden of tax complexity onbusinesses and individuals. At the moment, it is getting out ofcontrol. At 8,300 pages, the UK has the second-highest amountof primary tax legislation among the world’s top economies.

To prevent the problem of complexity in the tax system gettingworse, the way that tax legislation is made needs to bechanged. During Budget time, the Chancellor is always underpressure to “do something”, and faces a plethora of suggestionsfrom the Treasury, HMRC, professional bodies and the mediaabout what should be done.

However, to start reversing the problem of tax complexity now,the Government must accept the principle that the taxableprofits of a business (whether operated by an individual or acompany) should normally equal its accounting profits; abolishunjustified differences between employed and self-employedtaxation; reconsider the distinction between capital and income;and cut unnecessary reliefs.

By making these changes and adopting a principled approach,the Government might also start to remove unwarrantedexemptions in the tax system. At the moment, there are manyreliefs that incentivise environmentally friendly behaviour, and afew reliefs that discourage it. Furthermore, many measures thatare meant to help certain groups are largely unknown. Overall,these problems make the tax system more regressive than itneed be. Empirical evidence, collected for the first time in thisreport, shows that people and firms who cannot afford to hiretax advice suffer most from complexity.

TAX COVER - HDS.qxp 23/10/08 14:33

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The Cost ofComplexityHow Britain’s tax system strangles the economyand reduces British competitiveness

Nicholas Boys Smith, David Martin and Lawrence Kay

Edited by Natalie Evans

About the authors

Nicholas Boys Smith took a double first inhistory from Cambridge University and wasan adviser on welfare policy to thenSecretary of State of Social Security, PeterLilley, before working at McKinsey & Co forsix years where he focused on financial serv-ices and regulation in the UK, Europe andAsia. He has written several widely-coveredreports on the UK tax and benefit systemand on the impact of regulation on the UKeconomy. From 2005-06, he was secretary tothe Tax Reform Commission set up by theShadow Chancellor of the Exchequer,George Osborne. He is a director at a majorUK bank and of the think-tank, Reform.

David Martin enjoyed a career spanning 23years as a tax lawyer within a large City LawFirm, latterly as Head of the Tax

Department, before taking early retirementin 2002. During that time he advised bothcompany and individual clients. He nowlives a less pressurised life in Devon with hiswife and two daughters and maintains anactive interest in tax law. He is a member ofthe Tax Law Review Committee of theInstitute of Fiscal Studies, for which he wasthe co-author of two recently publishedpapers. With the Centre for Policy Studieshe published Tax Simplification and AnOverview of the Flat Tax. He was specialadviser to the Tax Reform Commission.

Lawrence Kay is a Research Fellow atPolicy Exchange.

Natalie Evans is Head of Research atPolicy Exchange.

© Policy Exchange 2008

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Contents

Executive Summary 4

Part 1: Why complexity matters 7The problem with tax complexity 7The growth in tax competition – simplicity as well as rates 14Six drivers of tax complexity 17Tax complexity – towards an evaluative framework 22

Part 2: British tax complexity – a historical and comparative analysis 24Personal tax complexity 29Indirect tax complexity 36Business tax complexity 40

Part 3: A false awakening and how to really change things 45

Appendix 49

Executive Summary

The problem of tax complexityThe credit crunch is clearly the most seri-ous and urgent of our current economicproblems. However, once stability returns,the Government must make the UK taxsystem fundamentally simpler. To be eco-nomically competitive, Britain needs toreduce the burden of tax complexity onbusinesses and individuals.

The tax complexity burden is gettingout of control. At 8,300 pages, the UK hasthe second-highest amount of primary taxlegislation among the world’s topeconomies.1 The average length of theannual Finance Act has increased fromunder 200 pages in the 1970s to over 500in the past few years. The constant addi-tion of one rule on top of another nowmeans that the economy bears a yearly taxadministrative cost of £5.1 billion.2 Peoplewho pay an adviser to help them with theirself-assessment forms pay out an estimated£1.25 billion every year.3

If the Government does not start tosimplify the tax regime, Britain willbecome ever less competitive as othercountries make their tax systems easier touse and thus attract businesses fromaround the world, including the UK. InMarch 2008, Belgium advertised itself inThe Economist as having “an intelligenttax system with notional deduction andadvanced ruling for investors”4 – in sum,simplicity and stability. In 2008 alone, sixhigh profile companies have decided torelocate outside the UK: ShirePharmaceuticals, the UK’s third biggestpharmaceutical company; UnitedBusiness Media, a publisher; Regus, anoffice services firm; Charter, an engineer-ing business; Henderson, an asset man-agement firm; and WPP, one of theworld’s biggest communications compa-nies.5 All cited the UK’s tax system as thereason for their relocation. Many others,

such as Google, have simply never movedhere but have set up their European head-quarters elsewhere.

By designing an evaluative frameworkwith nine tests that assess the absolute andrelative levels of tax complexity in theBritish system, we have been able to startfocusing on the issues that cause theseproblems, particularly the factors of cost,distortion, and bias against smaller enter-prises, in a way that allows reasonable his-torical and international comparison. Theresults of many of these tests show that theproblem of complexity has been gettingworse.

The shift towards a tax system that ismore comprehensible and easier to dealwith must also include a comprehensiveassessment of the exemptions in the taxsystem. There is an unknown number ofminor exemptions that have been intro-duced for one purpose or another over theyears, whose impact on revenue theGovernment itself has admitted is “notknown”. HMRC lists over 200 of these butthere are certainly more.6

These exemptions are often regressive.The difficulty of complying with a com-plex tax system, shown by empiricalresearch collected here for the first time,means that people and firms that cannotafford expert advice lose out because theyare often unaware of the benefits availableto them. Only 11 per cent of businessestake advantage of R&D tax credits, forexample.7 It would be better if these reliefsand exemptions were abolished in favourof lower tax rates or targeted benefits forthose who really need it.

Many exemptions are also contradicto-ry. Some of them, for example, are pro-car (there is an exemption for car parkingat or near a workplace), others are anti-car (there are exemptions for free mealson cycle to work days, cyclists’ safety

1. World Bank and

PricewaterhouseCoopers,

Paying Taxes: The Global

Picture, World Bank Group and

PricewaterhouseCoopers, pp 16,

2006

2. KPMG, Administrative

Burdens – HMRC Measurement

Project, 2006

3. Authors’ own calculations,

see page 30

4. The Economist (UK edition),

pp 101, 15th – 20th March 2008

5. Houlder V and Brown JB,

“Darling under pressure to ease

jitters over tax,” Financial Times,

August 30 2008; Houlder V, “Tax

factor beats patriotism in WPP

relocation,” Financial Times,

October 6 2008

6. See the following page on the

HMRC’s website:

http://www.hmrc.gov.uk/stats/ta

x_expenditures/00ap_b2.htm

7. PricewaterhouseCoopers,

Enterprise in the UK: Impact of

the UK Tax Regime for Private

Companies,

PricewaterhouseCoopers, 2006

4

equipment and relief for a work’s bus).Some favour well-off workers (presum-ably people in the City benefit most fromthe late night taxi relief ), while othersfavour poorer ones (some trades unioninvestments are exempt from IncomeTax).

The solution to the tax complexityproblemTo prevent the problem of complexity inthe tax system getting worse, the way thattax legislation is made needs to be consid-ered. During Budget time, the Chancellor isalways under pressure to “do something”,and faces a plethora of suggestions from theTreasury, HMRC, professional bodies andthe media about what should be done. AnOffice of Tax Simplification, proposed bythe Conservatives, could help to make thislegislative process more concerned withunnecessary complexity, and could start toaddress problems in existing law, but thesystem would still be predisposed towardsthe next big change rather than proper con-templation of the tax system.

While the legislative aspect of the prob-lem is significant, there are things that theGovernment can start doing without evenmaking any changes to the policy-makingprocess. To begin reversing the problem oftax complexity and thus lessen the eco-nomic burden of it, we recommend thefollowing immediate changes:

� Accounting and tax profits: theGovernment should adopt the princi-ple that the taxable profits of a business(whether operated by an individual or acompany) should normally equal itsaccounting profits.

� Employed and self-employed taxation:policy-makers should look at the differ-ences in tax treatment and abolish anyunjustified distinctions.

� Capital and income: the distinctionbetween the two is not justified in

many instances. Where it is, theGovernment needs to make sure that itis sufficiently clear.

� Reviewing reliefs: policy-makers shouldcut unnecessary reliefs and develop away to make sure that new ones are notadopted when not needed.

Instead of taking a knee-jerk approach,the reform process should first establish,following adequate consultation and care-ful evaluation, the tax principles thatshould apply to the area targeted forreform. A strategy can then beannounced, with consideration on theproblems outlined above, and a carefulschedule for implementation worked out.This is the best way to build a tax systemwhich is simpler and more transparent,with fewer distortions and lower compli-ance costs.

In an attempt to address some of theseproblems, the Government has recentlyannounced several changes intended tosimplify the system. However, these moveshave lacked direction or strategy. Theyhave not faced up to the structural prob-lems and have not been built upon clearunderlying principles. Sadly, we do notbelieve they will have any substantialimpact on tax complexity.

But reducing complexity in the tax sys-tem will be difficult. Because any changesto the current structure will affect the waysthat different groups benefit from certainexemptions, any politician will need todeal with the creation of lots of winnersand losers. There are several areas, forexample, that need addressing but only

Executive Summary


“ However difficult change may be, the benefits ofhaving a simple system that is fairer and encourages firmsto locate in the UK means that the effort would beworthwhile”

after careful consideration, such as simpli-fication of the distinctions made on thesupplies of goods and services for VATpurposes; the amalgamation of Income Taxand National Insurance Contributions;whether it would be sensible to distinguishbetween business and non-business profitsfor tax purposes (as commonly occursoverseas); if savings can be encouragedthrough rationalisation of the rules govern-ing investment vehicles; how stamp duty,stamp duty land tax and stamp dutyreserve tax might be aligned; whether taxcredits can be amalgamated into the taxsystem; and how distortion and complexi-

ty can be removed from the imputation sys-tem of taxing dividends. But however diffi-cult change may be, the benefits of having asimple system that is fairer and encouragesfirms to locate in the UK means that theeffort would be worthwhile.

Radical steps were first taken over twen-ty years ago to eliminate the worst excessesof high tax rates. Top rates of Income Taxwere reduced from 98 per cent to 40 percent. The full rate of corporation tax isnow 28 per cent instead of 52 per cent.Comparably fundamental reform is nowrequired to simplify and stabilise theBritish tax system.



Project, 2006

9. World Bank and


Paying Taxes 2008: The Global



2008

10. Authors’ own calculations,

see page 30

11. National Audit Office, HM

Revenue and Customs:

Accuracy in processing Income

Tax, National Audit Office, 2007

6

The Cost of Complexity

The problem of tax complexity in numbers

� Tax complexity costs the economy £5.1 billion per year.8

� The average length of the Finance Act has increased from under 200 pages in the1970s to over 500 in the last five years.

� World Bank data shows that countries with clear tax laws or tax codes that alignperfectly with accounting rules collect 6 per cent and 10 per cent more revenuerespectively (as a proportion of GDP) than countries that do not have clear taxlaws.9

� The personal cost of tax complexity is around £1.25 billion per year, i.e. the amountspent on tax advisors by self-assessment people who need advice.10

� To help complete the basic individual tax return, HMRC provide a 28-page set ofguidance notes. If the taxpayer is unfortunate enough to need to complete theadditional supplementary pages there is a further 32-page set of notes thatexplains how to do it. There are also more notes for the schedules.

� 22 million employed taxpayers take on trust that their PAYE and NICs have beenaccurately computed. They are not always wise to do so. HMRC estimate thatinaccurate processing led to 2.8 million errors on PAYE in 2006-07.11

The problem with taxcomplexity

The burden of high tax: from theoryto practiceIn 2006-07 only five countries increasedtheir corporate tax rates, Bangladesh, theDominican Republic, Hungary, Venezuelaand Zimbabwe. In contrast 27 countriesreduced profit taxes, 12 reduced labour taxesand six eliminated a tax altogether.12 There isnow near-global political subscription to theargument that lower taxation is good for eco-nomic growth. Robert Mugabe and HugoChávez may disagree, but every rule has itsexceptions.

The theoretical rationale behind thispolitical hegemony is well established.Taxation is necessary and desirable to pay forpublic services, but as well as transferringresources from individuals and corporationsto the government, it exerts a “deadweightcost” on the economy. For example, whereVAT is added to the price of goods or servic-es, sales may fall because consumers have topay higher prices. Tax can also depress thereal return on a proposed investment to theextent that it is not worth making it. As aresult, fewer producers will find fewer pur-chasers, and overall economic output will belower than it could be.

As long as they have enough revenue topay for basic public goods (such as security),economies tend to produce less when theyput taxes up than when they pull themdown. Taxation is necessary to pay for thegoods and services or redistribution that vot-

ers want, but the difference between a lowtax state and a high tax one is about morethan just revenue: the taxpayer’s loss from agiven amount of taxation exceeds the gov-ernment’s gain.

This theory is now buttressed by empiri-cal economic analysis. A generation ago itwas still possible to argue that the relation-ship between high tax and slow growth wasevidentially unproven. It no longer is. Anarray of international studies, set out inAppendix 1, has supported the link.

One of these studies suggests that “typicalestimates of the cost of a dollar of tax rev-enue range from 20 cents to 60 cents overand above the revenue raised.”13 This mat-ters. The OECD has concluded that “up toone-third of the growth deceleration in theOECD [over the 1965-95 period] would beexplained by higher taxes” and that “theincrease in the average tax rate of about 10percentage points over the last 35 years mayhave reduced OECD annual growth rates byabout 0.5 percentage points.”14

Unfortunately, Britain has started to losethe competitive edge that it once had fromhaving a low tax regime. Champion it ordecry it, it remains a fact that across theworld developed and developing economiesare cutting tax rates in order to encourageinvestment. There may be no absolutely sim-ple correlation between low taxes and invest-ment (international companies have to basethemselves in stable parts of the world with

12. World Bank and




PricewaterhouseCoopers, pp

20-1, 2008

13. Joint Economic Committee,

Economic Benefits of Personal

Income Tax Reductions, Joint

Economic Committee, United

States Congress, April 2001

14. Liebfritz WJ, Thornton J and

Bibbee A, “Taxation and

Economic Performance,” OECD

Economics Department Working

Paper 176, 1997


Part 1Why complexity matters

predictable laws and access to the necessaryworkforce), but it still matters.

But what about tax complexity?Even though the theoretical and empiricalarguments over tax levels and marginal rateshave become well known, the politicaldebate over tax systems is still young. Manyhave asserted that simplicity is a good thing.Speaking in 1980, the Chancellor of theExchequer, Geoffrey Howe said

“I have frequently drawn attention to theextent to which the tax system has wovenitself deeply into the fabric of national life.Tax has been piled upon tax, often withlittle regard for their interaction. e acci-dental effects of this tax onslaught haveoften been as damaging as the direct conse-quences.”16

Almost simultaneously, in America in 1981,Robert E. Hall and Alvin Rabushkafamously advocated the flat tax. Thisinvolved flat income and business taxes, theremoval of all other levies and an end to allexemptions, reliefs and credits.17 The pro-posal, and its plea for simplicity, has inter-mittently surfaced in political debate in sev-eral countries – most pertinently in Britain

in the summer of 2006 when the conceptwas raised by the Shadow Chancellor of theExchequer, George Osborne. Although ithas not actually been introduced in anyWestern economy, the flat tax has beenpromulgated (in one form or another) bymany east European ones.18

The Chancellor of the Exchequer,Alistair Darling, stated in the 2007 Pre-Budget Report that tax simplification is animportant Government objective. Toachieve it, he announced several initiatives.Their effect, however, has been disappoint-ing, as we argue in part three of this report.

But is tax simplification worth the can-dle? Is there actual evidence that tax com-plexity is a bad thing? Put another way, canwe make the case against complex taxationwith anything like the same empirical con-fidence that we can against high taxation?We can: the evidence suggests that com-plexity leads to inefficiency, particularlybecause it adds to distortion.

It has long been argued that simple taxeswith a wide base are less likely to producedistortion and inefficiency than complicatedones with many exemptions and reliefs. But,largely unknown to British political debate,a range of economists and social scientistshave begun the difficult work of amassingempirical evidence concerning the macro-


8

15. KPMG, KPMG’s Corporate

and Indirect Tax Survey 2007,

KPMG, 2007

16. Hansard, Parliamentary

Debates, vol 981, p 1478, 1980

17. Hall and Rabushka first pub-

lished articles on the flat tax in

1981. For further details, see

Hall R and Rabushka A, The Flat

Tax (Second Edition), Hoover

Institution Press, 1995

18. Estonia, Lithuania, Latvia,

Russia, Serbia, Ukraine,

Slovakia, Georgia, Romania and,

to a limited extent, Poland, have

all implemented a flat tax

40

35

30

25

20

15

10

5

0

1993 1995 1997 1999 2001 2003 2005 2007

Average EU corporate tax rate

Average OECD corporate tax rate

United Kingdom corporate tax rate

Per

cent

age

rate

Year

Figure 1: Corporate taxes in the UK, EU and OECD, 1993-200715


Part 1: Why complexity matters

economic consequences of complex taxa-tion, and the way it affects decision-making.Specifically, they have examined its affect onoptimal individual outcomes as well as over-all economic growth and investment. Someof their key findings are outlined below forthe first time to a non-specialist audience inthis country. Five of them stand out; we dealwith each in turn:

1 Tax complexity makes individuals poorer.2 Tax complexity lowers profits and makes

markets less efficient.3 Tax complexity hits small firms hardest.4 Tax complexity lowers tax revenues in the

long-term.5 Tax volatility further reduces profits and

investment.

Tax complexity makes individualspoorerIn an experiment, 89 US degree-educatedtaxpayers were asked to maximise theirafter-tax income by choosing between a tax-able and a non-taxable bond.19 They wereassigned to one of three groups with differ-ent levels of tax complexity: a low complex-

ity group which had a marginal tax rateunaffected by lower tax thresholds orrebates; a medium complexity group thathad a marginal tax rate affected by a lowertax threshold; and a high complexity groupwhere the marginal tax rate was affected byboth a lower tax threshold and a rebate. Thetaxpayers’ ability to maximise their returnswas entirely dependent on their skill ataccurately estimating their effective margin-al tax rate in the three investment decisionsthey were asked to make.

The low complexity group faced statu-tory and effective marginal tax rates thatwere the same: 38.5 per cent. The mediumand high complexity groups were given a35 per cent statutory marginal tax rate, butthe effective marginal tax rate, due to theimpact of thresholds and rebates, was 38.5per cent.

As Figure 2 shows, the greater degree ofcomplexity had a stark impact on the tax-payers’ ability to understand these effectivemarginal tax rates. 70 per cent of the lowcomplexity group (19 out of 27) were ableto accurately estimate their effective mar-ginal rate. However, none of the mediumcomplexity group could and only one (out

19. Rupert T, Single L, Wright A,

“The Impact of Floors and

Phase-Outs on Taxpayers’

Decisions and Understanding of

Marginal Tax Rates”, Journal of

the American Taxation

Association, vol 25, pp 72-86.

Full detail on (high) levels of sta-

tistical significance and experi-

mental controls are described in

the paper. In this, and similar

experiments described below,

participants were rewarded for

success to ensure optimal

efforts

20. Rupert T, Single L, Wright A,

“The Impact of Floors and

Phase-Outs on Taxpayers’

Decisions and Understanding of

Marginal Tax Rates”, Journal of

the American Taxation

Association, vol 25, pp 72-86

120

100

80

60

40

20

0

Low Medium High

Per

cent

age

Degree of complexity faced by participants

Ability to calculate marginal tax rate(percentage answering correctly)

Ability to optimise investment returns(percentage making optimal decision)

Ability to optimise investment returns (percentagemaking correct decision three times)

Ability to optimise investment returns (percentagewho made at least one correct decision)

Figure 2: Taxpayers’ ability to calculate marginal tax rates (MTRs) andoptimise investment returns under low, medium and high levels of taxcomplexity20

of 30) in the high complexity group man-aged it. On average, those in the mediumcomplexity group got their tax rate wrong by2.98 per cent. Those in the high complexitygroup were even less accurate with an averageerror of 6.47 per cent.

These errors in understanding led to mis-takes in decision-making. On average, tax-payers in the low complexity group made theoptimal decision 80 per cent of the time.Taxpayers in the medium and high complex-ity groups made the optimal decision only 29and 31 per cent of the time respectively. Notaxpayers in the low complexity group madethe wrong decision in each of the three exper-iments; 48 per cent of medium and highcomplexity taxpayers did. 59 per cent of par-ticipants in the low complexity group madethe optimum decision three times running;only 10 per cent of medium and high com-plexity taxpayers were able to achieve thesame feat.

In short, all else being equal (they were forthe purposes of this experiment), taxpayersunderstand their tax liabilities more acutelyand make better financial decisions under asimpler tax system than a complex one. Taxcomplexity does make individuals poorer.21

Tax complexity lowers profits andmakes markets less efficientThe logical extension of poor decision-mak-ing in situations of high tax complexityshould be that highly complex tax systemshave less efficient markets and lower returns.Does the academic evidence support this? Itdoes.

In a similar (though more complex) exper-iment, 42 taxpayers were split into six groupsof four buyers and three sellers. After train-ing, each group took part in a series of five“double-auction” markets in which sellerscould make offers and bids and all partici-pants were financially incentivised to max-imise their personal returns.22

However, half of the participants faced atransparent tax environment and half a farmore opaque one. Under low complexity,three of the groups faced a simple tax envi-ronment with only a flat, 40 per cent tax ontrading profits. Under high complexity con-ditions, the other three groups faced an envi-ronment with a 15 per cent base tax and twoadjustments based on the level of tradingprofit. These adjustments, which could bepositive or negative, were provided in a tableand were structured so that they alwaysresulted in a tax rate of 40 per cent of tradingprofits.

The actual economics of both sets of mar-kets were thus identical. All that differed werethe levels of tax complexity and transparencybetween the three low complexity and thethree high complexity markets. But this wasenough to create sharp differences. The highcomplexity markets had higher average prices,inefficiently high trading volumes and lowerlevels of overall profitability (measured bymarket efficiency which is a measure of profitmade by market participants as a percentageof total profit which could have been made ina perfect market).These differences are set outin Table 1. The key finding is again stark: thesimpler tax markets were over ten per centmore efficient than the higher tax ones.


10

21. This is not the only analysis

with these findings. See also

Rupert T, Wright A, “The Use of

Marginal Tax Rates in Decision

Making: The Impact of Tax Rate

Visibility”, Journal of the

American Taxation Association,

vol 20, pp 83-99

22. Boylan S, Frischmann P,

“Experimental Evidence on the

Role of Tax Complexity in

Investment Decisions”, present-

ed to The American Taxation

Association, February 24 2006

23. Across the five market peri-

ods and all six groups. Boylan S,

Frischmann P, “Experimental

Evidence on the Role of Tax

Complexity in Investment

Decisions”, presented to The

American Taxation Association,

February 24 2006

Table 1: Impact of tax complexity on market efficiency, pricingand volume23

Tax complexity Average units traded Average Price, $ Market efficiency, per cent

Low 4.4 645.0 98

High 5.9 658.0 85



In short, by raising the transactional costof an exchange, a complex tax system increas-es the deadweight cost of taxation. Multiplerates, tapers and adjustments may not be asheadline-grabbing or unpopular as raising taxrates, but they can be very nearly as harmful.Complexity may even discourage new invest-ment from happening at all.24

Tax volatility reduces profits andinvestmentThe research cited above found that the dif-ferences in market efficiency between low taxcomplexity and high tax complexity marketsdid erode over time. Volumes and prices bothdecreased and efficiency increased betweenthe first and fifth market periods (see figures

three, four and five for details). As we mightexpect a priori, market participants are goodat learning from their own mistakes and mas-tering initially challenging complexity.However, the differences did not disappearentirely, even though the scope of the taxrules in all the markets in the experimentwere very much more limited than the com-plex rules to be found in the real world. Putdifferently, under a stable tax regime, wherethe rules stay constant, markets can begin tocompensate for tax complexity. Under anunstable tax regime constant changes to therules make this much harder. Tax volatilityexacerbates the tendencies of a complex taxsystem to suppress market efficiency and holdback investment, as shown by the graphsbelow. Tax volatility reduces profits.

24. See below, for example, for

the success of the Netherlands

in attracting new holding com-

panies with its simple tax regime

25. “Market efficiency” means

the ratio of actual to possible

wealth that could have been cre-

ated. Boylan S and Frischmann

P, “Experimental Evidence on

the Role of Tax Complexity in

Investment Decisions,” unpub-

lished paper, pp 25, 2006

120

100

80

60

40

20

0

Market period

1 2 3 4 5

Efficiency

Efficiency under lowcomplexity

Efficiency under highcomplexityP

erce

ntag

e

9876543210

Num

ber

ofun

its

Volume

1 2 3 4 5

Market period

Price

Pric

e(U

SD

)

790690680670660650640630620610

Market period

1 2 3 4 5

Units traded under lowcomplexity

Units traded under highcomplexity

Closing prices under lowcomplexity

Closing prices under highcomplexity

Figure 3: Evolution of the impact of tax complexity on market efficiency,volume and price in a competitive market25

Unsurprisingly, high tax volatility is alsoassociated with lower levels of invest-ment.27 Levels of international tax volatili-ty, derived from data collated by a study of16 developed countries over many years,are set out in Table 2. Several findingsemerge. First, the UK’s effective capitaland marginal tax rates have been amongthe most internationally volatile over thelast quarter century. Britain’s effective cap-ital tax rate has been the fifth most volatileout of the 16 countries. Its effective mar-ginal tax rate has been the second mostvolatile – second only to Italy. This may inlarge part be as a result of reductions inpenally high tax rates in the 1980s.However, it also reflects more recent sub-stantive changes to capital taxation.

Edmiston found that regression analysesof these findings, compared to a range ofeconomic indicators (interest rates, wages,GDP price index, capital price index, realGDP per worker) finds a very high level ofnegative correlation (99 per cent confi-

dence), between high levels of capital taxvolatility and levels of overall investment.Increases in tax volatility are very stronglycorrelated with reductions in investmentper worker.

Tax volatility does, then, lower investmentlevels, as common sense would suggest.Permanence in the tax code encouragesinvestment in an economy. Volatility anduncertainty in the tax code discourage it.This is not just an opinion or (very reason-able) assumption. It is an observable fact.28

Tax complexity hits small firmshardestA complex tax system is harder to navigatefor small firms than for large ones. They donot have the specialist compliance, legaland accounting departments which thelarge firms’ efficiencies of scale permitthem to employ. The cost of externaladvice falls more heavily on smaller cash-flows.


12

26. The numbers in the table are

the product of a modelling

process, where the final size of

the figure reflects the degree of

volatility. See Edmiston K, “Tax

Uncertainty and Investment: A

Cross-Country Empirical

Examination”, Economic Inquiry,

vol 42, pp 425-440, for details of

the method used

27. Edmiston K, “Tax Uncertainty

and Investment: A Cross-

Country Empirical Examination”,

Economic Inquiry, vol 42, pp

425-440. Edmiston initially

analysed 17 countries but

Germany was excluded due to

insufficient time series data

28. This is not the only study to

investigate this issue but it is prob-

ably the most comprehensive.

Other studies have shown how dif-

ferent taxpayers respond to tax

rate uncertainty in directionally dif-

ferent ways. Some risk averse

savers may even save more under

conditions of tax uncertainty. See

Watson H, “The Effects of Income

Tax Uncertainty in a Dynamic

Setting”, Southern Economic

Journal, vol 53, pp 682-689. For a

more theoretical approach see Alm

J, “Uncertain Tax Policies,

Individual Behaviour, and

Welfare”,The American Economic

Review, vol 78, pp 237-24

Table 2: Observed international tax volatility (the higher the number, the greater the volatility)26

Country Effective capital Effective consumption Marginal effective Average effective Statutorytax rate tax rate tax rate tax rate tax rate

(1970-2001) (1970– 2001) (1982– 2002) (1982– 2002) (1982– 2002)

Austria 484.6 3.4 20.1 8.9 33.8

Belgium 45.0 6.3 1.7 2.3 2.3

Denmark 124.4 7.1 NA NA NA

Finland 1,431.1 11.4 34.9 40.0 46.6

France 119.5 1.8 11.2 36.4 32.3

Greece 23.8 2.7 1.0 1.1 1.2

Ireland 65.2 7.6 6.4 1.3 0.0

Italy 21.1 7.1 153.0 54.2 51.7

Japan 1,244.0 0.8 15.5 1.2 18.1

Luxembourg 715.1 4.0 NA NA NA

Netherlands 59.5 2.0 7.2 8.8 9.6

Portugal 21.8 7.0 67.1 15.1 17.2

Spain 8.5 4.0 1.3 0.7 0.9

Sweden 29.3 20.0 22.7 30.1 33.3

UK 203.3 6.2 107.8 2.2 55.5

US 7.2 0.7 0.3 25.2 57.4



The CBI’s recent report on the UK taxsystem argued that “the compliance bur-den of the corporate tax system falls dis-proportionately on SMEs.”30 Two academ-ics found evidence that strongly suggests asmuch. They conducted a fully controlledanalysis of the time spent by 1,569 Britishfirms on administering Pay As You Earn(PAYE), National Insurance (NI),Statutory Sick Pay (SSP) and StatutoryMaternity Pay (SMP) and found that themean compliance costs of tax administra-tion were sharply negatively correlatedwith size. As firms get larger their taxadministration bill becomes radically easierto manage (see Figure 6 for the latest data).

Tax complexity lowers tax revenuesAs complicated tax rules make it harder torun and grow businesses, other factorsbeing equal we would expect governmentrevenues to grow less quickly in countrieswith higher tax complexity than countrieswith lower tax complexity. Research isbeginning to back this up – though there ismore work to do. World Bank data showsthat countries with clear tax laws or taxcodes that align perfectly with accountingrules collect 6 per cent and 10 per cent

more revenue respectively (as a proportionof GDP) than countries that do not haveclear tax laws.31 In short, everyone loses –businesses suffer, but so do the taxpayerand the government in the long-run.

ImplicationsIn part two of this report we outline thecomplexity of the UK tax system andestablish the harm it does to the Britisheconomy. However, we hope that this sum-mary of recent behavioural and macroeco-nomic analysis can give policy-makers con-fidence. Tax complexity really matters. Itincreases the deadweight cost of transac-tions, reduces profits, distorts decision-making, dissuades investment and reducestax revenues. It undermines the poorestand the smallest firms most of all. Taxvolatility just makes matters worse.

Those seeking to optimise theGovernment’s tax policy should thereforebe tackling complex and uncertain taxationjust as confidently as they have been mak-ing the case against high taxation for thelast twenty years.32 Ironically, those want-ing to increase the Government’s tax takein the long-term should be doing preciselythe same things.

29. “Tax administrative burden”

means the compliance costs,

costs of working with intermedi-

aries and acquisition costs

borne by firms when then they

comply with UK tax law. “Nano”

firms means companies with no

employees; “micro” to those

with 1-9 employees; “small” to

those with 10-49; “medium” to

those with 50-249; and “large”

to those with more than 250.

Sources: KPMG, Administrative

Burdens: HMRC Measurement

Project, KPMG, 2006; BERR

Enterprise Directorate Analytical

Unit

30. CBI, UK Business Tax: A

Compelling Case for Change,

CBI, pp 39, 2008

31. World Bank and





2008

32. Even though tax rates have

fallen over recent years, the

amount of revenue collected has

risen, largely because tax

allowances have not been

increased in line with earnings

60

50

40

30

20

10

0

Per

cent

age

Size of firm

Nano Micro Small Medium Large

Share of the tax adminsitrative burden

Share of total turnover among all firms

Figure 6: Share of the tax administrative burden by firm size29

The growth in taxcompetition−simplicityas well as rates

Competition over tax complexityOne academic recently defined tax competi-tion as “the use by governments of low effec-tive tax rates to attract capital and businessactivity to their country.”33 Tax rates, however,are not the only means with which countriesare competing with each other. Simplificationof tax regimes has also become an importantpart of competition between countries.

Over the last decade many governmentshave very adeptly simplified their tax regimes,making them more attractive to companiesand investors in the process. Developingeconomies are doing this. But so are devel-oped ones in order to lure corporate head-quarters and specific sectors (such as insur-ance and fund management) away from moreestablished centres, such as London. InMarch 2008, for instance, the BelgianGovernment was advertising its country inThe Economist as having “an intelligent taxsystem with notional deduction andadvanced ruling for investors.”34 It promisedsimplicity and stability.

In 2006-07 alone at least eight countriessimplified the process of paying tax and sixmade major simplifications to their tax codes.Since 2005, 65 reforming economies havepromulgated 90 reforms.35 The World Bankand PricewaterhouseCoopers have cate-gorised simplifications under three mainheadings:

� The Introduction of online filing. Thisreduces the cost of paying taxes. It is avail-able to individuals and companies in theUK, as it is in many other countries.

� The combination of taxes. To reduce thebureaucratic burden for both the taxpayerand tax administration, over the last fiveyears many countries have melded differ-ent taxes together. For instance,

Portuguese companies now pay only twotaxes, at the same time, on profits.Slovakia has consolidated several socialsecurity and related contributions into asingle social contribution tax and Bosniahas combined three and Uruguay fourlabour contributions into one monthlypayment. In all, Uruguay has eliminated15 taxes in recent years.

� The simplification of tax administrationthrough alignment of tax and accountingsystems and the introduction of risk-basedtax authority audits. World Bank datashows that countries with clear tax laws ortax codes that align perfectly withaccounting rules collect 6 per cent and 10per cent more revenue respectively (as aproportion of GDP) than countries thatdo not have clear tax laws. A wide range ofcountries have therefore taken simplifyingmeasures in the last three years. Theyinclude Azerbaijan, Bulgaria, Colombia,Lesotho, Malaysia, the Netherlands,Tanzania, Turkey and Uzbekistan.

Three internationally-focused countries, NewZealand, Australia and the Netherlands, haveall recently made their tax systems simplerand more attractive. This shows that pro-grammes of tax simplification are possible.

New Zealand tax simplification36

Twenty five years ago, New Zealand’s tax sys-tem was widely seen as failing. A narrow base,high tax rates and enormous complexity wereall failing to generate sufficient revenues. Thesystem was seen by the public as unfair andlacking in integrity. Tax avoidance was rife.High tax rates and uneven rules were thoughtto be significantly contributing to NewZealand’s poor economic performance.

33. Teather R, The Benefits of

Tax Competition, Institute for

Economic Affairs, pp 25, 2005

34. The Economist (UK edition),

pp 101, 15th – 20th March 2008

35. World Bank and





21-25, 2008

36. The rest of this chapter is

based on analysis conducted for

and by the Tax Reform

Commission, published as part

of that report and written by the

authors and Corin Taylor and

Jonathan White

14

37. Dalsgaard T,” The Tax

System in New Zealand: An

Appraisal and Options for

Change”, OECD Economics

Department Working Papers No.

281, 2001

38. Rennie P, “How to Fix a

Leaky Tax System”, Issue

Analysis, The Centre for

Independent Studies, no 74, 14

September 2006



From 1984 governments embarked uponwide-ranging reforms that transformed thetax system. Key features were:

� Reductions in the number of tax rates. Thenumber of income tax bands was reducedfrom five to two and statutory rates werereduced from 20, 31.5, 45.1, 56.1 and 66per cent in early 1984 to 24 and 33 percent by October 1988.

� Broadening of the individual tax base. Theoriginal high income tax rates wereaccompanied by a large number of rebatesand exemptions. Many of these were sys-tematically removed.

� Broadening of the corporation tax base.Company tax concessions and avoidanceopportunities were greatly reduced. First yearaccelerated depreciation was removed.These and other measures have increasedthe corporation tax base as a percentage ofGDP from 5 per cent in 1984 to 15 percent in 2001.

� Broadening and simplification of indirecttax. The previous wholesale sales tax cov-ered less than a quarter of the total con-sumption base and had eight differentrates. It (and some other indirect taxes)was replaced in 1986 with a 10 per centgoods and services tax. This had fewexemptions, reducing distortions and sim-plifying record-keeping (the rate of thegoods and services tax was raised to 12.5per cent in 1989).

The Labour Government was replaced by aNational Party administration in 1990. Thisadministration reduced income tax rates andcontinued to abolish taxes and simplify thesystem. Key measures included:

� The abolition of several taxes. Estate duty(inheritance tax) was abolished in 1992and stamp duty was finally abolished, fol-lowing a phased reform, in 1999.

� The simplification of tax depreciation.� The attraction of foreign companies and

investment.The total tax imposed on most

non-resident portfolio and direct investorsin New Zealand was capped at 33 percent through foreign investor credits.

� The simplification of tax filing. From 1999a large number of taxpayers were nolonger required to submit an annual rec-onciliation of income tax.

New Zealand retains one of the most efficienttax systems among developed countries. It hasfull imputation so the distortion betweenequity and debt financing has been cut. Thecorporation tax rate and the rate at whichmany individuals pay tax are aligned at 33 percent. The OECD has concluded that:

“New Zealand’s tax system is one of the mostneutral and efficient in the OECD. Bases aregenerally broad and rates are moderate. efull imputation system for dividend paymentsworks to reduce tax distortions for corporatefinancing decisions, while efficiency in corpo-rate investment decisions is encouraged by thelow level of targeted tax incentives. e taxsystem is also more neutral vis-à-vis privatesaving than in most other countries, in partic-ular because no general incentives are provid-ed to private pension saving.” 37

Reform worked. In the 1990s New Zealand’stax system contributed to strong economicperformance. Following the global economicslowdown in the early 1990s, economicgrowth averaged 3.8 per cent from 1993 to2004. Unemployment also fell from over 10per cent in 1992 to 3.7 per cent in 2005. Inrecent years, however, tax reforms have stalledand in some cases been reversed. For instance,in 2000 an additional top rate of income taxat 39 per cent was created for income aboveNZ$60,000. This is not only a new compli-cation;38 it also applies at only 1.4 times theaverage wage.

Australian tax simplificationIn 1997, the Australian tax system was judgedby one panel of economists to have the worst

overall compliance cost (the UK was second)among comparable countries.39 In 1999, theOECD concluded that “…the Australian taxsystem has evolved largely in an ad hoc wayover several decades…[it has] high marginaltax rates, too narrow a tax base, uneven distri-bution of the tax burden, distortions inresource allocation, imbalances in the fundingof different levels of government, and highcompliance costs.”40

However, between 1998 and 2000 theAustralian Government promulgated a seriesof tax simplifications to accompany reduc-tions in capital, corporate and income taxrates. These included:

� A single “Pay as You Go” system forreporting and paying tax on businessincome.

� A simpler tax depreciation regime.� Simpler indirect taxation to replace the

wholesale sales tax and several state andterritory taxes.

These initial reforms were followed by a longseries of further simplifications, threshold rais-ing, rate reductions and the abolition ofminor taxes (for instance, stamp duty onshare transactions in 2001). The principal taxsimplification measures since 2000 have been:

� 2001. A simplified tax system for somesmall businesses was introduced, thusallowing them to do their tax accountingon a cash basis with simpler depreciationand trading stock rules.

� 2003 and 2004. A package of reforms toAustralia’s international taxation arrange-ments was introduced. These reduced thecompliance costs associated with the con-trolled foreign company rules andreduced tax on certain forms of foreignbusiness income and gains.

� 2006. A draft Bill to remove inoperativeprovisions from the tax law was published.These provisions were estimated toaccount for 28 per cent of the law’s totallength.

Dutch tax simplificationIn 2001, the Dutch Government embarkedon an overhaul of its income tax system.Rather than continue with a structure bedev-illed by exemptions, it classified income intothree categories: income from work, homeownership and social benefits; revenue fromsubstantial business interests; and incomefrom wealth. This change included wide-spread cuts to marginal tax rates, but also theflattening of the levy on business revenue to25 percent.41 Overall, the OECD judged thereform “…a shift from direct to indirect taxes,the removal and reduction of tax exemptions,and a decrease in the replacement rate.”42

With further reforms in the years to 2004,the OECD was able to conclude that

“…there has been a major shift from highmarginal tax rates on labour income towardsa broader income tax base and higher indirecttaxation since 2000, resulting in a composi-tion of tax revenues that is more supportive ofeconomic growth.” 43

Between 2004 and 2008, the DutchGovernment also managed to reduce the reg-ulatory weight of its tax system. Through sim-plifying its administrative rules and proce-dures, and by using its finance ministry to co-ordinate efforts to reduce the cost of taxation,it has saved around €4 billion per year. Thisamounts to around 25 per cent of the regula-tory burden.44

Implications for the UKTax systems across the world are becomingbetter, cleaner, and simpler. This is a goodthing. It will encourage investment, trans-parency and international understanding.

It would matter therefore if the UK were tofall behind in this area. Precisely because theUK cannot readily indulge in what the leftterms a “race to the bottom” on tax rates, itwould be foolish to lose out where the UKcan easily compete − by having a simple andstraightforward tax system.

39. Johnson D, Freebairn J,

Creedy J, Scutella R and

Cowling S, “A Stocktake of

Taxation in Australia,” Tax

Reform: Equity and Efficiency,

report no 1, Melbourne Institute

of Applied Economic and Social

Research, pp 94, 1997

40. OECD, OECD Economic

Surveys: Australia, OECD, pp 89,

1999


Surveys: Netherlands, OECD, pp

46, 2002



45, 2002



75, 2004



57, 2008

16


Six drivers of taxcomplexity

Why is simplicity so difficult?In practice, some degree of tax complexityis required. A “postcard” sized tax codemight be elegant, but it would not work.Its application to even a moderately com-plex financial transaction would leave somany important practical questions unan-swered as to create chaos. In such a sce-nario, questions over the profits of eachparty during the application of differentaccounting treatments, deals done at arm’slength, and the issues of hedging or specu-lation would quickly arise. When, forexample, would the profit from the tradebe treated as realised for tax purposes?

Complex transactions need special taxrules. For example, suppose that a group ofcompanies were intending to transfer somebusinesses to a new firm owned by some ofthe group’s existing shareholders, and that athird company would immediately acquirethe new business from those shareholders bypaying them a mixture of its own shares,loan notes and cash. The intra-group trans-actions, share reorganisations and transfersinvolved in this proposal would need to begoverned by special tax rules. A “postcard”tax system alone could not begin to give cer-tainty or consistent results for differentshareholders (who may, for example, applydifferent accounting policies, or indeed haveno need to produce accounts reflectingthese transactions).

But complicated transactions are notjust the preserve of City bankers. The vastmajority of medium and large British com-panies now rely on more than just “vanilla”loans, the simplest type of borrowing, tofund themselves.

If modern finance demands some taxcomplexity, so does globalisation. One crit-ical feature of the international economy isthe growth of globalised firms whose“value chains” are stretched across several

countries. The OECD estimates that intra-firm transactions now account for 60 percent of global trade.

In such cases the precise profit attribut-able in each jurisdiction can be highlyobscure. For example, if a product is madein Malaysia, marketed in the UK, soldacross the world and serviced by a call cen-tre in India, the precise tax due in eachjurisdiction depends on the internalcharges to be attributed to different servic-es the firm has delivered to itself. Withoutthe right evidence and rules this is nevergoing to be a simple matter. It is hard toenvisage a future where some degree of taxcomplexity on this and other areas doesnot continue to exist.45

But while some complexity is necessary,why do so many economies end up with somuch more than is strictly necessary? Whydo almost 50 per cent of countries havemultiple labour taxes when one would do?Why do 27 per cent have more than oneprofit tax? Why do 41 per cent have morethan one property tax?46 Governments donot deliberately set out to make their rev-enue-collecting frameworks as complicatedas possible. But several phenomena, out-lined below, drive the complexity andunpredictability in them.

� The weight of past legislation: constant,systemic tensions arise because a his-toric collection of tax rules has accumu-lated without any systematic review.

� The desire to prevent tax avoidance: thevicious cycle of complex anti-avoidancelaw interacts with an already complexsystem in ways which may not be fullyappreciated in advance. Subsequenttaxpayer circumvention requires evenmore complicated legislation.

� The temptation to use tax to change soci-ety: policy-makers often try to make

45. Other issues of necessary

complexity include, for example,

rules limiting tax relief for certain

kinds of expenditure, rules for

related persons, transactions

within a group of companies,

dividend payments to compa-

nies, and spreading lump sum

receipts for tax purposes,

among many others

46. World Bank and





21-25, 2008


the latest change they want to societythrough using incentives and penaltiesin the tax system.

� The need to “do something”: theChancellor always faces substantial cul-tural and legislative pressure to createsome headlines on budget day, so willfiddle with the tax system to do so.

� The desire to pluck the goose without ithissing: policy-makers often want, orneed, to raise taxes, but have long beenafraid of raising, say, rates of IncomeTax. They thus resort to raising revenuein ways that many people do not noticeor understand, and thus add extra com-plexity to the system.

� The problem of guarding the guardians:because tax policy is now made andtested by HM Treasury, it does notreceive the internal scrutiny that itshould. This has lead to poor policyand a greater likelihood of mistakes,thus undermining the trust in, and sta-bility of, the tax system.47

The weight of past legislationMany tax systems are an aggregate of dif-ferent tax codes developed over a long peri-od of time without any overall review ofhow they link together. This creates aninbuilt and systemic tension in the way therules combine in the real world, thus caus-ing instability. There is a constant need tomonitor interactions, plug gaps or resolveproblems on a piecemeal basis.

In the UK, for example, company taxliabilities can be derived from Income Taxlaw; a separate Capital Gains Tax code; acapital allowances code and accounts basedlaw for loan relationships; intangible fixedassets; and derivatives. Each one of thesecodes includes a large number of detailedrules used for calculating tax in specific sit-uations. Worse, the code for taxing incomeis itself split into separate divisions forincome from different sources under theschedular system. The timing of a sale is

defined differently for trading, capitalgains and capital allowances purposes.Incidental costs are defined differently.Anti-avoidance rules are framed separately.No clear principles apply to the pooling oflosses and profits from different sources.

This artificial segregation means that allcompanies of any size have a permanentneed to consider not just the accountingbut, quite separately, the tax implicationsof their business decisions. It creates theneed for much tax planning to ensure, forexample, that effective tax relief is availableby matching losses from one source againstprofits from another source.

The distinction between tax andaccounting profits also leads to similarproblems. For example, the accountingrules for depreciation and impairment ofassets are quite different from the tax rulesfor capital allowances. Companies try tomaximise the tax benefits through complexfinancing, leasing, or sale and leasebackmechanisms.

The desire to prevent tax avoidanceTax planning is a fiduciary duty to theowners of a firm and is the legal minimisa-tion of tax liabilities. Tax evasion is an ille-gal failure to pay due taxes. There is a greyarea where planning, or avoidance, mightbe seen as artificial or illegitimate, eventhough strictly legal. Nevertheless, theChief Financial Officer (CFO) of a compa-ny who needs to explain why his firm paidmore tax then necessary would not be in acomfortable position.

That CFO faces several problems that area function of a complicated tax system.Overlaps and differences between one taxrule and another produce contradictions anddistortions. They necessitate tax planning. If aprofit can be derived in several different ways,a firm needs to understand its options andhow its decisions will affect its tax bill.

One driver of increasing fiscal complex-ity comes about when a government

47. Policy used to be initiated by

Inland Revenue and Customs

and Excise, and reviewed by the

Treasury

18


48. For example, the rules for

taxing amounts economically

equivalent to interest

49. For example, see the com-

ments by the Institute of

Chartered Accountants of

England and Wales (ICAEW),

ICAEW Press Release, 8

September 2005

50. ICAEW Press Release, 8

September 2005

51. Tax Reform Commission, Tax

Matters: Reforming the Tax

System, The Report of the Tax

Reform Commission, Tax Reform

Commission, pp 106, 2006



engages in specific legislation to preventone particular type of tax planning. Thisoften has unforeseen consequences as thelegislative change interacts with so manyseparate sections of the tax system, and taxprofessionals seek out further opportuni-ties for their clients.48 This is particularlythe case when the proposed reforms areinadequately drafted – an outcome whichis more probable as tax law becomes morelabyrinthine.49 Further changes are thusrequired in order, in the words of theInstitute of Chartered Accountants ofEngland and Wales, to “iron out many ofthe problems that arise in practice.”50

Damon Lambert, a Tax Senior Managerat KPMG, has analysed how tax law com-plexity in a given area can often increasestarkly over a two to five year period due tothe possibilities created by an apparentlysimple change.He estimates that within, say, one

month, advisory firms appreciate theunintended possibilities for circumvent-ing or exploiting the proposed amend-

ment. Then, within two to six months taxproducts are being marketed to relevanttaxpayers (with disclosure to HMRCunder the Disclosure of Tax AvoidanceSchemes regime). Between six monthsand two years later, the sale of these prod-ucts has proliferated, and it is seen thatthe new legislation has either had morelimited scope than originally intended byHMRC, or has been turned on its head byadvisors to benefit those in the oppositecircumstances.In some cases HMRCmay challenge the

tax planning that is taking place in thecourts, although, as cases can take betweenthree to ten years to settle, this can merelyaccentuate uncertainty even more. In addi-tion to any court action, within two to fiveyears a further set of new legislativeamendments come into force to deal withthe consequences of the first change. Theamendments may take effect from the dateof a press release, which leaves the exactscope of the subsequent changes unclearuntil the new law is enacted. Further, the

Table 3: Changes to the UK tax system by year, 1993-200651

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Loan relationships � � � � � � �

Forex � � � � � �

Financial instruments � � � � � �

Share schemes � � � � � �

Intangibles � � � � �

CFC � � � � � � � � � �

Double tax relief � � � � � �

Substantial shareholdings �

Quarterly payments � �

Group relief � � �

Transfer pricing � � �

Stamp duty on property � � � �

Leasing � � � � � � �

Films � � � � � � � �

Insurance � � � � � � � � � � �

Key: Major rewrite � Anti-avoidance � Revision of existing law � Changes due to EU law �

final result is that the new anti-avoidancerules often block “innocent” transactionsand thus increase the compliance burden.

As Table 3 shows, one topic after anoth-er within the British tax system has beensubject to increasingly rapid and complexchanges in the last decade. Such reformsare often not completed and continue toaccelerate.

The temptation to use tax to changesocietyA generation ago, when much of Britishindustry was state-owned, the Governmenthad many means available to achieve itsends. With the commanding heights ofBritish industry now in private hands it hasfewer tools in its kit bag.

The temptation to use the tax system toeffect social ends is always present andmust be hard to resist. There is nothingnecessarily wrong with this. Most voterswould probably accept, for example, thecase for high tobacco duties to restrainsmoking. An increasing number wouldalso accept the need to cut alcohol con-sumption through the use of high prices. Itseems that the tax system will also beextensively used to encourage “green”behaviour over the next few years. Manyindividual actions are hard to argue againston any individual level.

The problem, however, is twofold.Firstly, many reliefs are in themselves inef-fective (for example, the tax exemption forprofit-related pay, which became the sub-ject of widespread abuse, had to be with-drawn). The fact that many reliefs are notindex-linked, and their real value dimin-ishes over time, demonstrates that theGovernment has ceased to believe in theirrationale.

Secondly, even when they work, thereliefs and exemptions laid into the systemover time build up into layers of interact-ing complexity and confusion. At times,studying the British tax system seems more

like studying the geological strata of previ-ous political priorities than a rational wayto fund Government expenditure. This hasto change. Governments have to build pol-icy ends into the tax system, but at the veryleast they should remove one old set ofpolitical priorities from the system whenthey put in new ones.

The need to “do something”One further driver of tax complexity is thecombined impact of the constitutionalneed for annual Finance Acts and a politi-cal culture which encourages “action.”

Since its first introduction in theNapoleonic wars and its recreation by SirRobert Peel, income tax in Britain hasalways been a temporary levy whichexpires each year on 5 April and needs tobe re-applied by Parliament in an annualFinance Act. Its abolition was constantlypromised during the nineteenth centuryalthough its continued existence has beenaccepted during the twentieth. The consti-tutional necessity to renew income tax isquite attractive, but has unfortunatelyencouraged many Chancellors to regularlyintroduce further changes.

This is a major driver of tax complexity– backed up by the weight of expectationand media pressure for the Chancellor to“do something.” Chancellors certainly faceno shortage of ideas at Budget time.Special interest groups press their case forreforms. Professional bodies have theirown suggestions. Further proposals arisefrom within the Treasury and HMRC.Politicians layer on further ideas to achievetheir policy ends or bolster their party’selectoral position. The media will also havea say. What could be worse than a boringbudget to indicate that a government has“run out of ideas?”52

The process of real reform is notenhanced by this annual ritual. It particu-larly tends to reinforce short-term thinkingor even panic-driven changes, without a

52. In 2008, Matthew Engel, a

political commentator at the

Financial Times, wrote of Alistair

Darling’s first budget that “It

wasn’t a bit boring, it was an

absolute crasher. Mr Darling did-

n’t have little to say, he had next

to nothing.” Engel M, “Speech

Bereft of Secrets and Light on

Soundbites,” Financial Times,

March 13 2008

20


connecting thread linking one set of alter-ations introduced in one year with whatmay follow in the next year. Tax reform hastherefore lacked a sense of direction andlong-term strategy.

The desire to pluck the goose withoutit hissingJean-Baptiste Colbert, a Finance Ministerto the French court in the seventeenth cen-tury, is reputed to have said that “the art oftaxation consists in so plucking the gooseas to obtain the largest amount of featherswith the least possible amount of hissing.”

He was right that the goose can hiss.From the Peasants Revolt of 1381 to thepoll tax riots of the 1980s, taxpayers onthis side of the Channel have shown thatmistakes in the art of taxation can lead touprising and rebellion.

Attempts to raise taxes surreptitiouslyare the consequence. Not increasing per-sonal allowances in line with earnings,with the result that tax liabilities become ahigher proportion of earnings, is onemethod. This does not complicate the taxsystem, though it does make it moreregressive. Other ways to increase tax rev-enue on the quiet, for example by chang-ing complex rules, can be major drivers ofcomplexity. Recent examples abound, suchas the treatment of loan relationshipsbetween related parties, or the treatment ofdividends as interest for the tax purposes ofthe recipient only. The civil servant whosuggests such changes is unlikely to dam-age their career prospects, particularlywhere such new law can be presented astackling “avoidance.”

The problem of guarding theguardiansAs salaries at the top of the professionshave increased, some national tax authori-ties have found it hard to hire a sufficientnumber of highly skilled and knowledge-

able tax professionals who understand thefull implications of proposals which mayhave a very wide impact. For example, inthe UK, although HMRC has some veryrespected senior officials, both long-serv-ing and recently recruited, some senior taxlawyers are concerned about the “strengthin depth” that exists.

Tax problems are exacerbated in the UKby the lack of internal scrutiny that taxpolicy currently receives. Before the merg-er of the Inland Revenue and HMCustoms and Excise in 2005 both organi-sations had tax policy functions. It wasthen the job of HM Treasury to test andchallenge their proposals. Since the merger,tax policy has been the preserve of theTreasury, with HMRC merely responsiblefor implementing and enacting policy.

This distinction can be justified: it fol-lows the logic of many agencies whosedelivery role has been separated from theministerial departments who set policy.Unfortunately, in practice the Treasuryseems to have suffered from a lack of inter-nal challenge and to have been inadequate-ly informed by tax specialists withinHMRC as to the implications of its ownactions. Some former officials certainlybelieve tax-making policy in the UK isessentially broken for want of expertise andrigour.53

It would appear to be no coincidencethat a rush of recent tax proposals havebeen ill thought through or misunder-stood, whether the abolition of the 10p taxband; the changing of the Capital GainsTax system (without recognition of thespecial issues that affect entrepreneurs orsome forms of investment); the introduc-tion of over-complex and unjustified rulesfor non-domiciled taxpayers; the publica-tion of a controversial consultative docu-ment on the taxation of foreign earnings;or the rise in vehicle excise duty for oldcars. There are lessons to be learned fromthese mistakes, however. These areaddressed further below.

53. These opinions were

expressed during private conver-

sations with the authors



Tax complexity –towards an evaluativeframework

The ProblemAs debate over tax complexity has grown inthe last few years, analysts and commentatorshave found it hard to gauge complications inthe system. Many discussions fall back on ashort range of readily available and widelycited measures: the length of Tolley’s taxhandbook, the average length of annualFinance Bills, and business opinion surveys.

Used carefully these individual tests areperfectly acceptable – they can be tellingmeasurements of tax complexity and volatili-ty. However, they do not provide objectivemeasures in the same way as, for example, acomparison of marginal tax rates, or tax rev-enues expressed as a portion of GDP. Nor arethey readily comparable internationally(there is no Tolley’s in Europe) or historically(Finance Bills were once published in A5).Tax legislation may sometimes be clearer if itis not précised too much. Similar tax law maybe reproduced separately for companies andfor individuals without actually doubling taxcomplexity. The tests can therefore add mis-understanding as well as enlightenment.

In the absence of one utterly comparable“killer fact” (such as tax as a portion of GDPas a measure of the level of taxation) it is bet-ter to use a range of metrics which can serveas a measure of relative and absolute tax com-plexity.

Such an evaluative framework needs to:

� Focus on the primary malign impacts oftax complexity (such as cost, distortionand the bias against smaller enterprises).

� Cover all primary areas of tax (income,indirect, corporate and transactional).

� Be (at least partially) capable of historiccomparison.

� Be (at least partially) capable of interna-tional comparison.

One possible evaluative framework oftax complexityWe set out below one possible framework tomeasure tax complexity across time andbetween nations. It is our attempt to start theprocess of evaluating the changes in tax com-plexity over the years, and thus help policy-makers thinking about simplification of thetax system to understand the magnitude ofthe problem.

The framework is very much, however, awork in progress. With further analysis wethink it could be substantially expanded andstrengthened; at the moment it is simply agood starting guide to how complex theBritish tax system really is and thus, we hope,of assistance to the policy-makers that reallyneed to assess the scale of the issue.

It is not perfect. But it is an attempt toopen up discussion on this issue and wewould welcome feedback from readers onthis framework.

The ABCD framework� Acceleration: is the tax system in an accel-

erating cycle of complexity?� Bias: is the tax system unfair towards

smaller firms and the less well-off?� Cost and complexity: how much absolute

and relative cost does complexity in thetax system add to the deadweight cost oftaxation? How comparatively complex isthe system?

� Distortion: does the tax system distortfundamental allocation decisions?

Our suggested measures of tax complexityare listed below. Each measure is tentativelyscored on a scale of -1 (no significant com-plexity or volatility/falling complexity orvolatility); 0 (some complexity or volatility);

22

or +1 (significant or worsening complexityor volatility). The (tentative) parameters wehave used to set out these scales for each testare shown below in Table 4. An overallgrade, calculated by combining all theresults, is at the end of the assessments(because of the number of tests, the range is+9 to -9).

� Acceleration� Test one: the increase in length of theannual Finance Act over the preced-ing twenty five years.

� Test two: the speed of increase of theannual Finance Act compared toprior years.

� Test three: level of capital tax volatilityover time, compared internationally.

� Bias� Test four: the cost per employee of taxregulation carried by small firmscompared to the cost per employeefor large firms.

� Test five: typical marginal tax rates forthe bottom income decile comparedto typical tax rates for the top incomedecile. While this measure is drivenby benefits as well as tax complexity,

the increasing convergence of the taxand benefit systems in the UK(through tax credits) makes the testeminently defensible.

� Cost and complexity� Test six: the number of pages of pri-mary tax legislation in the UK com-pared to the non-weighted interna-tional average.

� Test seven: the total cost of reliefs andexemptions as a proportion of thetotal tax take, compared historically(and ultimately internationally).

� Distortion� Test eight: the number of reliefs in thetax system.

� Test nine: the number of separate anddistinct tax codes by which businessprofits can be calculated (again ulti-mately compared internationally –though we have not attempted thatbelow).

We have tried in part two, below, to applythis framework to the UK tax system todayin order to start to make historical and inter-national comparisons.







425-440

Table 4: The parameters for each test

Possible Test Specific Metric (where relevant) Criteria for grading-1 0 +1

One: increase in Finance Act Length of last five years / length of act <50% <150% >150%20 – 25 years ago (percentage)

Two: speed of increase in Finance Act Increase during last 10 years / increase 15 to 25 years ago <1 <1.5 >1.5

Three: level of capital tax volatility Edmiston’s measure of capital tax volatility54 <100 <500 >500

Four: cost per employee of tax regulation Cost per employee for firms of 9-49 employees/ <5 <20 >20cost per employee for firms of more than 5,000 employees

Five: marginal tax rates for poorest Marginal tax rates for a non-parent working full-time on the <0.5 <1.5 >1.5minimum wage/marginal tax rates for highest level of Income Tax

Six: number of pages of primary tax legislation <500 <5,000 >5,000

Seven: cost of reliefs as a percentage of total tax take Not including exemption of low earnings. “Principal” reliefs only < 5% < 20% > 20%

Eight: number of reliefs in tax system Not including exemption of low earnings. “Principal” reliefs only <50 <100 >100

Nine: number of tax codes for business profits 1 <3 >3

The ABCD framework can be used to pro-vide an overview of the tax system in theUK, in order to understand its historic andcomparative competiveness.

AccelerationIncome Tax was introduced to fund theNapoleonic wars. The rules have beenchanging ever since. However, until recent-ly it was possible, every 30 years or so, toconsolidate all the law for taxing incomeinto one combined act, thus reflectingchanges in the law since the last timeround. The Income Tax Act 1952 provid-ed a complete code at that time for bothindividuals and companies. It consisted of532 sections and 25 schedules, and ran toa total of 528 pages of the Law Reportsvolume of Statutes.

The last major consolidation was theIncome and Corporation Taxes Act 1988,the title reflecting the fact that a separatecorporation tax had been introduced forcompanies. This Act consisted of 845 sec-tions and 30 schedules. It filled 1,318 pagesof the Statutes. This represented significantgrowth (150 per cent) from 1952.Furthermore, the rules for capitalallowances and Capital Gains Tax were notincluded in the 1988 Act. Nevertheless allthis tax law could still be conveniently pub-lished in one volume of a Tolley’s tax hand-book. A professional tax adviser wouldexpect to carry this handbook to meetings,and could easily look up the law in thecourse of a meeting. One of the currentauthors remembers habitually doing so.

Since then, however, there has been anexplosion in the amount of new tax lawgenerated. There is now far too much lawfor consolidation in a single Act. MostIncome Tax law is currently contained inthree acts: the Income Tax (Earnings andPensions) Act 2003 (725 sections and 8schedules); the Income Tax (Trading andOther Income) Act 2005 (886 sections and4 schedules); and the Income Tax Act 2007(1,035 sections and 4 schedules). Thecombined total is 2,536 sections and 16schedules. This does not include any taxlaw for companies, which is reproducedseparately. It does not include the CapitalAllowances Act (which affects Income Taxliability), statutory instruments applyingto Income Tax, or, of course, Capital GainsTax.

Tolley’s Direct Tax Handbooks are nowfour in number, each of them being largerthan the 1998 handbook. They are anastonishing 11,000 pages long. This is fivetimes the length of a typical Bible. No pro-fessional tax adviser would now dream ofregularly carrying the combined weight ofall these tax handbooks to a meeting.

The same process can be seen in thegrowing length of the Finance Act. Theaverage length of the Finance Act hasincreased from under 200 pages in the1970s to over 500 in the last five years. TheFinance Act 2004 was particularly note-worthy, with 328 sections and 42 sched-ules requiring 634 A4 pages.

Despite current efforts at simplificationthe law continues to expand. This year’sFinance Bill consisted of another 160 sec-

24

Part 2British tax complexity – a historicaland comparative analysis

tions and 46 schedules. Some simplifica-tion will result (such as through the aboli-tion of the taper relief rules), but this ismore than counterbalanced by the newlaws being introduced (such as the entre-preneurs relief for Capital Gains Tax andthe new law for non-domiciled persons).

Most professional bodies involved withtax law have expressed their strong concerns.The Institute of Chartered Accountants ofEngland and Wales believes that “The UKtax system is spiralling out of democraticcontrol .... the complexity of the system hasdeveloped in such a way that even highlynumerate taxpayers are struggling to under-stand the implications of their actions.”55 Byapplying our tests to the accelerating prob-lem of complexity, we can see the followingresults:

� Test one: the increase in length of theannual Finance Act over the precedingtwenty five years.� This has increased sharply over the

last quarter century. Over the 2000-05 period the Finance Act averaged481 pages compared to 157 in theearly 1980s, an increase of 206 percent.56

� Score: +1

� Test two: the speed of increase of theannual Finance Act compared to prioryears.� British Finance Acts are not just

getting more complicated. They arerapidly getting longer too.

� The average length of Finance Actsfrom 1985-89 was 57 pages longerthan in the five preceding years. In2000-05 it was 168 pages longerthan in the previous five years. Therate has increased nearly three-fold.57

� Score: + 1

� Test three: the level of capital tax volatil-ity over time, compared internationally.

� British capital tax volatility (asmeasured by Edmiston between1982 and 2002)58 was 203 as com-pared to an unweighted average of287, a low score of 8.5 (Spain) anda high score of 1,431 (Finland).

� Score: 0

BiasIn 2006-07 an estimated 1.72 millionhouseholds had an effective marginaldeduction rate in excess of 60 per cent. Ofthese, 160,000 had a rate in excess of 80per cent and 30,000 had a rate in excess of90 per cent.59 Almost all of these house-holds were on below average incomes.These high marginal rates are caused bythe combination of paying Income Taxcombined with the withdrawal of tax cred-its, often exacerbated by the withdrawal ofother benefits, such as housing benefit. Bycontrast, the marginal deduction rate forthose on the highest incomes is never morethan 41 per cent.

It is not just that the less well off payhigh marginal tax rates. Were it not for taxcredits and other benefits, the proportionof gross income paid in tax by the poorestin work would be as high as 90 per cent.60

This is not just unfair, it also wastes publicspending in a merry-go-round of tax andbenefits.

Thus some of the poorest in society facesome of the highest marginal rates of tax ifthey attempt to improve their circum-stances by moving from low paid or part-time work. The fact of high marginal taxrates is not wholly a function of complexi-ty, but because of the complexity peopleare unable to work out the consequences oftrying to increase their income. This canlead to paralysis. Having once navigatedthrough the complex tax and benefits sys-tem to reach a stable, if relatively impover-ished position, there is naturally greatreluctance to take steps which may lead toa very uncertain outcome. This problem,

55. Policy Briefing by the

Institute of Chartered

Accountants

56. The Tax Reform

Commission, Tax Matters:

Reforming the Tax System, The

Tax Reform Commission, pp 30,

2006

57. The Tax Reform




2006





425-440

59. HM Treasury, Pre-Budget

Report 2005, HMSO, pp 89,

2005

60. When Income Tax, NICs,

VAT, excise duties and net coun-

cil tax are accounted for. See the

Office for National Statistics for

details

Part 2: British tax complexity


61. The Tax Reform




2006

62. “Tax administrative burden”

means the compliance costs,

costs of working with intermedi-

aries and acquisition costs

borne by firms when then they

comply with UK tax law. “Small”

firms means companies with

between 1 and 49 employees,

i.e. an amalgamation of the

“nano”, “micro” and “small” defi-

nitions of companies described

in footnote 31. Sources: KPMG,

Administrative Burdens: HMRC

Measurement Project, KPMG,

2006; BERR Enterprise

Directorate Analytical Unit



Project, 2006

26


of the complex inter-relationship betweentax, tax credits and benefits, is well beyondthe scope of this paper. It is a very seriousproblem, however, and must be addressedif large numbers of people are to be able toimprove their circumstances and to befreed from dependency.

There are many other examples of howcomplexity affects the smaller firms or thepoorer families, disproportionately. Onesuch is the disproportionate payroll com-pliance costs which fall on small business(see test four below). Furthermore, ordi-nary individuals and small firms are notable to pay for expensive advice to exploitan over complex system to their advantage.For example capital gains are now chargedat 18 per cent. The less well off are notusually in a position to realise capital gainsand take advantage of this rate, or the sep-arate annual allowance for capital gains.Still less are they able to enter into schemesfor turning their income into capital – anarea which is likely to be an increasinglylucrative source of fees for the tax planningindustry.

Application of our tests to these issuesshows that things are getting worse:

� Test four: the cost per employee of tax reg-ulation carried by small firms comparedto the cost per employee for large firms.� The smallest firms pay many times

the tax compliance cost per employ-ee that large firms do. Firmsemploying between 10 and 50 peo-ple pay on average nearly 18 timesmore per employee than do thoseemploying over 5,000. Sole traderspay around £330, the largest firmsonly £5.61

� Overall, small firms pay a dispro-portionately large share of thenation’s tax administrative burden(56 per cent) even though they onlyaccount for 28 per cent of total UKturnover.62

� Score: 0

� Test five: typical marginal tax rates for thebottom income decile compared to typicaltax rates for the top income decile.� The marginal tax rate for anyone in

the highest income bracket is 41 percent.

� For a single non-parent workingfull time on the minimum wage(and thus earning around £11,000)their marginal tax rate is likely to be70 per cent, a combination of taxand NICs at 31 per cent and work-ing tax credit withdrawal at 39 percent (if they are also receiving hous-ing or council tax benefit it couldbe even higher). This is a multipleof 1.7 times the highest earners’marginal tax rate.

� Score: +1

Cost and complexityManaging tax and tax risks absorbs signifi-cant manpower and capital in the privatesector, which could be more productivelyemployed elsewhere. HMRC MeasurementProject, which was published in March2006, estimated that the administrativeburden of UK tax regulation on UK busi-nesses was £5.1 billion.63 Application of ourtests shows that this burden helps to makethe UK system more complex and less com-petitive.

� Test six: the number of pages of primarytax legislation in the UK compared to anon-weighted international average.� PricewaterhouseCoopers have com-

pared the number of pages of pri-mary tax legislation in a basket ofdifferent countries. The test is notperfect (it is obscured by differencesof language in the legal code), butthe findings are startling.

� At 8,300 pages, the UK has thesecond longest tax code of anymeasured country, the longest ofany developed economy and is two

64. World Bank and





21-25, 2008

65. World Bank and


Paying Taxes: The Global



2006

66. HM Treasury, Budget 2008,

HMSO, 2008

67. Evidence provided to the Tax

Reform Commission by one of

the major professional services

firms. See The Tax Reform




2006



and three quarter times the meanof the twenty countries with thelongest tax codes.64 See Table 5below.

� Score: +1

� Test seven: total cost of reliefs and exemp-tions as a proportion of total tax takecompared historically (and ultimatelyinternationally).� The principal structural reliefs or

allowances embedded in the tax sys-tem have an aggregate cost to theTreasury of £209 billion, notincluding the personal allowances.In 2008-2009 the total HMRC taxtake is projected to be £470 bil-lion.66 Reliefs thus account for 44per cent of the actual tax take.

� Score: +1

DistortionDistortion occurs when two taxpayers whodo similar things are taxed differently. One ofthem may need to carry out a transaction inone way rather than another way to takeadvantage of available reliefs or through usingsome other method to avoid unacceptabletaxation, even though the commercial resultis similar. There are many examples:

� Capital gains are taxed very differently forincorporated and unincorporated busi-nesses (a company may claim indexationrelief but otherwise pay the full rate of taxon capital gains, whereas individuals paytax at the new 18 per cent rate only). Thisand many other tax factors could deter-mine the incorporation of a business.

� A lease premium is taxed differently fromrent paid in advance, even if the econom-ic effects are exactly the same.

� A hire purchase agreement is taxed differ-ently from a finance lease, even thoughtheir economic effects may be identical.

� Very different tax consequences ensue if acompany pays a salary or dividends to itscontrolling shareholder.

� Income can sometimes be recast as a cap-ital gain, which is generally taxed morelightly.

� Pension contributions paid by employeesdo not save National InsuranceContributions (NICs), whereas similarcontributions by employers do saveNICs.

Tax can therefore lead to decision-makingwhich would be irrational in the absence oftax considerations. One of the major pro-fessional services firms which gave evi-dence to the Tax Reform Commission said“Advice [our firm] provides often .... setsout steps to “force” commercial transac-tions to comply with extremely uncom-mercial tax rules.”67

Economists state, however, that wherebehaviour of a business is changed for taxreasons, the overall efficiency of the econo-

Table 5: Number of pages ofprimary tax legislation in theworld’s top economies65

Country Number of pages ofprimary tax legislation

India 9,000

United Kingdom 8,300

Australia 7,750

Japan 7,200

United States 5,100

Korea 4,760

Italy 3,500

Canada 2,440

China and Hong Kong 2,000

Germany 1,700

Netherlands 1,640

Mexico 1,600

France 1,300

Belgium 830

Russia 700

Sweden 700

Spain 530

Brazil 500

Turkey 350

Switzerland 300

68. HMRC Data Table 1.5

28


my is impaired, even if the business is ableto improve its own after tax position. Taxlaw should therefore seek to removeunnecessary distortions, and economicallyequivalent transactions should be, as far aspossible, taxed on an equivalent basis.Some parts of the UK system mean that, asour tests show, unnecessary distortion istaking place.

� Test eight: the number of reliefs in the taxsystem.� The tax system has 104 principal

structural reliefs or allowances embed-ded in it.68

� Score: 0

� Test nine: the number of separate and dis-tinct tax codes by which business profitscan be calculated (again ultimately com-pared internationally, though we havenot attempted that below).

� UK tax is calculated by aggregatingthe results of four separate tax codes(Income Tax law, the Capital GainsTax code, the capital allowance taxcode and more recent accounts-based law). There are further ruleson how to combine the separate cal-culations.

� Score: +1

Overview of the UKOur draft ranking of the UK tax system hasthus assessed the UK as having significant orworsening tax complexity or volatility on sixout of nine measures. It is somewhat com-plex or volatile on the remaining three meas-ures. This gives an overall score of six on arange of -9 to +9. Though things could beworse, the UK is clearly a complex andvolatile tax environment. We do not expectthis conclusion to change.

Personal TaxComplexity

This section sets out nine key problemswith the tax system as it affects individuals:

1 How the complexity of personal tax lawleads to incomprehension, errors andunfairness.

2 How the rules for National InsuranceContributions are needlessly distinctfrom the Income Tax rules.

3 How the system is clogged up withineffectual reliefs, which not only com-plicate but also serve to increase taxrates for everyone.

4 How too many separate rules apply tothe taxing of employee benefits.

5 How complex personal allowances andeffective tax rates – the tapering rules –mean that pensioners can face the mostcomplex calculations of all.

6 How the low paid and savers face taxrate volatility.

7 How capital tax complexity has beenchanged, not reduced by recent taxvolatility.

8 Why there are too many investmentschemes, thus undermining equity andtheir own effectiveness.

9 How inheritance tax is overly complexand needs review.

How the complexity of personal taxlaw leads to incomprehension, errorsand unfairnessTax legislation applicable to individuals isnow so complicated that it is effectively ano-go area for the layman. HMRC isobliged to publish extensive guidance totry and explain it.

To help complete the basic individualtax return, for example, HMRC provide a28-page set of guidance notes. If the tax-payer is unfortunate enough to need tocomplete the additional supplementary

pages there is a further 32-page set of notesthat explains how to do it.

Having warmed up with this the taxpay-er may then need to complete up to eightsets of further information sheets, alsoforming part of the tax return, coveringsuch matters as employment or self-employed income and capital gains. Toassist with this there are a total of 67 HelpSheets which supplement further sets ofguidance notes. However, the Help Sheetsonly deal summarily with some issues.HMRC draw attention to 13 Inspectors’Manuals which contain more completeinformation (with luck, it should not thenbe necessary to consult any of the other 61Inspectors’ Manuals, some several volumeslong, which are less likely to be relevant foran individual tax return).

There are of course separate tax returns,and yet more help sheets, for individualswho happen to be trustees or in partner-ship etc.

Having completed the tax return theremay be a lot more work to do for a taxpay-er who wants to carry out his own calcula-tion of the tax due. For 2007-08 there are39 pages of notes to help with the comple-tion of the tax calculation summary. Theunwitting taxpayer needs to beware, how-ever. In about a dozen special situationseven all these notes are inadequate. Thetaxpayer is then advised to consult his advi-sor or HMRC to complete the calculation.

Who is affected by this complexity?Around 30 million people pay IncomeTax in the UK, of whom there are 8.8million self-assessment taxpayers. 56 percent of these use agents.69 Employing a taxadvisor to provide guidance through thevarious rules, reliefs and allowances couldeasily cost £250 a year for relatively sim-ple matters. For many it costs muchmore. This is particularly unfair for those

69. HMRC, Review of HMRC

Online Service, HMRC, March

2006


on relatively low incomes who need toemploy an agent. Overall, these figuressuggest that people who pay an adviser tohelp them with their self-assessment taxforms pay out £1.25 billion per year.

22 million employed taxpayers trustthat their PAYE and NICs have been accu-rately computed. They are not always wiseto do so. HMRC estimate that inaccurateprocessing led to 2.8 million errors onPAYE in 2006-07.70

How the rules for National Insurancecontributions are needlessly distinctfrom the Income Tax rulesNational Insurance contributions are compli-cated. Compared to Income Tax, they arepointlessly calculated in many different ways:

� Income Tax is based on annual thresh-olds. It is not charged on the first £6,035of income (2008-09 tax year), but thenlevied at 20 per cent for the next £34,800and charged at 40 per cent above that.71

By contrast, employees’ NICs are notcharged on the first £105 of weeklyincome, are then charged at 11 per centon all income up to a weekly maximumof £770 per week and at one per cent onearnings above £770 per week.72

� The amounts on which employees’National Insurance contributions and onwhich Income Tax is calculated are notthe same. An employee is not liable toNICs in respect of the value of manybenefits in kind which an employermight provide on top of salary, eventhough those benefits are subject toIncome Tax.

� NICs and Income Tax are based on dif-ferent periods. National insurance con-tributions are based on when income isearned. PAYE is normally based onwhen income is paid. This can createanomalies. For example, when over-time is worked in the last week of a taxyear, but paid in the first week of the

following year, the two liabilities areowed at different times.

� NICs do not operate on a cumulativebasis like Income Tax under PAYE. Afresh calculation of liability for NICs(having regard to such matters as holi-day pay, back pay, the earnings thresh-old etc) has to be made for each earn-ings period.

� Finally, unlike Income Tax, NICs are cal-culated separately for different employ-ments. An individual with severalemployments may therefore escape NICliability by being below the earningsthreshold for each employment. Thiswould be unlikely for Income Tax, forwhich purpose all income is aggregated.

The interplay between Income Tax andNICs produces further anomalies – forexample the pension contribution anomalyreferred to above.

The Treasury has recently reviewed theissues, but has proposed no substantivereforms, let alone the possibility of abolish-ing NICs by merging them into IncomeTax.73 An interim paper published by theInstitute of Fiscal Studies, however, makesplain that the Treasury could have consid-ered fundamental issues further before com-ing to its conclusions. For example, thebasic Treasury premise that the NIC systemgives effect to the contributory principle,and should be retained for that reason, isundermined by the IFS analysis.74

How the system is clogged up withineffectual reliefs, which not onlycomplicate but also serve to increasetax rates for everyoneThe tax system has embedded in it 104principal structural reliefs or allowances.Their aggregate cost to the Treasury is£199 billion, not including the personalallowances.75

In addition there is an unknown num-ber of minor exemptions introduced for

70. National Audit Office, HM

Revenue and Customs:

Accuracy in processing Income

Tax, National Audit Office, 2007

71. These figures apply following

the Chancellor’s announcement

of compensation for the loss of

the 10 per cent tax band. They

are simplified, however, and do

not take account of issues such

as age-related allowances and

differential savings rates

72. Although the Government

has attempted to bring into line

the threshold at which the 11

per cent rate reduces to 1 per

cent and the threshold at which

the higher rate of 40 per cent

income tax applies, the very

recent subsequent reduction of

the 40 per cent income tax

threshold (under the revised pro-

posals for withdrawing the 10

per cent band) demonstrate that

the two thresholds remain dis-

connected

73. HM Treasury, Income Tax

and National Insurance

Alignment: An Evidence-Based

Assessment, HMSO, 2007

74. Adam S and Loutzenhiser G,

Integrating Income Tax and

National Insurance: An Interim

Report, Institute for Fiscal

Studies, 2007

75. HMRC Data Table 1.5

30




one purpose or another over the years,whose impact on revenue the Governmentitself has admitted is “not known”. HMRClists over 200 of these but there are certain-ly more.76 The HMRC list reads like asocial history of varying priorities over thedecades. Many reliefs have been allowed toreduce in value in real terms over time tosuch an extent that they have becomemeaningless. However, they have neveractually been repealed. Other reliefs comewith complicated pre-conditions, whichare hardly worth navigating to obtain thetax benefit concerned.

Available exemptions include those for15p luncheon vouchers, for welfare coun-selling and for eye tests. Some exemptionssupport travelling to work (there is anexemption for support to public bus servic-es) or travelling in general (incidentalovernight expenses are exempted up to £5).Others discourage it (there is an exemptionor £2 or more for extra household expensesfor home workers). Some exemptions arepro-car (there is an exemption for car park-ing at or near a workplace). Others are anti-car. There are exemptions for free meals oncycle to work days, cyclists’ safety equip-ment and relief for a work’s bus. Someexemptions seem designed to help the bet-ter off (presumably city workers gain themost from the late night taxi exemption).Some seem to reflect the bias in favour oforganized labour of another age. Forinstance, some trade union investments areexempt from Income Tax. Many reliefs arejust obscure. Why on earth should the taxsystem exempt payments under staff sug-gestion schemes?77 We believe that most ofthese minor reliefs could be swept away.

In addition, many of the more substan-tial reliefs, even where their origin is lessmysterious, should be abolished. Forinstance, relocation relief was introducedto help encourage a flexible labour market.However, its real value has withered awayand now seems difficult to justify. The caphas remained constant for 15 years and the

value to a higher rate taxpayer is £3,200(40 per cent of £8,000). This is a smallfraction of the likely actual costs of movinghouse, so is unlikely to be a material factorin encouraging job mobility.

The foreign service allowance could alsobe abolished. It relieves crown servants liv-ing outside the UK from tax paymentsreflecting extra costs of living abroad. Whynot just pay them more, as private sectoremployers do?

The tax exemption for benefits to “lowerpaid” employees who earn less than £8,500per year should also be reviewed.Following the introduction of the mini-mum wage the relief now mainly applies topart-time workers. It is not clear why part-time workers should be preferred in thisway, particularly if a part-time worker isproportionately better paid than a full-time colleague. The exemption is not aneffective or well targeted anti-povertymeasure.

A further significant relief is for paymentsto employees on the termination of employ-ment. An exemption is currently availablefor the first £30,000 of a termination pay-ment to a departing employee, provided(very broadly speaking), the employee wasnot expecting to receive the payment whilestill working. Its abolition, or the restrictionof the relief to any statutory redundancypayment, would be a major advance in taxsimplicity. The existing law is so complicat-ed that the latest (second) edition of Tolley’s“Tax on the Termination of Employment”runs to 367 pages. The extra tax could, forexample, then be used by the Governmentto increase the statutory redundancy pay-ment.

76. See the following page on

the HMRC’s website:

http://www.hmrc.gov.uk/stats/ta

x_expenditures/00ap_b2.htm

77. Particularly when one bears

in mind that an employer can

“gross-up” an award if he wants

it be received “tax free”

“ All reliefs should be reviewed to see whether, for rea-

sons of administrative efficiency or for other reasons, their

retention is justified”

All reliefs should be reviewed to seewhether, for reasons of administrative effi-ciency or for other reasons, their retention isjustified. But there should be a burden ofproof to be discharged before any relief iskept.

How too many separate rules applyto the taxing of employee benefitsSimplifying the code for taxing benefits foremployees is also required. There are 155sections in the Income Tax (Earnings andPensions) Act 2003 which apply to the tax-ation of benefits other than shares.78 Theseprovisions could be simplified and stan-dardised to apply the basic principle thatthe taxable amount is the cost to theemployer of providing the benefit. Specialrules are often not justified and should bere-examined. The rules for cash vouchers,non-cash vouchers and credit tokens couldbe standardised, while the rules for benefitsprovided for past employees and familiescould be rationalised. Car benefit rulescould be simplified, as there are 58 sectionsin the Act applying to car benefits alone.The rules for living accommodation, intro-duced when most houses cost less than£75,000, should be updated and simpli-fied.79

Even more complex are the further 162sections and four lengthy schedules whichapply to benefits derived from shares.80 Thecurrent share benefits legislation could bere-written so that it is focused on princi-ples.81 This approach would also help sim-plify highly complicated returns requiredfrom employers.82

How complex personal allowancesand effective tax rates – the taperingrules – mean that pensioners can facethe most complex calculations of allDuring the last decade a range ofGovernment actions to raise revenue orreduce headline rates has created personal tax

rate volatility, particularly for savers and thelow paid.

In 1999 Gordon Brown introduced the10 per cent rate for income up to the first£1,500 over the personal allowance. In2008-09 he abolished it.83 The abolitionwas claimed to be a tax simplifying meas-ure. It was not. The 10 per cent rate stillapplies for certain savings income – com-plexity therefore remains. The change wasprimarily intended to fund the 2p cut inthe basic rate of Income Tax. Fortunatelythis latter change did achieve simplificationas there is no longer any differencebetween the savings rate tax of 20 per centand the new basic rate of tax.

In April 1999 Gordon Brown took hisnow infamous decision to make the taxcredit on dividends non-refundable toUK pension funds.84 As is well known thishad the net effect of raising theGovernment’s takings by £5 billion peryear and making savers and future pen-sioners worse off by the same amount – inthe process severely discouraging saving.Less well known is that this step also cre-ated substantial distortion by undermin-ing the imputation system of tax. Put sim-ply, investment in equities became muchless tax efficient for pension funds thaninvestment in debt. This exacerbated thetendency for companies to leverage them-selves too highly, one of the several driversof recent problems.

Two further changes introduced at thattime were

� The introduction of the reduced taxcredit of 10 per cent for dividends; and

� New special rates of Income Tax of 10per cent and 37.5 per cent for dividendincome.

It is likely that the main reason for makingthese changes was to reduce the amount ofdividend credit refunded to non-UK share-holders under double tax treaties.85 It creat-ed, however, additional and probably

78. HM Government, Income Tax

(Earnings and Pensions) Act

2003, HMSO, sections 63 – 191

and 201-226, 2003



2003, HMSO, sections 103- 106,

2003



2003, HMSO, sections 417 –

554 and schedules 2-5, 2003

81. This is a simplification meas-

ure which would be enacted on

an aggregate basis so that it did

not result in an increase in taxa-

tion on individuals or companies

82. The HMRC’s Form 42, which

applies for non-approved bene-

fits, is 12 pages long

83. The nil per cent rate of tax

for small companies suffered a

similar fate

84. It was also made non-

refundable to individuals with

incomes below the level of the

personal allowance

85. The Schedule F rates are 10

per cent for basic rate taxpayers

and 32.5 per cent for high rate

taxpayers

32


unwarranted complication in the calcula-tion of tax for UK taxpayers.

How the low paid and savers face taxrate volatilityThe Government’s actions have added tothe existing complexity as well as intro-duced instability into the system. The deci-sion to increase personal allowances tocompensate for the withdrawal of the 10per cent tax band was probably the sim-plest and quickest way out of the problemthat the Government created for itself.However, it did create anomalies. It con-ferred a benefit on those whose earningsare near the top of the basic rate bandwhich was not really intended. Althoughless publicised, it also conferred a similarunwarranted benefit on savers who werestill entitled to the 10 per cent rate, anddid not therefore need to be compensated.It will be interesting to see what furtherproposals are introduced next year if theGovernment tries to reduce the long-termcosts of these measures which took effectfrom April 2008.

The system of personal allowances wascomplicated at the same time by withdraw-ing them for non-domiciled people whoclaim the remittance basis of taxation. Thisnot only appears harsh but also adds to thedifficulties of non-domiciled persons whoare also faced with a horribly complicatednew law for remittances. It will be verydifficult for many to decide on the opti-mum tax elections and to carry out thenecessary calculations. Perhaps worse, itwill be hard to decide on the financialimplications of coming to the UK in thefirst place.86

The system of age-related allowancesand married couples’ allowances is a majordifficulty for many pensioners, due to theirhigh taper rates as the allowances are with-drawn with increasing income.

There are at present two higher person-al allowances for the over 65s and the over

75s of £9,030 and £9,180 respectively. Thecomplex tapering rules apply whereincome exceeds £21,800.87

In addition there is a married couple’sallowance which is available where at leastone of the married partners was bornbefore 6 April 1935. This allowance (ofeither £6,535 or £6,625, depending onwhether the person is aged 75 or over)gives relief at 10 per cent. It too is subjectto a tapered reduction for those on higherincomes. There are very complex rulesrelating to the transfer of the married cou-ple’s allowance between husband and wife.

The rules are inconsistent and createmuch confusion for a section of societythat may not be well placed to cope withcomplexity. In addition, at income levelswhere tapering of these allowances applies,pensioners are subject to marginal tax ratesof 70 per cent.88

How capital tax complexity has beenchanged, not reduced by recent taxvolatilityUntil 2008 the Capital Gains Tax payableon the disposal of an asset had the advan-tage of being reasonably internationallycompetitive and the disadvantage of beingstaggeringly complex. The competitiveeffect resulted from the low rate of 10 percent tax available for “business assets”. Thecomplexity was largely derived from thetwin system of indexation in use for assetspurchased before March 1998 and taperrelief used on assets purchased since thatdate.89

The Government has now simplifiedthe Capital Gains Tax code by abolishingtaper relief and replacing it with a flat 18per cent charge on all capital gains.90 Theeffective increase in tax on entrepreneurs,and the clamour of complaints about thespeed and lack of consultation with whichthis change were introduced, are wellknown. The need to reinstate further reliefto entrepreneurs (through a system which

86. Andrew Hodge, head of

employer and personal taxes at

Deloitte, has recently referred to

this as a “compliance night-

mare.” He asked ”How can any-

one believe that such a complex

regime is suitable for individuals

other than the very wealthy?”

Houlder V, “Foreign Workers

Face Compliance Headache

over Tax Plans,” Financial Times,

May 19 2008

87. The HMRC’s P161 form is

issued to persons approaching

retirement age. However, it is

difficult to complete when

income is typically subject to

change. As a result “There is

failure by the Revenue to give

people their allowances, a failure

to tax people correctly and igno-

rance by the taxpayer of what

they are entitled to. It is a recipe

for disaster.” Paddy Millard,

director of Tax Help for Older

People

88. The taper rate applicable to

the age allowance is 50 per cent

which in addition to the basic

rate of tax at 20 per cent gives a

combined marginal tax rate of

70 per cent

89. Indexation was a process

through which the acquisition

cost of an asset was increased

for tax purposes by an amount

equal to the RPI. Taper relief

reduced the gain that would oth-

erwise arrive by a percentage

that depended on how long after

1998 the asset was owned

90. HM Government, Finance

Bill 2008, HMSO, 2008



caps relief to £1 million of lifetime gainsand requires tracking of the amounts ofrelevant gains realised by an individualover his whole lifetime – a proposal whichfew regard as practical law-making) hasstarkly reduced the simplification whichwas originally expected.

It has been less appreciated, however,that the change had further limitationswhen evaluated as a tax simplificationmeasure. This is because the interactionwith Income Tax becomes even more diffi-cult. The 18 per cent flat rate applies evenif the asset has been held for a very shorttime – perhaps for only a few weeks or afew days. As a result it will become evenmore difficult to distinguish betweenincome and capital gains and more reliancewill need to be made on old and unsatis-factory case law for this purpose. The verycomplex statute law which has been intro-duced to differentiate capital gains fromincome in certain circumstances or todeem income to be capital in other circum-stances will also become even more impor-tant.91 This means existing highly complexavoidance legislation will be used moreoften, and probably more such legislationwill be required in the future.

We are likely to find, for example, oneperson selling his second home within ashort time and being taxed at 40 per centbecause it is held that he intended toresell the house at a profit when hebought it. He may wonder why, in prac-tice, another person who sold his secondhome within a similar period only paidtax at 18 per cent.

HMRC will need to strictly police theborder between income and capital gains,even though it is often almost invisible onthe ground. Without any statement fromGovernment as to the principles whichhave led them to introduce such differentrates of tax for assets which have been heldfor only a short time, HMRC and thecourts will often find it extremely difficultto make the required distinction.

Nor is it clear that the new situation isequitable. The shop assistant working atTesco, taxed at an effective rate of 43.8 percent may, to put it mildly, need a lot ofconvincing that it is fair that someone sell-ing their second home should only pay taxon their gain at 18 per cent.92

The real problem is that a powerful casecan be made for different approaches toCapital Gains Tax reform. For example thecapital gains system could have been fur-ther integrated with the Income Tax sys-tem (it will be recollected, for example,that companies pay the same rate of tax onincome and capital gains). Although reliefsfor entrepreneurs, employee shareholdingsand perhaps for savers (for example byexempting savers’ income and gains fromtax until withdrawn for personal expendi-ture) would then be appropriate, the sys-tem could have been substantially simpli-fied compared with at present. Robust dis-tinctions could be made for those mattersqualifying for relief, unlike the currenthazy capital/income distinction. As it is theopportunity for a full and principled con-sultation and consideration of the issueshas been lost.

The tax avoidance industry will alreadybe gearing up to find schemes for turningincome into capital. It is unlikely, in ourview, that a stable framework for taxingcapital gains has been achieved. A wholenew minefield for complexity has beenlaid.

Why there are too many investmentschemes, thus undermining equityand their own effectivenessThere are currently many different taxregimes for different investments, with dif-ferent applicable tax rates. Examplesinclude:

� Ordinary companies and investmenttrust companies (dividends taxed asexplained above);

91. Examples of special rules for

deeming capital gains to be

income include rules for offshore

funds, the accrued income

scheme, rules for deep dis-

counted securities, employee

share schemes, rules for premi-

ums for leases, rules for certain

transactions in securities, rules

for sales of occupational

income, rules for certain trans-

actions in land, rules for certain

payments made from trusts,

rules for certain gains from

assets transferred abroad, rules

for gains derived from repos,

rules relating to the sale of

patents, rules for disposals of

futures and options with guaran-

teed returns, rules for taxing

gains from with profit bonds,

and rules for payments on termi-

nation of employment. This list

could be continued

92. 43.8 per cent equals the

basic rate of 20 per cent, plus

employees’ NICs of 11 per cent

plus employer’s NICs of 12 per

cent. Economists generally reck-

on that the effect of employer’s

NICs is to reduce an employee’s

pay commensurately. Of course

the payment of NICs gives enti-

tlement to contributory benefits,

but the value of those benefits is

not likely to equate to the NICs

paid

34


� Share based unit trusts (distributionstaxed like dividends);

� Bond based unit trusts (distributionstaxed like interest);

� Pension based savings (tax relief forinvestment, within qualifying limits,and tax relief for investment profitswithin the pension fund);

� Qualifying endowment policies (noCapital Gains Tax on encashment, butpossibility of higher rate Income Tax);

� National savings (sometimes taxable,even if interest not paid out, sometimesexempt);

� Guaranteed equity bonds (profits usu-ally taxed as income);

� ISAs – no tax provided conditions sat-isfied; and

� Venture capital schemes and enterpriseinvestment schemes (complicated rulesfor tax relief on initial subscription forshares and subsequent tax reliefs ongains).

This list is not complete. Further invest-ment possibilities, with yet more varyingtax rules, are unauthorised unit trusts,non-qualifying pension or life policies,children’s bonus bonds, offshore funds,friendly societies, permanent interest bear-ing shares, Government stocks, onshoreand offshore bank accounts, communitydevelopment finance institutions, realestate investment trusts, direct investmentsin real estate and investments in commodi-ties such as wine or stamps.

Even something apparently simple like acorporate bond might prove very compli-cated if the accrued income schemeapplies, or if there is a dispute with HMRCas to whether interest payments should betreated as dividends for tax purposes.

So many rules for investment schemesundermine their own effectiveness as anincentive to saving and underline distor-tions in the system. Tax advisors (who aremore affordable for the well off ) arerequired to help confused taxpayers. Acoherent and integrated framework forsavings is needed to give simplicity andtransparency for savers. This could providean incentive for saving which would be asimportant as the overall level of taxation.93

How inheritance tax is overly complexand needs reviewInheritance tax is essentially a charge onassets held on death. In these circum-stances it is clearly necessary to have a ruleto bring death-bed gifts into charge. In theUK, however, this rule (which is derivedfrom the old capital transfer tax rules,which taxed cumulative lifetime transfers)extends to gifts made in the seven yearsbefore death. This may give rise to a formof retrospective taxation which may not befair for an inheritance tax. Thus, for exam-ple, two 50-year-olds, both in good health,may each make a gift of £1 million. Onesurvives for seven years, and the gift is taxfree. The other is run over by a bus afterjust one year and the gift (charged at amarginal rate of 40 per cent) gives rise to atax liability of £400,000. It is not clearwhat justifies this difference in the taxtreatment of the gift. Furthermore, therules have developed over time into furthercomplexity, such as the tax regime for pre-owned assets.94

A principled re-evaluation of inheri-tance tax may be justified. Such a re-evalu-ation of what is to be taxed, and why, maylead to significant simplification.

93. See, for example, Investment

Managers Association, Investing

in Savers: A Fresh Approach,

Investment Managers

Association, 2004

94. An individual who gifts an

asset but continues to enjoy a

benefit from it may be subject to

income tax on the market rent

value of the asset. Such a rule

would not have been required

under the old capital transfer tax

regime, because a lifetime trans-

fer could be taxable. Irrespective

of the date of death



Indirect taxcomplexity

This section sets out what we believe arethe key existing and (given current trends)potential problems with the indirect taxsystem:

1 VAT is much more complex than itneeds to be.

2 Despite some improvements, stamp dutystill creates complexity and distortion inboth property and share markets.

3 To date, environmental taxes have notbeen based on clear principles, haveoften been ineffective and have beenhighly regressive. There is a serious riskthat further moves towards environ-mental tax will introduce yet more lay-ers of complexity into the system unlessthey are accompanied by matchingsimplifications.

VAT complexityVAT was introduced in 1972. It replacedthe former purchase tax in order to satisfythe requirements of European law. Manyof the old distinctions under purchase taxbetween different kinds of goods and serv-ices were not required by Europe.Nevertheless, many of them were retainedin UK VAT law.

However, there has been no rationalisa-tion of the position since 1972. Thereremain far too many different categoriesfor fully taxable, exempt and zero ratedsupplies. This means that, all too often,different rates of tax apply for very similarsupplies because of very fine tax distinc-tions. Who understands why cakes are zerorated, but chocolate biscuits are standardrated? Or why yoghurt is zero rated, unlessit is frozen yoghurt which is standardrated, apart from frozen yoghurt which isunsuitable for immediate consumptionwhich is, of course, zero rated?

Children’s clothing is also zero-rated.One does not need to be naive about thepolitical difficulties of changing this rule torecognise the anomalies it creates or itsimprecision as a tool of public policy.Taxpayers may be subsidizing a sixth pairof designer jeans for a child from a wealthyfamily. Tall but poor children pay the stan-dard rate earlier than small but rich chil-dren of the same age. Belts may be zerorated as “clothing”, but ear muffs do notqualify.95 However, if the Government wereto address these issues, then it must do sowithout harming the poorest people whobenefit. This would mean, for example,increasing child benefit or other help tocompensate for the change.

Many other VAT distinctions resultfrom the desire to achieve worthy ends.However, they create complexity whichmay not in fact be justified. This complex-ity is often experienced most directly bythe retailer who is required to administerthe fine distinctions, often through com-plicated VAT retail schemes.

Having different rates also exacerbatesthe difficulty of charging VAT on multiplesupplies (made at the same time butcharged at different rates) and the need todifferentiate such supplies from compositesupplies (where it is held that there is onlyone supply for VAT purposes, with theVAT charge determined by the “dominantelement” within the supply). Sales promo-tions, where one item is given “free” on thepurchase of a different item but where dif-ferent rates apply to the two items, areanother fruitful source of disputes withHMRC.

Of course it can be argued, with moreforce than is possible on other tax issuesaddressed in this paper, that now it is easi-er not to rock the boat and to leave thingsas they are. People have got used to the

95. A recent paper written for

the Mirrlees Review makes a

powerful case for broadening

the VAT base by removing spe-

cial VAT reliefs, thereby simplify-

ing VAT and saving costs, and

using the extra revenue to

reduce direct tax or increase

other benefits. See Crawford I,

Keen M, Smith S, Value-Added

Tax and Excises, Institute for

Fiscal Studies, 2008

36

96. The schemes were particu-

larly popular where the land had

substantial commercial value, so

that the implementation costs of

the schemes were justified.

These schemes might have

involved the use of partnerships

(varying the partner’s profit

shares to achieve the desired

commercial result), the use of

overseas trusts, the packaging

of land in a company which was

then sold, or the artificial split-

ting of land into freehold and

leasehold interest which were

then sold separately



existing rules. If similar arguments hadsucceeded in 1971, however, we would stillbe using pounds, shillings and pence. Evenwhere simplification causes short-term dis-ruption, it may be justified by long lastingfuture benefits.

Stamp duty complexityStamp duty has in some respects been con-siderably simplified. Whereas it used toapply to sales of all forms of property, theGovernment has restricted it to transac-tions in shares and property. However, theintroduction of stamp duty reserve tax onshare transactions and stamp duty land taxon property sales has served to increasecomplexity.

Stamp duty land tax, for example, wasintroduced in 2003 following some hastyand unsuccessful legislation enacted tocounter avoidance in 2002. Avoidance ofduty on land transactions was indeedbecoming widespread at that time, partic-ularly because of the increased rates ofstamp duty that had been enacted.96 Thelaw for stamp duty land tax ran to 83 sec-tions and 17 schedules in the Finance Act2003, but commentators also describedthis legislation as ill thought through, withmany gaps which had to be dealt with byfurther regulations, bulletins and “cus-tomer newsletters.” Further amending leg-islation was again required in the FinanceAct 2007.

In the 2008 budget there were, however,some welcome administrative reformsrelating to reporting thresholds and com-pletion of returns.

One important respect, however, inwhich stamp duty land tax continues toproduce unwarranted complexity and dis-tortion affects ordinary small scale domes-tic land transactions. Duty is currentlycharged at 1 per cent on sales from£175,000 to £250,000, at 3 per cent onsales over £250,000 and up to £500,000and at 4 per cent on sales over £500,000.

This means that a sale for £501,000attracts duty of £20,040, which is £5,040higher than the duty of £15,000 on a saleof £500,000 exactly. Similar anomaliesoccur at sales close to the £175,000 and£250,000 thresholds for the same reason:the duty applies to the entire price paid,not just that part of the price whichexceeds the threshold. This regime is notonly unfair. It also produces distortion inthe market pricing of properties, andencourages exaggerated prices to be attrib-uted to non-stampable household itemssold with the house. There is an easy tech-nical answer to this problem, althoughthere would be a cost to the Treasury. Forexample, sales could be charged at 2.5 percent on any value over the £175,000threshold and at 4 per cent on any valueover the £250,000 threshold. Nobodywould pay more duty than at present, buta serious anomaly would be removed.

Stamp duty (or stamp duty reserve tax)is payable at the rate of 0.5 per cent onshare sales. However, it is not payable ontransfers of loan stocks and is more easilyavoided on transfers of equities issued byoverseas companies. The commercialeffects of share transactions can andincreasingly are being replicated throughderivatives which are not subject to stampduty. This all creates potential distortionand tax planning opportunities. The levyof stamp duty or stamp duty reserve tax onshares has the commercial effect of reduc-ing share values. It indirectly increases thecosts of raising capital and has a strongnegative impact on the City of London asa financial centre. Stamp duty also distortsthe international market in share transac-

“ The commercial effects of share transactions can and

increasingly are being replicated through derivatives which

are not subject to stamp duty”

tions. The market in exchange tradedfunds is moving overseas for this reason.

Stamp duty reserve tax has also beenconstantly revised over recent years andthereby become increasingly complicated.

For all these reasons the best way to sim-plify duty on shares would be to abolish it.There would be a substantial cost to theTreasury. However, there would be verysignificant claw backs of the cost throughincreased Capital Gains Tax (share valueswould immediately rise) and increasedcommercial activity.97

Complexity has been exacerbated by thetechnical problems of having three over-lapping sets of rules, stamp duty, stampduty reserve tax and stamp duty land tax.Many of the provisions aim to tackle thesame mischief, but different wording isused in the different taxes. Even if duty onshares were not abolished, substantial sim-plification might be achieved by combin-ing the three sets of rules into one coherentframework.

Environmental taxesMost environmental taxes are not, inthemselves, complex or unstable. Mostvoters would also support their existence.It seems sensible after all to tax “bads” (e.g.pollution) not “goods” (e.g. going towork). Complexity is, however, certainlycreated by the number of environmentaltaxes which have been introduced over thelast 15 years. Taxes with a primary or sec-ondary environmental purpose nowinclude

� Fuel duty. Some form of this has beenwith us for over a century and it is nowa fixed charge on each litre of fuel. Thecharge is normally due to increase everyyear in line with inflation, but in facthas decreased in real terms since thefuel escalator was abolished in 1999.The planned 2008 increase (from50.35p per litre to 52.35p per litre on

petrol) has been postponed until theautumn (and it may be postponed fur-ther as a result of public disquiet con-cerning spiralling petrol and dieselprices);

� VAT on fuel. This is charged at theusual rate of 17.5 per cent on the aggre-gate of the basic fuel price and fuelduty. It is estimated that theGovernment has received an extra £500million in VAT in the first six weeks ofthe current tax year as a result of theincreased price of oil;

� Vehicle excise duty (VED). This is aduty on any vehicle not kept off theroads. The rates are currently between£0 and £400 p.a. depending on theengine emissions of the vehicle. Theyare scheduled to increase sharply infuture;

� Landfill tax. This is charged on wastedisposed of by way of landfill. It wasintroduced in 1996 at a standard rateof £7 per tonne. The rate is £24 pertonne in 2007/08 and will be increas-ing to £32 per tonne in 2008/09 and to£40 per tonne in 2009/10;

� Aggregates levy. This was introduced in2002 at a rate of £1.60 per tonne onaggregates production. It is currentlycharged at £1.95 per tonne;

� Air passenger duty. This was introducedin 1993 at a rate of £5 per passenger fora flight within the EU and £10 for aflight going outside the UK. The ratesare now £10 to £20 for flights withinthe EU and £40 to £80 for those out-side the EU, depending on the class oftravel. It is proposed to replace thisduty with a new aviation duty from2009, payable per plane instead of perpassenger; and the

� Climate change levy. This was imple-mented in 2001 as a charge on energysuppliers. It is currently charged, forexample, at 0.456p per kWh for elec-tricity. This has increased little since2001.98

97. HMRC Table 15.1. The total

cost would be about £3bn,

before the claw backs men-

tioned

98. Tobacco products duty and

alcohol duty are not included in

this list of environmental taxes

38


However, the picture is even more complexthan this list implies. Other taxes are alsooften used to achieve environmental objec-tives – the calculation of Income Tax oncompany cars is one example. The stampduty exemption for “zero carbon” homes isanother. Increased capital allowances aregiven for energy saving plant. There arefurther regulations and charges which,while not strictly taxes, may still have afinancial impact. These include waterabstraction charges and emissions tradingschemes. There can be little doubt there-fore that taxes driven by environmentalconsiderations have already substantiallyincreased British tax complexity. Is thisnecessary or justified?

As one usually finds with complex taxa-tion the underlying cause of the complexi-ty is, at least in part, the lack of clearunderlying principle.99 Are environmentaltaxes intended to discourage the activitywhich is being taxed, or are they intendedto raise money for the Government?

The strongest argument for levying suchtaxation may well be the “polluter paysprinciple,” i.e. that the polluter should payfor the cost on society caused by his activ-ities. Although different measures havebeen estimated, one can certainly attributea cost to the use of carbon, for example.100

However, governments have generallydeclined to base environmental taxessoundly on this principle. One can see atleast two reasons why.

Firstly, a number of taxes would not beeasily justifiable on this basis. For example,vehicle excise duty applies no matter howmany miles a vehicle is driven. Yet this taxis scheduled to double from £210 to £430in 2010 for a car having emissions greaterthan 225g of CO2 per km, even if that carwas purchased as far back as March 2001(unless, as seems more than likely at thetime of going to press, the Government isforced to make another U-turn on thisissue in the autumn). This not only gives

rise to an element of retrospective taxation(the extra tax could not have been foreseenwhen a vehicle was purchased in 2001), italso fails to reflect the cost on society ofusing the vehicle. A little-driven car shouldcost less than a much-driven one.

Furthermore, the issue of whether thetax reflects the cost on society is clouded bythe possibility of double or even triple tax-ation. Not only is vehicle excise dutypayable, but fuel duty (in addition to VAT)is payable on petrol. The driver may also beliable to tax, if it is a company car, on abenefit in kind, which is also calculated byreference to the emissions of the car. Allthese taxes make a rational decision as towhat car to purchase, whether to scrap acar which has become subject to highertaxes, or whether an employee should takeextra salary instead of a company car andbuy a car privately, extremely difficult tocalculate.101

The second point is that if environmen-tal taxes were intended to pay for the envi-ronmental damage caused it would followthat governments should spend the moneyraised on that problem. Again the connec-tion between the taxes raised and themoney spent by Government is usuallymissing.

There is a very serious risk therefore thatenvironmental taxes have generally become“stealth taxes”, a way of raising Governmentrevenue without either (as is stronglyarguable) making a substantial impact onbehaviour or paying for the environmentaldamage. Environmental taxes also tend to beregressive, because they are not matchedwith the ability to pay. And they have sub-stantially increased the complexity in the taxsystem. Any further environmental taxes(and there almost certainly will be more)should be based on clear principles andshould be accompanied by matching taxsimplifications. To do otherwise would be toneedlessly undermine the competitiveness ofthe British economy.

99. See Fullerton D, Leicester A,

and Smith S, The UK Tax

System and the Environment,

Institute for Fiscal Studies, 2008

for a helpful discussion of rival

views concerning the purpose of

environmental taxes

100. See Taxpayers’ Alliance,

The Case Against Further Green

Taxes, The Taxpayers’ Alliance,

2007 for various possibilities

101. We will spare the reader an

explanation of the special rules

for capital allowances and for

input VAT on motor cars which

further complicate the tax calcu-

lation for company cars



102. For example the timing of a

sale may be different under the

capital allowances code (section

28 TCGA 1992 cf section 572(4)

CAA 2001). Numerous other

examples could be given

40

Business taxcomplexity

The uncompetitive nature and instabilityof the British tax system became the sub-ject of very stark business complaints inthe first half of 2008. The simultaneoushigh profile fit of tax instability did realharm to Britain’s reputation for tax admin-istration. However, this is a manifestationof problems that have been developingover a much longer period. Several themesstand out:

1 Companies have to negotiate a mine-field of different rules to work out theirprofit for tax purposes.

2 The UK has become a systemically lessattractive tax environment for businessdue to growing complexity and insta-bility.

3 The UK is now a less attractive placefor highly skilled non-domiciled citi-zens to base themselves.

4 Recent volatility has gravely under-mined the UK as an attractive place toheadquarter an international company.

5 There is scope to remove corporate taxreliefs, to widen the tax base and reducecorporate tax rates.

Companies have to negotiate a minefieldof different rules to work out their profitfor tax purposes

As we saw above, tax is calculated byaggregating the results for different sourcesof profit under four separate tax codes.Each source is subject to a very large num-ber of rules. And there are further rules onhow to combine the separate calculations.The four underlying sources are:

� Income Tax law, which reflects theschedular system, whereby incomederived from defined sources is sepa-rately calculated and then aggregatedtogether;

� A separate Capital Gains Tax code(which could be seen as an additionalschedule for a further source of profitwith its own computational rules);

� A capital allowances code conferringtax relief (in various ways) for the capi-tal cost of specified assets; and

� Accounts-based law for loan relation-ships, intangible fixed assets and deriv-atives, which has been introduced forcompanies.

Various other provisions, above all anti-avoidance provisions, straddle the bound-aries between these tax law categories. Theaggregation of different tax codes createscomplexity in itself. What causes evenmore difficulty is that the rules in these taxcodes do not always fit comfortablytogether.102

The rules also leave gaps. For example,there is no general relief “for tax nothings”(capital expenses written off as incurred).There is no general relief for depreciation,even though, for a businessman, deprecia-tion is as real a cost as salaries or heatingbills. These gaps have not originated fromsound policy planning. They are historicalanomalies arising from the piecemealdevelopment of tax law.

The result is a quagmire of legislation.An individual’s business tax profits areworked out under the Income Tax(Trading and Other Income) Act 2005(approximately 886 sections and 4 sched-ules, 465 pages), the Capital AllowancesAct 2001 (approximately 581 sections and4 schedules, 341 pages), and the Taxationof Chargeable Gains Act 1992 (approxi-mately 291 sections and 12 schedules, 482pages), together with many more regula-tions made under these Acts.

Under the current system too many taxrules result in far too many boundaries and

“all or nothing” tax outcomes. For exam-ple, an asset is either plant and machineryor it is not plant and machinery for taxpurposes. There are many borderline cases,where either generous tax relief may beavailable if the asset falls inside the bound-ary and qualifies as plant and machinery,or no tax relief is available if it falls outsidethe boundary. If the asset is plant andmachinery one still needs to check whetherspecial rules for short-life or for long-lifeassets apply. Is the asset not a long-life assetbecause special exemptions apply, or is theasset a fixture? Whenever there is doubtover whether an asset falls inside or outsideone of these definitions there is substantialtax uncertainty. These legal difficulties and“all or nothing” outcomes would not occurif tax relief were given for commercialdepreciation, regardless of whether theasset is plant and machinery and regardlessof all the other rules.

The plethora of tax rules tends toobscure underlying principles which arerequired for the sensible interpretation oflegislation – whether by HMRC, the tax-payer or the courts. It becomes difficult tosee the wood for the trees. All these rulesalso tend to sever the relationship of taxwith the real world as seen by economistsor businessmen. Examples of unnecessarytax rules are:

� Rules based on distinctions betweenincome derived from different sourcesunder the schedular system, and forcalculating capital profits separatelyfrom income profits. These rules alsolead to further very complex rules gov-erning the utilisation of losses from onesource against profits from anothersource;

� Rules which create distinctionsbetween hire purchase contracts andfinance leases, advance rentals and pre-miums paid for leases, and arbitrarydelineations between assets in theCapital Allowances Act;

� Tax rules for wasting assets,Government grants, options, appropri-ations to and from trading stock, gainson insurance contracts, disposal of theright to annual payments, sales of debtsby individuals, tangible movable prop-erty, and passenger vehicles and many,many more; as well as

� Rules based on inadequate or out-datedtax definitions.103

There are currently substantial differencesbetween business tax law for individualsand for companies, which further compli-cates the picture. For example, someaccounts-based rules only apply to compa-nies.104 Business capital gains for individu-als benefit from the 18 per cent rate, butcompanies pay the full rate of tax on capi-tal gains, after deducting the indexationallowance. Business tax law is being draft-ed separately for individuals and for com-panies under the tax law rewrite project.

It seems sensible that a similar taxapproach should be applied to businessactivities of companies and individuals.Naturally there would have to be some dif-ferences:

� For instance, UK dividends received bycompanies should be tax free to preventseveral charges to tax arising as divi-dends are paid by one company toanother.

� Special rules are also needed for trans-actions within a group of companies.

But subject to such exceptions a similar taxcode should apply to all businesses,whether conducted by individuals or com-panies.

A more accounts-based tax approach hasbeen supported by business. In the TaxReform Commission survey 63 per cent ofrespondents either agreed or stronglyagreed that a system which used account-ing based profit to calculate corporationtax using a tax rate so as to leave the total

103. For example the concept of

“disposal” and “part-disposal” for

tax purposes depends, at root, on

the distinction between whether

the taxpayer still owns the asset

or has ceased to own it. In mod-

ern commercial transactions there

is, however, a wide spectrum of

possibilities for dealing with an

asset, from pure financing

secured on the asset, to limited

recourse financing, to a range of

finance lease or HP contracts,

sales with specified repurchase

terms, sales retaining specified

risks, effective sales achieved

through derivative contracts etc.

The accounting concept of “reali-

sation”, based as it is on whether

significant risks and benefits in

the asset have been transferred,

seems more adequate for these

purposes than the tax concept of

“disposal”

104. Such as rules for loan rela-

tionships, derivatives and intan-

gible fixed property



tax burden unchanged would be “benefi-cial to my business”. Only 9 per cent dis-agreed or strongly disagreed.105 The recentreport by the CBI tax task force has alsostrongly endorsed a more accounts-basedapproach.106

The UK has become a systemicallyless attractive tax environment forbusiness due to growing complexityand instabilityA range of specific tax issues influencebusiness decisions. The UK would be moreattractive to business with simpler and bet-ter rules for

� The taxation of overseas profits;� Transfer pricing;� Controlled foreign companies (CFC)

legislation;107 and� Start-up costs.

On these types of issues, the UK tax systemis becoming less attractive to business thanmany international regimes. Recent legisla-tive changes have exacerbated this trend.As one director of group tax at a FTSE 100firm put it

“Other EU countries have become moreattractive from a tax point of view, whilethe UK has become less attractive.” 108

Tax law for business is becoming increasing-ly complicated. The HMRC MeasurementProject found that there are 6,614 datarequirements relating to business taxation.109

The Tax Reform Commission’s survey foundthat 78 per cent of business executivesbelieve that the level of complexity in the taxsystem had increased over the preceding fiveyears.110

Tax stability suffers just as surely as taxsimplicity does. A stable and predictabletax system allows business to invest andbudget with confidence. This has becomeincreasingly hard over the last decade. For

example, the 10 per cent additional imposton oil companies (announced with hardlyany consultation or warning to the compa-nies affected) was a good example. It hasbeen followed by unexpected and substan-tive changes to the capital allowancesregime, the rules for non-domiciled indi-viduals and, potentially, the taxation offoreign profits. An example of a changewhich was soon reversed is the creationand subsequent removal within 48 monthsof the zero per cent starting rate for corpo-ration tax.

From 2005-06 to 2007-08, theGovernment managed to increase its cor-poration tax receipts by nearly £5 billion(without increasing headline rates) as aresult of significant changes to HMRC’sinterpretation of tax law.111 A differentapproach has sometimes been applied ret-rospectively. Examples include a range ofchanges affecting the insurance and privateequity industries.

Anti-avoidance legislation is beingintroduced to raise as much tax as possiblewithout increasing headline rates, ratherthan to counter artificial tax avoidanceschemes. Furthemore, the Government hasoften announced what it deems to be anti-avoidance legislation without consultationor adequate discussion in Parliament.112

The UK is now a less attractive placefor highly skilled non-domiciled citi-zens to base themselvesThere is clearly some justification forcharging some tax on non-domiciled peo-ple who may live in the UK for long peri-ods and who, in the past, have paid little orno tax on their offshore income and gains.However, by their very complexity the newrules have caused unwarranted problemsfor these people. They may well end updiscouraging further new immigrants fromcoming to the UK, many having highlyrated skills to offer. The new rules alsoimpact directly on employers, who have to

42


105. Tax Reform Commission,

Tax Matters: Reforming the Tax






CBI, pp 39, 2008

107. The UK’s controlled foreign

companies legislation is

designed to bring into the UK

tax net profits which are held

offshore

108. Director of Group Tax at a

FTSE 100 firm cited in Tax

Reform Commission, Tax

Matters: Reforming the Tax



Commission, 2006



Project, KPMG, Table 1, March

2006. This figure includes the

data requirements for VAT

110. Question 9 of the Tax

Reform Commission joint survey,

see Tax Reform Commission,





111. HMRC Data Table T1.2

112. Naturally it may sometimes

be appropriate to do this to pre-

vent the burgeoning use of a

new tax avoidance scheme. But,

for example, in 2006 the

Government changed the taxa-

tion of certain life assurance

products with no advance

notice. Likewise in 2005 transfer

pricing rules were applied to pri-

vate equity structures without

warning at a time when detailed

discussions were taking place

between the British Venture

Capital Association and the

Government on the taxation of

private equity. Another example

is from 2000 when changes

were made to the taxation of

general insurance, that again

were not pre-announced



operate the PAYE system. Individuals donot need to decide until January 2010whether to give up their personalallowances in order to keep the remittancebasis of taxation for the current tax year.What PAYE code should apply in themeantime?113

Recent volatility has gravely underminedthe UK as an attractive place to head-quarter an international companyOne of the most important issues for UKholding companies is how to tax dividendsfrom foreign subsidiaries. What anti-avoidance rules are appropriate to preventprofits being artificially diverted from theUK to lower taxed jurisdictions overseas?

UK companies have long complainedabout the complexity of our controlled for-eign company and other tax legislationwhich applies.114 They have drawn atten-tion to such tax regimes as theNetherlands, which confer a completeexemption for most dividends from over-seas subsidiaries. In June last year HMTreasury published a consultative paper.The paper did suggest exempting foreigndividends for large companies. Howeverthere were four important problems:

� There were no clear principles beingapplied;

� The exemption was not to be availablefor smaller companies; and

� The sheer variety of proposed tax treat-ments was not likely to have producedsimplification;115

� Worst of all, the paper contemplatednew avoidance legislation to catch “pas-sive income” accruing to overseas sub-sidiaries. This could have caught ordi-nary commercial activity, or preventedordinary commercial development ofoverseas businesses.

In the business survey carried out for theTax Reform Commission in 2005, 19 per

cent of respondents said that the complex-ity of the UK tax system had alreadyforced them to consider transferring oper-ations outside the UK. In 2008, high pro-file decisions to relocate outside the UKhave been taken by Shire Pharmaceuticals,the UK’s third biggest pharmaceuticalcompany; United Business Media, a pub-lisher; Regus, an office services firm;Charter, an engineering business;Henderson, an asset management firm;and WPP, one of the world’s biggest com-munications firms.116 Many others, such asGoogle, have simply never moved here butset up their European headquarters else-where.

Matters have got even worse recentlyfollowing the Treasury discussion paper,which seriously unnerved a number ofbusinessmen. The Treasury has now con-vened a new high level working group toconsider these issues, and assurances havebeen given that proposals will not beeffected that are not broadly acceptable tobusiness. Unfortunately, serious damagehas already been done by further looseningmany UK companies’ commitment to theUK.

There is scope to remove corporatetax reliefs, to widen the tax base andreduce corporate tax ratesReliefs and exemptions are an obstacle toreducing tax rates, create complexity andmay not be effective or efficient. To cite afew opinions:

“We believe that our members regard thedelivery of incentives through the tax sys-tem as largely ineffective. e combined

“ Serious damage has already been done by

further loosening many UK companies’ commitment

to the UK.”

113. Mike Templeman, a mem-

ber of the CBI tax committee

has said “There may not be a

solution....this is a potentially

serious worry for employers in

the City”. Eaglesham J,

“Warning over New Non-Dom

Rules,” Financial Times, 20 May

2008

114. The rules for calculating

underlying tax credits for divi-

dends routed through offshore

“mixer companies” in the

Finance Act 2000 are notorious

examples of other such complex

tax law. Many others could be

cited

115. The question of whether

capital export neutrality or capi-

tal import neutrality should apply

was especially confused

116. Houlder V and Brown JB,

“Darling under pressure to ease

jitters over tax,” Financial Times,

August 30 2008; Houlder V, “Tax

factor beats patriotism in WPP

relocation,” Financial Times,

October 6 2008


44

survey results suggest that the complexity ofthe tax system makes such incentives virtu-ally incomprehensible to small businesses,and that this contributes to making suchbusinesses reliant on help from theiraccounting and tax advisors.” 117

“It was pointed out that, for many businesses,other features of the tax system were probablymore important [than R & D tax credits],particularly the headline corporation tax rateon income flows resulting from R&D.” 118

“Tax credits for research and development… are restrictive and the expense of claim-ing them largely outweighs the tax creditreceived.” 119

“Research and development tax credits havenot worked as they were meant to.” 120

A recent PricewaterhouseCoopers reportconfirmed these sentiments. It found thatonly 11 per cent of businesses took advan-tage of Government tax relief schemes suchas capital allowances on energy savingtechnologies and R&D tax credits. Only 7per cent of the smallest companies (thosewith a turnover of £2 million or less) tookadvantage of these reliefs.121

In addition, film tax credits have failedto achieve their purpose of increasingBritish film production.122 The Treasuryhas also conceded that they have led towidespread tax avoidance.

The scope of tax incentives should bereviewed. The withdrawal of just tworeliefs, for R&D Tax Credits and film cred-its would simplify the tax code and enableabout £1.2 billion to be returned to tax-payers through lower headline tax rates.

117. Institute of Chartered

Accountants of Scotland, First

Contact Survey, Institute of

Chartered Accountants of

Scotland, 2005

118. Abramovsky L, Griffith R

and Harrison R, Background

Facts and Comments on

‘Supporting growth in innova-

tion: Enhancing the R&D Tax

Credit’, Institute for Fiscal

Studies, pp 18, 2005

119. Submission provided to Tax

Reform Commission by a repre-

sentative body

120. Leader, Financial Times, 28

July 2006

121. PricewaterhouseCoopers,

Enterprise in the UK: Impact of

the UK Tax Regime for Private

Companies,

PricewaterhouseCoopers, 2006

122. See, for example, UK Film

Council, “Statistical Yearbook:

Annual Reviews, and Research

and Statistics Bulletin,” vol 3 no

2, UK Film Council, March 2006,

for evidence of this

Calls for simplificationOver the past decade many professionalbodies, such as the Chartered Institute ofTaxation (CIOT); Institute for CharteredAccountants in England and Wales(ICAEW); Confederation of BritishIndustry (CBI); Institute of Directors(IOD); British Chambers of Commerce(BCC); and the Investment ManagementAssociation (IMA), to name but a few,have become both united and ever louderin their calls for tax simplification and sta-bility. This was also a key concern for theShadow Chancellor of the Exchequer,George Osborne, when he established theTax Reform Commission in 2005. It wasinstructed under its terms of reference toadvise on policy options which wouldimprove the economic efficiency, trans-parency, simplicity and fairness of the taxsystem.

The government responseThe Government’s first significant responseto these increasing calls for reform came in2007. In the Pre-Budget Report of that yearthe Chancellor identified tax simplificationas a priority.123 Three simplification reviewswere announced as part of the programme toachieve this:

� The first review focused on anti-avoid-ance legislation, with a particularemphasis on the rules for taxing returnsin the same way as interest if they wereeconomically equivalent to interest and

taxing sales of income streams asincome. Draft legislation was intro-duced to achieve this. However, it wasso heavily criticised that it did notappear in the 2008 Finance Bill. It isnow subject to further review.

� The second review focused on certainVAT rules. It has resulted in minorchanges to the option to tax land andsome limited administrative changes.

� The third review focused on the simpli-fication of corporation tax rules forrelated companies. This has resulted ina minor simplification of the associatedcompanies rules relating to the smallcompanies rate of taxation.

Other areas identified for further work,such as transactions in securities and pre-miums for leases are also very limited intheir scope.124

The Government has announced anumber of other detailed issues on whichthey have already achieved simplification,or where they plan to do so, in the 2007Pre-Budget Report and in the 2008Budget.125As a separate exercise this year’sFinance Act has also repealed some outdat-ed anti-avoidance provisions which are nolonger used.

Perhaps the most important intendedsimplification was the change to CapitalGains Tax. As discussed above, however,the simplification may prove to be moreapparent than real.

The Government is also addressing thesimplification of administrative matters,


123. See, in particular, HM

Treasury, 2007 Pre-Budget

Report and Comprehensive

Spending Review, HMSO, para-

graph 4.51, 2007

124. Utilisation of capital losses,

value shifting, certain employee

shareholding rules, aligning rules

for “unallowable purpose” etc.

are also included

125. HM Treasury, 2007 Pre-

Budget Report and

Comprehensive Spending

Review, HMSO, Box 4.6, 2007;

HM Treasury, Budget 2008,

HMSO, Box 3.5, 2008

Part 3A false awakening and how to reallychange things

although these do not directly impact onthe underlying complexity of tax law.Examples are given below:

� HMRC published a paper “Making aDifference: Delivering the Review of Linkswith Large Business” in March 2007.The targets set out in that paper havebeen reviewed in the 2008 budget.

� A further paper “Delivering a NewRelationship with Business: Progress onHMRC’s Plans to Improve the SMECustomer Experience” was publishedduring the 2008 Budget.

� The Government is also conducting anon-line survey to try and find ways ofsimplifying tax calculations and returnsfor small companies.

� Simpler requirements for returningemployee share benefits have beenintroduced.

A critique of the governmentresponseThese very detailed proposals are welcome.Sadly, however, they will have limited over-all impact on most taxpayers most of thetime. The underlying problems of tax com-plexity are not being resolved. The simpli-fication reviews have been deliberately lim-ited in their scope. For example, the reviewof anti-avoidance legislation has notaddressed whether the underlying tax lawthat has given rise to the need for complexanti-avoidance law is appropriate or sensi-ble. Furthermore, and most importantly,the reviews have lacked any sense of strate-gy or direction.

The ICAEW, in their 2008 budget sub-mission to the Government, welcomed theGovernment’s explicit commitment to taxsimplification. But they said that they were

“concerned that the Government had “divedinto the detail” without first articulating anagreed tax simplification strategy. At thepresent time there appear to be a number ofdifferent initiatives but there is no clarity asto the overarching strategy and principlesthat we believe should underpin a majorwork of simplification.”126 Similarly theCIOT indicated that a more wholesalereview would be required in order to achievesubstantial simplification than merely iden-tifying some isolated points to work on.127

The CBI tax task force reached the sameconclusion in its recent tax task forcereport.128

The Government is looking to findpieces of tax law which it can simplifywithout attempting to identify and addressmore fundamental issues. This means thatunderlying principles are not beingaddressed. The efforts are well intentioned.However, they are not commensurate withthe scale of the problem. They will have nomajor impact on the current volume of taxlaw. As a result of other provisions in thisyear’s Finance Act, with its 166 sections,46 schedules, its new rules for non-domi-ciled individuals, its raft of new capitalallowance rules, a further collection ofanti-avoidance law and much else besidestax law is en route to becoming more com-plicated than ever.

Possible next stepsA bold approachRadical steps were first taken over twentyyears ago to eliminate the worst excesses ofhigh tax rates. Top rates of income tax werereduced from 98 per cent to 40 per cent.The full rate of corporation tax is now 28per cent instead of 52 per cent.Comparably fundamental reform is nowrequired to simplify and stabilise the Britishtax system. This might sound impracticalor even risky. In fact, we believe that as longas approached carefully and with meaning-ful consultation and review, it is not only


46

126. The Institute of Chartered

Accountants in England and

Wales, 2008 Budget Submission,

The Institute for Chartered

Accountants in England and

Wales, pp 5, 2008

127. See their letter dated 19

December 2007 to the Treasury

on the use of accounts for com-

puting business profit



CBI, pp 39, 2008

“ The underlying problems of tax complexity are not

being resolved”

achievable but will win the profound sup-port of British business and anyone serious-ly concerned about the British economy.This is more than ever the case in the cur-rent “credit crunch” environment. Oncethe strategy and direction of reforms hadbeen determined, reforms should be madeincrementally and carefully. This wouldminimise the risk of confusing taxpayers orof imperilling public finances.

Potential specific measuresThe Government needs to lead a debate.What are the basic principles that shouldbe applied to tax areas targeted for reform,and what strategy is appropriate for actual-ly implementing those principles? Thisshould lead to substantial, probably radi-cal, simplification in most areas. Thereneeds to be a willingness to take radicalsteps when the right principles have beendetermined, even though it may be appro-priate to achieve that in incremental stages.

In particular, we recommend the follow-ing changes:

� Accounting and tax profits: to improveour tax law, we should adopt the prin-ciple that the taxable profits of a busi-ness should, except in limited situa-tions, equal its accounting profits.

� Employed and self-employed taxation:policy-makers should look at the differ-ences in tax treatment and abolish anyunjustified distinctions.

� Capital and income: the distinctionbetween the two is not justified inmany instances. Where it is, theGovernment needs to make sure that itis sufficiently clear.

� Reviewing reliefs: policy-makers shouldcut unnecessary reliefs and develop away to make sure that new ones are notadopted when not needed.

To further push the simplification debate,the Government must also urgently look atthe following areas:

� VAT: Would it be worthwhile to sim-plify distinctions made on supplies ofgoods or services for VAT purposes?

� National Insurance and Income Tax: therules for calculating NICs and IncomeTax should, at the very least, be amalga-mated. It may be that NICs should beabolished altogether.

� Business and non-business profits: wouldit be sensible to distinguish betweenbusiness and non-business profits for taxpurposes (as commonly occurs overseas)rather than delineate between profitsderived from the different tax schedulesthat exist under the current system?

� Taxation of various kinds of investments:can the plethora of rules governing dif-ferent investment vehicles be rationalisedas a means to encourage savings?

� Stamp duty, stamp duty land tax andstamp duty reserve tax: could these sepa-rate rules be aligned and combined?

� Integrating tax credits into the tax system:can the two systems be merged or oth-erwise combined, so as to achievegreater transparency and simplicity?HM Treasury and HMRC should con-sider ways that they could be.

� The imputation system of taxing divi-dends (or what is left of the system afterthe abolition of repayable tax credits ondividends): HM Treasury and HMRCshould look at ways this system couldbe improved so as to reduce distortionand complexity.

Making tax lawAs we showed above, the debate about taxcomplexity and volatility has suffered froma lack of comparative measures and datapoints as well as from a difficulty in under-standing the multiple implications of spe-cific tax proposals. A government commit-ted to tax reform would:

� Make a public commitment to notmaking up tax policy “on the hoof”


Part 3: A false awakening and how to really change things

and commit to minimum periods ofconsultation wherever possible.

� Invest time in really understanding andpublicly testing the impact of specificproposals on both the tax system and theeconomy (“Tax Impact Assessments”?).

� Commit to corresponding reductionsin tax complexity for any new social orenvironmental uses of the tax code

Simplifying tax in the context ofreducing taxIt is in the nature of tax reform that win-ners and losers will be created. It is a com-monplace that the losers are more vocifer-ous than the winners in expressing theirconcerns. Reform may therefore requireconsiderable political courage and convic-tion. The rewards, however, of simplifyingtax and removing some privileges currentlyenjoyed by special interest groups would bevery great. Most individuals would benefit.So would the economy at large.

Nevertheless it is clearly easier from apractical political point of view if thechanges are implemented in the context ofreducing tax rates generally. “Base broad-ening” (the use of money saved by theTreasury for eliminating exemptions andreliefs to reduce headline tax rates) clearlyhelps in this respect. There also remainsthe possibility of rebalancing the system byreducing direct tax and increasing indirecttax such as VAT at the same time. Thisapproach would conform with that recom-mended by many academic studies in

order to maximise economic efficiencyfrom the time of the Meade Committee in1978. It is likely that the Mirrlees review,also established under the auspices of theInstitute for Fiscal Studies, which is due toreport later this year, will shed further lighton fundamental issues affecting the direc-tion for tax policy.

Tax simplification officeA working party chaired by Lord Howe ofAberavon has very recently published itsreport entitled “Making Taxes Simpler”which recommends that an Office of TaxSimplification (“OTS”) should be estab-lished, reporting to a new JointParliamentary Select Committee, and over-seen by a Steering Committee appointed bythe Chancellor of the Exchequer. The reportalso recommended that changes to tax lawhaving a technical content should be pro-posed no later than the Pre-Budget Reportbefore the Finance Bill in which they are tobe included, to allow sufficient time for con-sultation and scrutiny.

The OTS is an exciting proposal. Wehope very much that it can be established.It will of course need to be managed care-fully. Furthermore, once proposals are inthe public domain, it may be appropriateto give assurances or confirmations to thepublic up front as to the timing or extentof any possible changes. The OTS should,however, be a powerful instrument foreffecting the reforms in tax law that theUK so badly needs.


48

Appendix 1: The relationship between tax,and GDP growth129


129. Tax Reform Commission,





Study

Cashin (1995)

Engen and Skinner (1996)

OECD – Liebfritz, Thornton and Bibbee (1997)

Liebfritz et al (1997) additional model simulations

Bleaney, Gemmell and Kneller (2000)

Folster and Henrekson (2000)

Bassanini and Scarpetta (2001)

Gemmell and Kneller (2001)

PricewaterhouseCoopers (2003)

OECD (2003)

Coverage

23 OECD countries over the 1971-

1988 period

US modelling together with a sample

of OECD countries

OECD countries over the 1965-1995

period

European Commission Quest 2 –

model simulations

17 OECD countries over the

1970-1994 period

Sample of rich OECD/non-OECD

countries over the 1970-1995 period


1998 period

12 OECD countries over three- year

periods from 1987-89 to 1995-97


1999 period

OECD countries over the 1980-2000

period

GDP impact

1 percentage point increase in the tax-to-GDP ratio low-

ers output per worker by 2 per cent

2.5 percentage point increase in tax-to-GDP ratio reduces

annual GDP growth by between 0.2 and 0.3 per cent

10 percentage point increase in tax to GDP ratio reduces

annual GDP growth by between 0.5 and 1 per cent

1 percentage point of GDP rise in labour taxes reduces

UK GDP by 2.4 per cent versus baseline level

1 percentage point of GDP increase in distortionary tax

revenue reduces annual GDP growth by 0.4 per cent

10 percentage point increase in tax-to-GDP ratio reduces

annual GDP growth by 1 per cent


per capita output levels by between 0.3 and 0.6 per cent

1 percentage point of GDP increase in distortionary taxa-

tion reduces average annual GDP growth by 0.4 of a per-

centage point

1 percentage point of GDP increase in distortionary taxa-

tion reduces annual GDP growth by between 0.2 and 0.4

per cent


output per capita by 0.3 per cent, or 0.6-0.7 per cent if

the effect on investment is taken into account

The Costof Complexity

How Britain’s tax system strangles theeconomy and reduces British competitiveness

Nicholas Boys Smith, David Martinand Lawrence Kay

Edited by Natalie Evans

The

Cost

ofComplexity

Nicho

lasBoys

Smith,D

avidMartin

andLaw

renceKay

edited

byNatalie

Evans

Policy

Exchang

e

£10.00ISBN: 978-1-906097-34-9

Policy ExchangeClutha House

10 Storey’s GateLondon SW1P 3AY

www.policyexchange.org.uk

This report argues that the Government must make the UK taxsystem fundamentally simpler. To be economically competitive,Britain needs to reduce the burden of tax complexity onbusinesses and individuals. At the moment, it is getting out ofcontrol. At 8,300 pages, the UK has the second-highest amountof primary tax legislation among the world’s top economies.

To prevent the problem of complexity in the tax system gettingworse, the way that tax legislation is made needs to bechanged. During Budget time, the Chancellor is always underpressure to “do something”, and faces a plethora of suggestionsfrom the Treasury, HMRC, professional bodies and the mediaabout what should be done.

However, to start reversing the problem of tax complexity now,the Government must accept the principle that the taxableprofits of a business (whether operated by an individual or acompany) should normally equal its accounting profits; abolishunjustified differences between employed and self-employedtaxation; reconsider the distinction between capital and income;and cut unnecessary reliefs.

By making these changes and adopting a principled approach,the Government might also start to remove unwarrantedexemptions in the tax system. At the moment, there are manyreliefs that incentivise environmentally friendly behaviour, and afew reliefs that discourage it. Furthermore, many measures thatare meant to help certain groups are largely unknown. Overall,these problems make the tax system more regressive than itneed be. Empirical evidence, collected for the first time in thisreport, shows that people and firms who cannot afford to hiretax advice suffer most from complexity.

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