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Reformers not spenders
Andrew Haldenby
Dr Patrick Nolan
Lauren Thorpe
Kimberley Trewhitt
March 2012
Reformers not spenders
The authors
Andrew Haldenby is the Director of Reform
Dr Patrick Nolan is the Chief Economist at Reform
Lauren Thorpe is Research and Corporate Partnership Director at Reform
Kimberley Trewhitt is a Researcher at Reform
1

Reform
Reform is an independent, non-party think tank whose mission is to set out a better way to deliver public
services and economic prosperity. Reform is a registered charity, the Reform Research Trust, charity no.
1103739. This publication is the property of the Reform Research Trust.
We believe that by reforming the public sector, increasing investment and extending choice, high quality
services can be made available for everyone.
Our vision is of a Britain with 21st Century healthcare, high standards in schools, a modern and efficient
transport system, safe streets, and a free, dynamic and competitive economy.
2
Reformers not spenders
Andrew Haldenby
Dr Patrick Nolan
Lauren Thorpe
Kimberley Trewhitt
March 2012
3
Reformers not spenders
Contents
Foreword:
1NameReconnecting capitalism
Executive summary
5
page
6
Austerity is the new normal
10
The squeeze
10
Labour participation and childcare
12
Household debt
13
Deleveraging and its consequences
15
Long run growth not government spending
16
High pay is not the problem
18
Facts on pay
18
High pay creates social benefits
18
High pay did not cause the recession
19
Rewards for failure?
20
A closed little club?
21
The global context
22
More capitalism not less
23
Rescuing the public finances
24
Where the money goes
24
The Coalition’s fiscal consolidation
25
The long-term fiscal outlook
26
Implications of slowing growth
28
Implications of departmental ring-fencing
28
Implications of protecting low value for money in welfare
29
Strengthening the tax system
31
Tax revenues
31
Value for money of tax cuts
32
Broadening the tax base
33
The tax gap
36
How the Coalition has increased incentives for tax avoidance
38
Big bang reform
40
Bibliography
41
Annex 1: Facts on pay
45
Annex 2: Means-testing the Child Benefit
47
Reformers not spenders
Foreword: Reconnecting capitalism
Iain Anderson, Director and Chief Corporate Counsel, Cicero
The financial crisis has mutated into a wider debate about the very nature of capitalism. I thought it would
happen sooner than it did. Only when real middle incomes started to be severely squeezed in 2010 and 2011
did this debate start to gain political traction – and it is not going to melt away.
There has been something of a common currency between both ends of the political spectrum around the
Wall Street and St Paul’s protests. The left attack capitalism as a failed system while the Tea Party in the US
and many British Conservatives attack the “corporatism” of big, private institutions.
Simply put, small and local is good. Big and global equates to bad. This is the new mantra of politicians
everywhere across the developed world.
The right sees this moment as an opportunity to re-invent or re-invigorate capitalism – while the left wants
a totally new outcome. Both sides have yet to articulate just what this will mean in practice for voters or
institutions.
Let me be clear: I am in the camp that favours a re-invigoration of capitalism. There is no better system to
create economic wellbeing for the many. But markets and policymakers need to work on solutions to
re-wire capitalism for new generations. And that means working together – not shouting at each other for
airtime.
The financial crisis continues. It will for the medium-term. The sticking plaster solutions we saw in 2008
have come home to roost allied with continued low growth and developing public anger. It is the same
everywhere.
I have spent a week almost every month in the past year in the United States as we build our business there.
America remains a great place to do business but policymakers there have not found any solutions to
reconnecting capitalism with the mainstream.
So where should we start? Policymakers have rightly been focused on ensuring we maintain liquidity and
rebuild the solvency of financial institutions. It is important stuff. But there seems to me to be a better way
of rewiring capitalism – and that is to create new mechanisms for private markets to allow voters to see the
positive effects on their daily lives.
With a continuing crisis of confidence around markets, there has never been a better time to shout and
connect the public imagination with private sector ingenuity. If public policymakers and private sector
investors can get the incentives right for both sides – only then will we reconnect capitalism. The wakeup
call has come but at the moment the alarm clock appears to be on snooze.
5

Reformers not spenders
Executive summary
Executive summary
This report illustrates what lower growth means for the Government’s fiscal targets. Based on this the
report then identifies what the Government’s fiscal policy should do and how this relates to issues like the
squeezed middle and high pay.
The overall fiscal picture
The Coalition has a target of getting spending down to 39 per cent of GDP by 2016-17. This is a revised
target. Since Budget 2010 the target for Total Managed Expenditure for 2015-16 has been moved from 39.8
to 40.5 per cent of GDP. As the outlook for growth has weakened the Coalition has eased its fiscal mandate.
Yet there is a limit to which the Coalition can continue to shift the goalposts in this way.
Table 1: Changes to Government Fiscal Targets for 2015-16
Sources: HM Treasury (2010), Budget 2010; HM Treasury (2011), Budget 2011, HM Treasury
(2011), Autumn Statement 2011
June Budget 2010,
% of GDP
Budget 2011, % of
GDP
Autumn Statement 2011,
% of GDP
Public Sector Current Receipts
38.7
38.4
37.7
Total Managed Expenditure
39.8
39.9
40.5
Cyclically-Adjusted Surplus on Current
Budget
0.8
0.8
-0.6
Real GDP Growth Forecast (2011-12)
2.4
1.8
0.6
Nevertheless, to achieve its most recent target the Government has a plan to reduce Total Managed
Expenditure (set in cash terms). However, this plan was based on a favourable outlook for growth. If growth
is lower than the Government expects it will not achieve its target for reducing the size of the state. Reform
has estimated that, as a rule of thumb, for every half a percentage point fall in the rate of growth there is a
need for the Coalition to find an additional £20 billion in savings to hit the target of 39 per cent of GDP by
2016-17.
Austerity is here to stay. Indeed, as Sir Nicholas MacPherson, the Permanent Secretary to the Treasury,
noted at a recent Reform conference, the Treasury forecasts public spending to be even tighter in the first
two years of the next Parliament than in this one. The deficit reduction challenge has grown in intensity
rather than eased. People who argue that a weakening in growth means that the Coalition should ease up on
its spending plans or introduce tax cuts do not grasp the fiscal position. Liam Byrne was right - there really
is no money left.
Implications for spending and taxes
It could be argued that easing spending reductions or introducing tax cuts would have dynamic effects that
would help achieve the fiscal targets but the empirical evidence for this is very weak.
For any easing in spending plans to have a large impact on growth the change would have to be major. Yet a
major shift in fiscal policy would damage the Coalition’s fiscal credibility and risk increasing interest rates.
To show the importance of this Reform calculated that with current low bond rates the UK will be able to
service its debt even with low growth. However, if yields on 10-year bond rates were to rise above 5 per cent
(similar to the levels currently in Spain) the Government would have to run a surplus in each year of the
current Spending Review period or else face a debt spiral.
Achieving additional spending restrain will be challenging. The most principled and effective way of
achieving further spending restraint would be to look again at the protected budgets. In particular:
>Health
and education (schools) are the key ring-fenced budgets. In nominal terms, departmental
resource spending in health will increase by 8.2 per cent and education 4.9 per cent over the next
three years. This compares to the average increase in total nominal departmental resource spending
over the next 3 years of 2.0 per cent.
6

Reformers not spenders
Executive summary
>If
the budgets in health and education increased in line with this total departmental spending only
the Coalition would save £12.2 billion a year by 2014-15. If the budgets in health and education
remained unchanged in nominal terms by 2014-15 the Coalition would save £16.2 billion a year by
2014-15.
>Spending
on welfare is forecast to increase by £10.1 billion by 2014-15. If, however, this budget was to
grow by 3.0 per cent (the average increase in total nominal Annually Managed Expenditure) then the
Coalition would save £5.6 billion a year by 2014-15. Greater savings in welfare could come from
middle class welfare benefits which are currently protected, such as the Winter Fuel Allowance, free
TV licences, free bus passes and concessionary coach fares, which are poor value for money and
account for spending of the order of £3.6 billion. Reform has estimated that total spending on middle
class welfare is equivalent to around £31 billion.
On tax, while the medium-term goal must be to move towards a low rate and broad based system, many of
the current advocates of tax relief fail to consider how tax cuts must be subject to a value for money
assessment. In particular:
>There
is no empirical support for temporary tax cuts on labour as firms tend to look through
temporary reductions (as the hiring decision is largely permanent) so only hire people they would
have hired anyway and any increase in employment tends to displace new employment elsewhere.
>Temporary
reductions in consumption taxes have little influence on the final prices of goods and
services to consumers (while increasing compliance costs for retailers).
There is also little serious support for the argument that tax cuts are always fully self-funding, although they
may be a “cheap lunch” (partially paying for themselves) if they are designed correctly.
On tax design the Coalition is getting it seriously wrong – it is increasing personal allowances which are a
very poorly targeted way of directing support to lower to middle income families. The large majority of the
spending on allowances goes to people with incomes above the level of the allowance. They will also fail to
grow the tax base and will have no net positive benefit on the labour market (as for most people they will
lower average not marginal tax rates).
By introducing high and variable tax rates the Coalition has also increased the incentives for tax avoidance.
Incentives have been increased by policies such as the 50p tax rate, the clawback of personal allowances and
of pension tax relief, reductions to company tax and increased personal allowances.
It is important to note that the ability to avoid tax will largely depend on personal circumstances. Yet recent
policy changes have clearly reduced the integrity of the income tax system. This is especially the case for
families that own small businesses. The increase in personal allowances has increased the benefits from tax
planning for these families. As shown in the table, the benefit from splitting income between family
members to a family on £26,000 has increased by £607 to £2,533 since 2009-10. Increasing the personal
allowance further to £10,000 would mean that a married couple could reduce their tax liability by a further
£750 through engaging in this tax planning. The benefit from this tax planning increases as marginal rates
increase, so the benefits from tax avoidance are greater for higher than lower income families.
7
Reformers not spenders
Executive summary
Table 2: Impact of Tax Arrangements on Net Pay
Source: Reform
Gross Income Levels (1)
£26,000
Income
Splitting
Company
Vehicle
£50,000
2009-10
2012-13
2009-10
2012-13
Individual (PAYE)
£18,968
£20,214
£34,337
£35,781
Splitting income equally
between spouses(2)
£20,894
£22,747
£36,626
£39,067
Benefits from tax
planning
£1,926
£2,533
£2,289
£3,286
Individual (PAYE)
£18,968
£20,214
£34,337
£35,781
Retaining earnings in
company(3)
£21,920
£23,842
£39,932
£43,042
Benefits from tax
planning
£2,952
£3,628
£5,595
£7,261
Notes: (1) Incomes adjusted for assumed 5 per cent wage growth between 2009-10 and 2012-13; (2) Income split between two adults in the same
household; based on relevant personal allowances for the year; (3) Employees draw smallest salary to avoid income tax and NI payments
(£5,730 in 2009-10 and £7,605 in 2012-13) and leave remainder of earnings in company vehicle, retained earnings taxed under small business
rate as profits below £300,000.
It is important not to confuse tax rates with tax revenue and so rather than raising tax rates the emphasis
must be on strengthening the tax base and reducing the tax gap. Any additional tax revenues should be
raised through efficiency enhancing changes to the tax system. As Reform and the OECD have previously
argued the VAT base needs to be broadened.
The expensive system of pension tax relief is another potential area for reform. Any changes should be
developed in a way that is free from political whim and consistent with a set of principles (as saving for a
pension is a long term decision and requires a stable and certain tax environment). This means an open
process of consultation and robust scrutiny of policies. This also means that the potential for changes to
double tax pensions and the relatively high economic costs of taxes on savings (as opposed to, say, taxes on
consumption) must be recognised.
The squeezed middle and high pay
Since the early part of this Century the policy response to any squeeze on family incomes was to increase
government spending. Given the state of government accounts this is no longer possible. Some
commentators have said that this funding challenge can be reconciled through increased taxes on, or
reductions in relief for, higher income earners. But this continues to assume that the answer is increased
government spending.
Simply increasing spending without reform is a mistake. Take the example of childcare. Childcare in the UK
is expensive for parents and for the government too. The UK has the third highest level of spending on
formal childcare in the OECD. As funding for childcare has increased the costs have also increased.
Increased funding in areas like early years’ education has also not led to improved performance. There is a
risk that further funding will simply continue to drive up costs and insulate programmes from pressure to
improve. This highlights the importance of not confusing inputs (spending) with outcomes (such as
increased secondary participation of second earners).
There needs to be a recognition that incomes cannot always rise. Real incomes need to deflate to increase
the competitiveness of the economy. The risk is that in the face of this fall in real incomes families will look
to debt as a way to compensate for a fall in living standards, without realising that the fall in their income is
a permanent not cyclical change. In this case they will not be able to rely on future increases in wages and
capital gains in property to fund their increased indebtedness. The large increase in household debt
between 2000 and 2008 has meant that households are already vulnerable to changes in their economic
circumstances (such as losing a job or facing higher mortgage rates).
8
Some commentators argue that middle income families can be insulated from any squeeze on their incomes
through measures that target higher income earners. Yet there is a need to be cautious. These measures
could become own goals and actually increase the squeeze facing middle income families.

Reformers not spenders
Executive summary
The debate on high pay is becoming damaging. There is a need to focus on the specific policy problem and
clear facts. Commentators must not fall into the trap of thinking that making someone else worse off will
automatically make other people better off. There are benefits to high pay. High pay can help grow the tax
base which will increase resources available for spending, debt repayment and tax reductions.
High pay was also not the cause of the problems facing the economy. City pay is not responsible for the large
increase in spending from the late 1990s and the large increases in household borrowing. Further, a
number of financial services organisations that spectacularly failed (such as Lehman Brothers) had
coherent pay systems. The issues were elsewhere (such as banks and regulators mispricing sub-prime debt).
The problems were poor quality spending and poor financial regulation.
9
Reformers not spenders
1
Austerity is the new normal
The squeeze
Reform has argued that austerity is the new normal.1 Research by the Resolution Foundation has, for
example, shown that households’ net incomes have stagnated, with real household incomes for low to
middle income households being approximately the same in 2010-11 as they were in 2001-02.2 This squeeze
on low to middle incomes has several causes. A major longer term cause is increasing global competition
facing parts of the economy and labour market. In the shorter term inflation and the stagnation of real
wages are issues. It is often argued that fiscal consolidation is a key factor driving the squeeze on family
incomes yet inflation is a more serious concern.
The Coalition has set out to focus the burden of fiscal consolidation on higher income families. The
Treasury’s Distributional Impact Analysis in the 2010 Spending Review showed the changes will be borne
more heavily by upper quintile households.3 This is based on a view that these families are most able to
compensate for the loss of state support through private means.
There has been, however, debate over the degree to which this fiscal consolidation is progressive. Given that
the bulk of government spending goes to lower income families it appears that changes are naturally going
to more heavily fall further down the income distribution.4
Yet, as Reform has noted analysis often fails to account for the dynamic effects of fiscal consolidation. Too
much emphasis is placed on static estimates of measures like poverty, which fail to capture the importance
of behavioural change and a wider range of variables, such as food and fuel prices, in influencing the living
standards of low income families. The result is that the debate becomes too heavily dominated by measures
that emphasise existing spending through the tax and benefit system and assume that more government
spending is synonymous with fairness. The role of economic growth in providing resources for
redistribution is often ignored.5
Inflation plays a major role in shaping the purchasing power and living standards of low and middle family
incomes. The Office for Budget Responsibility has estimated that inflation (as measured by the CPI) will be
4.5 per cent in 2011, 2.7 per cent in 2012, 2.1 per cent in 2013 and 2.0 per cent 2014. Lower to middle
income households spend a large proportion of their disposable income on essentials (housing and fuel,
food and drink, and transport).6 The costs of these goods have increased faster than the overall increase in
the CPI.
Table 3: Price Inflation by Area (indexed, 2005 = 100)
Source: Office for National Statistics (2012), Detailed CPI and RPI reference tables
Year
Food, Alcohol
and Tobacco
Travel and
Electricity, Gas
Clothing and
Transport
and Misc. Energy Footwear Goods Services
CPI Overall Index
2005
100
100
100
100
100
2006
102.6
125.5
95.8
103.7
102.3
2007
106.9
135.5
92.1
109.2
104.7
2008
115
159.2
86
115.9
108.5
2009
120.9
173.7
79.2
122.2
110.8
2010
125.7
166.5
78.3
131.9
114.5
2011
133.7
181.7
80
144.2
119.6
1Haldenby et al. (2011), The long game, Reform.
2Whittaker and Bailey (2012), Squeezed Britain: The annual audit of low to middle income households, Resolution Foundation.
3HM Treasury (2010), Spending Review 2010.
4Nolan (2011), The fairness test, Reform.
5Nolan (2011), The fairness test, Reform.
6See for example Hirsch (2011), Priced Out, Resolution Foundation and Hirsch et al. (2011), Global influences on the cost of a minimum
living standard in the UK, the Joseph Rowntree Foundation.
10
Reformers not spenders
Austerity is the new normal
A relatively high rate of inflation combined with a weak labour market has to led to a low rate of growth in
real wages. The Office for Budget Responsibility has forecast growth in average earnings of 2.0 per cent in
2012, 3.1 per cent in 2013 and 4.3 per cent in 2014.7 Real average earnings are not, however, expected to rise
much more than prices before 2014. The weak labour market can be shown in the increase in the headline
unemployment rate (to 8.4 per cent) and long-term unemployment (to 854,000 in December 2011). The
headline unemployment rate is forecast to increase into 2013 but then fall.
Table 4: Growth in Average Earnings in Private and Public Sectors and CPI Inflation 2008 to 2011
Source: Office for National Statistics (2012), Consumer Price Indices – CPI annual percentage
change 1989 to 2011; Office for National Statistics (2012), Average weekly earnings – all sectors,
seasonally adjusted
CPI Rate, %
Change in Average
Weekly Earnings
(AWE), %
Change in Private
Sector AWE, %
Change in Public
Sector AWE, %
Jan-08
2.2
4.5
4.2
3.1
Jul-08
4.4
3.7
3.8
3.4
Jan-09
3.0
1.2
0.7
3.3
Jul-09
1.8
0.8
0.1
3.4
Jan-10
3.5
1.0
0.3
3.8
Jul-10
3.1
1.3
0.8
3.1
Jan-11
4.0
2.4
2.5
2.4
Jul-11
4.4
2.8
2.9
2.3
Note: AWE figures used are for total pay (includes bonuses)
This average change in real wage growth masks the different experiences of the public and private sectors.
Between July 2008 and January 2009 there was a large fall in the average wage growth in the private
sector. This rate of growth remained low until January 2011. In contrast public sector wage growth
remained strong until January 2011 and then fell but not as far as the fall in private sector wage growth. The
fall in real wages was thus largely felt in the private sector.
Table 5: Unemployment Rate
Source: Office for National Statistics (2012), Labour Market Statistics, February
2001
2011
2013 Forecast
2015 Forecast
Long Term Unemployment
(3 Months to December)
385,000
854,000
N/A
N/A
Headline Unemployment Rate
(3 Months to December), %
5.2
8.4
8.6
7.2
This pressure on real wage growth should not be seen as a temporary phenomenon. Many lower to middle
income jobs have become subject to global competition. This reflects an increasingly global labour market.
Employment for low and middle income workers tends to be concentrated in retail, health and social care,
manufacturing, construction, administration and support and hotels and restaurants.8
It is sometimes argued that increasing migration has put downward pressure on wage rates in these jobs.
This is, however, based on a lump of labour fallacy. Restricting migration to artificially raise wages will risk
reducing the competitiveness of employers in these sectors. In the face of global competition this fall in
competitiveness will mean businesses are likely to contract and employment fall.9
7HM Treasury (2011), “OBR central economic forecast,” Autumn Statement.
8Whittaker and Bailey (2012), Squeezed Britain: The annual audit of low to middle income households, Resolution Foundation.
9Haldenby et al. (2011), The long game, Reform.
11
1
Reformers not spenders
Austerity is the new normal
Labour participation and childcare
As well as changes in real wage rates, families’ incomes also reflect changes in how many family members
work. There has been particular concern that second earners in partnered households have reduced their
participation in the labour market. Between 2008-09 and 2009-10 (the most recent year for which data for
this series are publicly available) the average number of workers in families in deciles 6 to 10 (the richest
half) increased. In contrast families in deciles 2, 3 and 5 experienced reductions in the numbers of workers
while deciles 1 and 4 experienced little change. The reduction in participation was largely concentrated
among families in the bottom half of the income distribution. Additional Office for National Statistics data
on the labour market has shown that the employment rate for women aged 16 to 64 has continued to fall,
from 66.5 per cent in the final quarter of 2008 to 65.4 per cent in the final quarter of 2011.10
Table 6: Economically Active People in Non-Retired Households
Sources: Office for National Statistics (2011), The effects of taxes and benefits on household
income 2009-10; Office for National Statistics (2010), The effects of taxes and benefits on
household income 2008-09
Decile Group (Non-Retired Households
Ranked by Equivalised Disposable Income)
2008-09
2009-10
1
1.02
1.02
2
1.09
1.00
3
1.40
1.33
4
1.57
1.59
5
1.85
1.69
6
1.80
1.84
7
1.79
1.82
8
1.93
1.95
9
1.85
1.95
10
1.70
1.80
All
1.60
1.60
One reason identified for this fall in participation is the increasing cost of childcare.11 The OECD has shown
how formal childcare costs reduce returns to paid employment in the UK. The total effective tax burden
after childcare for a second earner is 88 per cent where one earner in the family earns less than average
earnings and is 68 per cent in a family where both earners earn 100 per cent of average earnings.12
Table 7: Childcare Costs
Source: Mulheirn and Shorthouse (2011), The parent trap: Illustrating the cost of childcare,
Social Market Foundation
Typical Childcare Costs Mid Financial Year,
£ per week(1)
Percentage Change Over Past 12 Months, %
2008-09
88.25
5.0
2009-10
92.49
4.8
2010-11
94.43
2.1
2011-12
98.61
4.4
2012-13
102.98
4.4
2013-14
107.54
4.4
2014-15
112.30
4.4
2015-16
117.27
4.4
Note: (1) Childcare costs claimed for by parents (based on HMRC Child and Working Tax Credit statistics)
10Office for National Statistics (2012), “Summary of employment, unemployment and economic inactivity for people aged from 16 to 64 ,
seasonally adjusted,” Labour Market Statistics, February. 11See for example, Kelly (2011), “Why the “squeezed middle” is here to stay,” The Observer, 22 May, Plunkett, J. (2011), The missing million:
The potential for female employment to raise living standards in low to middle income Britain, Resolution Foundation and Pearce, N.
(2011), “Why childcare spending makes economic sense,” Public Finance Magazine.
12OECD (2011), Doing better for families, OECD Publishing.
12
1
Reformers not spenders
Austerity is the new normal
Childcare in Britain is not just expensive for parents but is expensive for the Government too.13 OECD data
show that the United Kingdom spends more than 1 per cent of GDP on formal childcare, which is the third
highest rate among OECD countries.14 The problem is not a lack of spending but the quality of current
spending. Increased funding in areas like early years’ education has also not led to improved performance.15
It is important to understand the nature of the childcare problem as there is a risk that simply increasing
childcare funding (without improving value for money and performance) would simply drive costs further
up without benefitting families. It is important not to confuse inputs (spending) with outcomes (such as
increased participation of second earners). To illustrate, Table 8 combines data used in Table 7 with data on
spending on family benefits and the CPI. (Note that childcare spending is just one component in these data
on spending.) This shows that as spending increased over the period 2006-07 to 2010-11, childcare costs
increased at a rate greater than the rate of inflation. To address these costs there needs to be reform in key
areas, such as the cost of labour and regulation.
Table 8: Increases in Childcare Costs and CPI
Sources: Mulheirn and Shorthouse (2011), The parent trap: Illustrating the cost of childcare,
Social Market Foundation; Office for National Statistics (2011), Consumer Price Indices - CPI
annual percentage change 1989 to 2011; HM Treasury (2011), PESA, Public sector expenditure
on services by sub-function, 2006-07 to 2010-11
Family Benefits, Income
Support and Tax Credits, £
Billion
Percentage Change Over
Past 12 Months, %
CPI, %
2006-07
19.6
5.6
2.3
2007-08
20.4
4.6
3.6
2008-09
20.7
5.0
2.2
2009-10
21.3
4.8
3.3
2010-11
20.8
2.1
4.5
Household debt
Part of the squeeze now facing families reflects the high levels of borrowing and spending through the later
part of the last decade. There was a large increase in total gross debt in the UK (from 322 per cent of GDP in
2000 to 543 per cent of GDP in 2009) and in household debt (with household leverage increasing from 121
per cent to 161 per cent between 2000 and 2008). This large increase in debt effectively shifted
consumption from the future into the past.
13Daycare Trust and Save the Children (2011), “New survey shows soaring cost of childcare is pushing the poorest out of work and children
into poverty,” News release, 7 September.
14OECD (2011), Doing better for families, OECD Publishing.
15National Audit Office (2012), Delivering the free entitlement to education for three- and four-year-olds.
13
1
Reformers not spenders
Austerity is the new normal
Table 9: Household Leverage, 2000-2010
Source: Haldenby et al. (2011), The long game, Reform
Total Consumer Credit
Outstanding, £ Million
Average UK House Prices
(Seasonally Adjusted and
Adjusted for Inflation),
£ Thousands
Household Leverage
(Debt as a Proportion of
Household Income), %
2000
135168
109
112
2001
150802
115
116
2002
169209
129
127
2003
180649
158
138
2004
198856
178
151
2005
211038
190
154
2006
212835
195
166
2007
221687
204
173
2008
-
201
169
2009
-
168
161
2010
-
175
-
184
151
Change from
2000 to 2008 (%) 164
Note: For consumer credit the total percentage change over the period is based on the years 2000 to 2007
Families need to recognise that the squeeze on their incomes is not a temporary phenomenon. If families
believe that the squeeze is temporary they may try and maintain existing levels of consumption through
increasing borrowing. Borrowing for consumption is not a productive use of resources. Families cannot rely
on wage growth or capital gains in property to fund any increase in debt they are now accumulating. Instead
of greater borrowing they must reduce consumption.
Families also need to take greater responsibility for sorting out their finances. Aviva has shown that
finances are the second most taboo topic in families and that more families have satellite TV than health
insurance.16 Scottish Widows has also shown while “no money available” is the major obstacle to families
saving, this is a broadly equal objection across people working full-time and part-time and people in
full-time education. This indicates that this barrier relates to how families prioritise spending not just
earnings.17 Families also need to have more realistic expectations of the level of income and living standards
that they can expect. Many families fail to recognise how wealthy they are. Survey data show that people
often think they are middle income even if they are relatively well off. For example, in a 2009 YouGov
survey for the TUC as many as 60 per cent of those people in the top income quintile placed themselves in
or below the middle and even towards the bottom of the income quintile scale.18
There is a risk that when incomes come under pressure families reduce their savings and expenditure on
protection (such as insurance). This increases the vulnerability of these families to economic shocks to their
incomes. Many families are already living on thin margins and so would be very vulnerable to changes in
circumstances. Research has shown that 67 per cent of low to middle income families have less than one
month’s worth of income in savings and only 35 per cent of these families report that they were able to pay
bills and debts without problems.19 As the Consumer Credit Counselling Service has reported:
>8
per cent of households in Great Britain spend more than half their incomes on total debt
repayments.
>8.9
per cent of households are spending more than 25 per cent of household incomes on unsecured
debt repayments.
>The
average household pays nearly £200 per month in interest payments.
16Aviva (2012), The Aviva Family Finances Report January 2012.
17Scottish Widows (2012), Savings and Investment Report 2012.
18Lansley (2009), Middle income Britain survey for the TUC, YouGov. See also Bamfield and Horton (2009), Understanding attitudes to
tackling economic inequality, Joseph Rowntree Foundation.
19Whittaker and Bailey (2012), Squeezed Britain: The annual audit of low to middle income households, Resolution Foundation.
14
1
Reformers not spenders
Austerity is the new normal
>10.5
per cent of households are in arrears on any debt, with 14 per cent reporting that debt is a heavy
burden.
>In
the UK as a whole 20 per cent of mortgages have payment problems.20
Research from Shelter has shown that in the last year close to a million people used a high cost payday loan
to cover their rent or mortgage and a further 6 million used other types of credit such as unauthorised
overdrafts and credit cards.21 Research from R3 found that the number of households reporting debt
worries has grown by 20 per cent over the last year. 45 per cent of households now report that they struggle
to make it to payday.22
Deleveraging and its consequences
A recent McKinsey report highlighted the process that an economy should follow when reducing debt and
deleveraging.23 This report highlighted that the process of deleveraging is only just beginning in the United
Kingdom. In contrast the deleveraging process is more advanced in the United States.
Some limited paying off of debts has taken place. Bank of England data have shown that in December 2011
households in the UK increased their repayment of personal loans and credit card bills, with unsecured
loans falling from £216 billion to £207 billion between December 2010 and December 2011.24
There is a view that it would be wrong for families to reduce their exposure to debt. This view is incorrect for
a number of reasons. By reducing their exposure to debt families will reduce the costs of debt servicing. The
reduced costs of debt servicing do not fall in a simple linear way – debt becomes progressively cheaper as
families pay it off. With fewer borrowings families are likely to be able to access less costly debt.
It is also wrong to argue that debt fuelled spending will support consumption and create confidence to
invest. This argument ignores the fact that debts will have to be eventually paid. Rather than increasing
consumption the increase in debt will shift consumption from the future to the present and this will mean
that the incentives for investment (which depend on future consumption) are lower.
Reducing debt and consumption will also help the economy rebalance towards a model based on savings
and exports. As the Governor of the Bank of England, Sir Mervyn King, has noted, such a change is
necessary, especially given increasing global competition and an ageing population.25
Deleveraging and the government’s fiscal position
The Coalition is right to emphasise that the bulk of the fiscal consolidation should come from reductions in
spending. Evidence on OECD countries that have undertaken past fiscal consolidation exercises has shown
that placing a greater emphasis on cuts in social spending tends to increase the chances of reaching a level
of sustainable level of debt from consolidation.26
The Coalition’s plans are important as they are helping keep down the cost of borrowing. Using the primary
balance concept,27 even in a low growth scenario the UK will be able to service its own debt at manageable
levels.28 However, this is based on assumptions around the cost of debt in the UK. As 10-year bond yields
are currently low the UK is in a strong position to continue paying down debt. With a yield on a 10-year UK
Government Bond of 1.5 per cent the Coalition could run a small deficit and have sustainable debt. If the
bond yield was to increase to 3.0 per cent (the average rate over the last year) then the Coalition would need
to run a surplus, unless nominal growth is above the rate forecast by the Office for Budget Responsibility.
20Consumer Credit Counselling Service (2012), Debt and the regions report and Consumer Credit Counselling Service (2011), Consumer
debt and money report Q4.
21Shelter (2012), “Millions rely on credit to pay for home,” news release, 4 January.
22R3 (2011), Personal debt snapshot: “Zombie” debtors emerge, November 2011.
23Roxburgh et al. (2012), Debt and deleveraging: Uneven progress on the path to growth, McKinsey.
24Davies (2012), Credit Action Debt Statistics February 2012 Edition.
25See for example King, M. (2012), Speech at the Grand Hotel, Brighton, 24 January.
26OECD Economic Outlook (2007), Fiscal Consolidation: Lessons from past experience, OECD, Paris.
27The primary balance is the government’s net borrowing (deficit) or net lending position (surplus) corrected for interest payments on its
debt.
28Bencek and Klodt (2012), “The Kiel Institute Barometer of Public Debt,” http://www.ifw-kiel.de/think-tank/policy-support/The-KielInstitute-Barometer-of-Public-Debt%20, accessed 7 March 2012.
15
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Reformers not spenders
Austerity is the new normal
Table 10: Primary Surplus Requirements given Interest Rates and GDP (2011-12)
Sources: Reform calculations based on Bencek and Klodt (2012), “The Kiel Institute Barometer
of Public Debt”; European Central Bank (2012), “10-year bond yield statistics for EU Member
States”; HM Treasury (2011), Autumn Statement, “Nominal GDP growth rates and primary debt
ratio”
10-Year UK Government
Bond Yield, %
Nominal GDP Growth Rate Scenarios (%)
for 2011-12
2.75
3.0 (1)
3.25
1.5
-0.84
-1.01
-1.18
3.0
0.17
0.00
-0.17
5.5
1.86
1.69
1.52
14.0
7.59
7.43
7.26
Note: (1) Office for Budget Responsibility 2011-12 nominal GDP growth forecast
Table 11: Primary Surplus Requirements given Interest Rates and Office for Budget
Responsibility GDP Forecasts
Source: Reform calculations based on Bencek and Klodt (2012), “The Kiel Institute Barometer of
Public Debt”; European Central Bank (2012), “10-year bond yield statistics for EU Member States”;
HM Treasury (2011), Autumn Statement, “Nominal GDP growth rates and primary debt ratio”
10-Year UK Government Bond Yield,
%
2011-12
2012-13
2013-14
2014-15
2015-16
1.5
-1.01
-1.61
-2.60
-3.04
-3.17
3.0
0.00
-0.51
-1.46
-1.87
-2.01
5.5
1.69
1.32
0.46
0.08
-0.08
14.0
7.43
7.55
6.97
6.71
6.50
Note: All figures are based on Office for Budget Responsibility nominal GDP growth rates
However if yields on 10-year Government Bonds were to rise to 5.5 per cent (similar to current levels in Spain),
the Government would need to run a surplus in each year of the current Spending Review period. If yields
were to rise to 14 per cent (similar to current levels in Portugal) then the Coalition would need to run a primary
surplus higher than that currently required in Italy (above 5 per cent). This is considered to be the level at
which it is extremely difficult for a country to prevent its debt from increasing infinitely without haircuts.29
Long run growth not government spending
The previous Government largely aimed to increase families’ incomes through greater government
spending, such as Child and Working Tax Credits and childcare subsidies (such as employer sponsored
childcare vouchers). In the Resolution Foundation’s low-middle income group in 2009-10 around 23 per
cent of household income was made up of cash benefits, including tax credits, and between 2002-03 and
2008-09 tax credits accounted for £581 of total net income growth.30
Much of this spending had little to do with lifting the incomes of families in need. This spending was largely
motivated by a desire to use the tax and transfer system to attract votes. The squeezed middle is a powerful
voting lobby. In 2011, 5.8 million households (10.1 million adults) were defined as being in the low to
middle income group. The squeezed middle is a political concept that has little practical relevance for
designing policy. This concept hides considerable heterogeneity.
The approach of lifting incomes through spending is no longer possible given the poor outlook for the
public finances. This poor outlook is not just a short-term challenge but also reflects longer term changes
taking place. In particular, demographic changes mean that government spending on the welfare state will
increase significantly unless entitlement reform is undertaken. This approach also fails to recognise that the
source of these funds is often families’ incomes themselves (through the tax system). It also overlooks the
real causes of falls in family incomes and the arguments for allowing incomes to fall.
29Bencek and Klodt (2012), “The Kiel Institute Barometer of Public Debt,” http://www.ifw-kiel.de/think-tank/policy-support/The-KielInstitute-Barometer-of-Public-Debt%20, accessed 7 March 2012.
30Whittaker and Bailey (2012), Squeezed Britain: The annual audit of low to middle income households, Resolution Foundation.
16
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Austerity is the new normal
Families’ incomes change over time. Incomes may, for example, vary through a lifecycle, with families’
incomes potentially increasing as children get older (as primary earners progress in the labour market and
secondary earners are more able to work as children get older). As the Resolution Foundation has shown,
after 10 years 34 per cent of households in the low to middle income group remain in this group, 14 per cent
move down to a benefit reliant group and 52 per cent of households move up to a higher income group.31
The concern should not be with low incomes but with persistently low (and falling) incomes.
Much of the current debate is simply a lite version of the previous Government’s approach, with the default
solution being for government to spend more but to fund this with greater taxes on higher earners. But
these higher taxes risk reducing the tax base (or at least reducing the rate of growth of the base), meaning
there are fewer resources available for spending than otherwise.
Living standards should not be seen as static. Discussion on changes in families’ incomes often fails to
include a feedback loop between these incomes and the performance of the economy. This static view of
policy changes can fail to highlight the importance of change in a wider range of variables, such as inflation
and food prices, in influencing the living standards of low income families.32 Consider, for example, a
hypothetical cut in the generosity of a welfare policy that would increase labour supply and economic
growth. A static measure would only consider the change in the level of a transfer and so it is not surprising
that it would lead to an increase in measured poverty. Yet if the effect of the change on labour supply and
economic growth was also taken into account then the impact on poverty could be quite different.
The importance of economic growth can be shown by how a change in the rate of growth translates into a
change in GDP per capita. Forecasts for future economic growth vary widely. The most recent data from the
Bank of England contains the most positive outlook and would lead to an increase in per capita GDP of
£2,191 between 2011 and 2016. If, however, the UK was to fall back into recession, as predicted in the CEBR
forecasts, GDP per capita would fall by £108 (in real terms) and each household in the UK would be £872
worse off.
Table 12: GDP Growth Forecasts (%) and GDP per capita33
Sources: Office for Budget Responsibility (2011), Economic and Fiscal Outlook November 2011;
Bank of England (2011), Inflation Report November 2011; International Monetary Fund (2011),
World Economic Outlook September 2011; Centre for Economics and Business Research (2011),
“UK in recession already – base rates on hold till 2016”; Office for National Statistics (2011),
Statistical bulletin: 2010-based national population projections - principal projection and key
variants; Department for Communities and Local Government (2010), Live tables on household
projections, Table 401: Household projections, United Kingdom, 1961-2033
Bank of England33
International
Monetary Fund
Office for Budget
Responsibility
CEBR
2012
0.8
1.6
0.7
-0.4
2013
2.7
2.4
2.1
0.9
2014
3.3
2.6
2.7
1.0
2015
3.3
2.7
3.0
1.0
2016
3.3
2.7
3.0
1.0
GDP per capita 2011 £22,439
£22,439
£22,439
£22,439
Implied GDP per
capita 2016
£24,630
£24,267
£24,160
£22,331
Growth in GDP per
capita 2011 to 2016
£2,191
£1,828
£1,721
-£108
Growth in GDP per
household 2011 to
2016
£4,433
£3,596
£3,349
-£872
31After 15 years 32 per cent of households remain in the low to middle income group, 15 per cent move down into the benefit reliant group
and 54 per cent of households move up to the higher income group (Whittaker, M. and J. Bailey (2012), Squeezed Britain: The annual
audit of low to middle income households, Resolution Foundation.).
32Nolan (2011), The fairness test, Reform.
33Median Bank of England forecasts for GDP growth projections are based on Bank estimates of past growth and market interest rate
expectations and £275 billion asset purchases. GDP growth for 2015 and 2016 assumed to be the same as 2014.
17
Reformers not spenders
2
High pay is not the problem
Facts on pay
Politicians of all the major political parties are encouraging a debate on executive pay. Debate on this topic
is not new. Executive pay has been a source of controversy since the 1980s. Yet the facts are that in 2012
executive pay is growing less quickly or falling34 and businesses are starting to review their pay structures.35
Within the banking sector, for example, bonuses and overall compensation packages have been reported as
25 to 35 per cent lower this year compared to last year.36 Further, the CEBR forecasts (contained in annex
one in this report) show that following a fall in bonuses in 2011-12 of 38 per cent, bonuses will fall further in
2012-13 before starting to recover.
Published data on the level of executive remuneration is subject to wide interpretation. For example, one
source shows FTSE 100 CEO’s earnings in 2011 rising by an average of £3.8 million,37 while another shows
an average of £4.7 million.38 This is a difference of around 20 per cent. This difference illustrates the
difficulty in attributing an accurate value to CEO remuneration packages. Figures depend on the
components of a total earnings package, which may not only contain salary but also deferred bonuses, the
money value of any long-term incentive plan (LTIP) awards and the nominal gains on the exercise of any
share options issued. The way in which data are calculated and averaged also significantly affects the
accuracy of the statistics.39
High pay creates social benefits
There is a view that “excessive top pay is deeply damaging to the UK as a whole.”40 This view is often based
on the notion that inequality (as measured by the Gini coefficient) has risen in the UK. Yet these measures
are limited.41 If the world’s richest person was to move all of their resources to the UK then the Gini
coefficient would worsen (i.e., measured income inequality would increase). However, the extra taxes that
this person would pay in the UK would mean that the tax base is larger and UK tax revenue would increase.
No one would be any worse off and more funds would be available for repaying government debt, reducing
tax burdens or spending on goods and services. The worsening of the Gini coefficient would be of no
practical importance.
The importance of high pay to the tax base can be illustrated with HMRC data. In 2011-12 the highest
earning 50 per cent of tax payers are expected to contribute almost 90 per cent of all income tax revenue.
The very highest earners (the top 1 per cent of income tax payers who pay tax at the 50p rate) are expected
to contribute 28 per cent of all income tax revenue and the top 5 per cent almost half of all revenue.42
34A survey of employers suggests that businesses expect to raise executive pay by 2.7 per cent in 2012 and median pay is expected to rise
by 2.8 per cent (Hay Group (2012), Rewards in 2012). Based on 122 pay reviews the pace of salary growth for managers and professionals
is slowing (Income Data Services (2011), Executive Compensation Review).
35Respondents also suggested that they are looking to change the structure of pay by increasing or decreasing base pay (16 per cent of
respondents), improving the link between pay and performance (16 per cent), changing the type of benefits offered (15 per cent),
adapting bonus design (15 per cent) and altering pension arrangements (14 per cent). Within financial services the survey suggests 80
per cent of respondents are changing benefits or bonus schemes (Hay Group (2012), Rewards in 2012).
36City AM (2012), “Truth about banker pay: It’s falling”, 6 February.
37Income Data Services ((2011), “FTSE 100 directors get 49% increase in total earnings,” news release, October 26) and Income Data
Services ((2011), “SmallCap bosses earnings rise four times faster than workforce,” news release, 17 October).
38One Society (2011), A Third of a Percent.
39City AM (2012), “Meaningless numbers hinder meaningful debate over pay”, 20 February
40Hargreaves (2011). Cheques With Balances: why tackling high pay is in the national interest, High Pay Commission.
41Nolan (2011), The Fairness Test, Reform.
42HMRC (2011), Income Tax Liability Statistics, Survey of Personal Incomes.
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Reformers not spenders
High pay is not the problem
Figure 1: Share of Total Tax by Percentile Group
Source: HMRC (April 2011), Income Tax Liability Statistics, Table 2.4
45
1999-00
2011-12
Share of income tax revenue paid (%)
40
35
30
25
20
15
10
5
0
Bottom 25%
of earners
25-50%
50-90%
90-99%
Top 1%
of earners
Note: Data based upon the 2007-08 Survey of Personal Incomes using economic assumptions consistent with the Office for Budget
Responsibility’s March 2011 economic and fiscal outlook
To illustrate the importance of high pay Reform has also modelled the static effect of capping all incomes in
the UK at £1 million (resulting in all individuals with total earned taxable incomes above this level
migrating from the UK). With such a cap equality would improve. The Gini coefficient, which the Office for
National Statistics estimates at 38 per cent, would improve by 6.0 percentage points (back to the level of the
early to mid-1980s). However, this increase in equality would come at a static cost with income tax
revenues falling by £6.9 billion (4.5 per cent) and national income by £16.4 billion (2.1 per cent of the
income tax base). These costs are before accounting for any multiplier effects that would result from the
reduced number of top income earners. Further, these illustrative estimates are conservative and likely to
understate the loss of tax revenue and national income from the change.43
High pay did not cause the recession
There is a view that “the unjust rewards of a few hundred ‘masters of the universe’ exacerbated the risks we
were all exposed to many times over.”44 Yet high pay was not the cause of the problems the economy
currently faces.
High pay was not responsible for the fiscal deficit. Although the global financial crisis led to a fall in tax
revenues as a share of GDP (of equivalent to around two percentage points), the major driver of the deficit
was the large increase in spending. Between April 2000 and March 2006 total public spending increased by
4.8 per cent on average in real terms. Spending on public services increased at an average rate of 6.4 per
cent from April 1999 to March 2006.45 The deficit also cannot be attributed to the provision of financial
support for the financial sector.46 City pay was not responsible for the health budget doubling in real terms
between 1999 and 2011 and spending on social protection doubling in real terms from 1989 to 2009.
Further, high pay is not responsible for the demographic changes that mean that the UK’s welfare state,
which is already unaffordable, will become increasingly so.
The connection between high pay and the global financial crisis is often misunderstood. The financial
organisations that failed most spectacularly had relatively coherent pay policies. For example, the boards
and thousands of senior executives at Bear Sterns, Lehman Brothers, Merrill Lynch, Royal Bank of Scotland
and HBOS all held significant share holdings. The theory is that if board members and senior executives
43Nolan (2011), The Fairness Test, Reform.
44Compass (2009), “Compass launch campaign for a High Pay Commission,” news release, 17 August.
45IFS (2010), Public spending under Labour.
46This financial support has been excluded from the government’s main measures (such as net debt). The longer term impact of this
financial support is also likely to be minimal, particularly if the government’s stakes in the banks can be sold at a profit.
19
2
Reformers not spenders
High pay is not the problem
hold shares and subordinated debt in their institutions then they will have less incentive to make dangerous
bets to maximise short-term profits.47
The crisis was caused by the structure of banks’ balance sheets and not the structure of their pay.48 The
problem was that banks, funds and regulators all incorrectly measured the level of risk within the global
banking sector.49 To improve the financial sector the focus should thus be on the structural reform of banks.
If done properly these reforms would in turn lead to a market correction of pay in the sector.50
The banking sector should also not be seen as typical of executive pay. Supposed failures within the banking
sector are being used to justify greater regulation over remuneration more generally, although there has
been little careful analysis of whether and how existing compensation practices outside this sector have
been flawed.51,52
Rewards for failure?
There is a concern that executives are being rewarded for failure and that the link between pay and
performance has been broken. Many of the criticisms directed towards executive pay have expressed
concern over remuneration in failing companies (largely measured by a fall in share price). Yet when
making these criticisms it is necessary to assess whether share price is the main indicator of success or
failure and whether pay statistics that have been reported are accurate.
Measuring executive pay can be challenging given the complex structure that remuneration packages often
take. It is also difficult to correlate pay with criteria for a firm’s success. In particular, while the FTSE 100
has risen around 30 per cent since the start of 2009, total shareholder return (TSR) has risen by more than
this (47 per cent). Total shareholder return is a better measure of business success over time than share
price performance alone, as it better reflects how well a company has created long-term value. Total
shareholder return is also a more important metric for shareholders as it includes free cash flow, which is
the portion of company earnings that is paid out to investors via dividends.
Figure 2: FTSE 100 Share Price Performance and Total Shareholder Return (January 2009 = 100)
Source: Bloomberg, FTSE100_Index and TOT_Return_Index_Net_DVDS, accessed 7 March 2012
150
140
130
120
110
100
FTSE 100
90
FTSE 100 TSR
80
70
Jan
09
Mar May
09
09
Jul
09
Sep Nov
09
09
Jan
10
Mar May
10
10
Jul
10
Sep Nov
10
10
Jan
11
Mar May
11
11
Jul
11
Sep Nov
11
11
Jan
12
Mar
12
47Peston (2011), “Why Government can’t stop big bonus payments,” 7 January, http://www.bbc.co.uk/blogs/thereporters/
robertpeston/2011/01/why_government_cant_stop_big_b.html, last accessed 7 March 2012.
48Gregg et al. (2011), Executive Pay and Performance: Did Bankers’ Bonuses Cause the Crisis?
49Boys Smith (2009), A dangerous consensus: Where we are going wrong on banks and bonuses, Reform.
50Wolf (2011), “Why and how should we regulate pay in the financial sector?” The Future of Finance: The LSE Report, London School of
Economics.
51Core and Guay (2010), “Is there a case for regulating executive pay in the financial services industry?” The Wharton School, University of
Pennsylvania.
52Bhagat and Romano (2009), “Reforming Executive Compensation: Simplicity, Transparency and Committing to the Long-term,” Working
Paper, Yale University.
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Reformers not spenders
High pay is not the problem
Literature suggests that there is a stronger correlation between company size and chief executive pay than
there is between pay and company performance.53 Evidence also suggests that executive directors in firms
that exceed corporate targets are paid substantially more than those who merely achieve targets. The
difference grows in line with company size.54 The current criticism of executive pay does not account for
this. Evidence also suggests that realised pay (rather than that which is estimated based on the current
value of stock options) is highly related to performance.55 If company success is measured on profit growth
and total shareholder return (based on a three year average) then 80 per cent of FTSE 100 firms (based on
87 firms for which data is available) have remuneration policies which reward employees successfully
against performance.56 This is a higher percentage than that for similar sized samples in the US and
Germany.
Given the range of metrics used by large businesses to measure success it is difficult to choose which ones
should be used as a basis for determining executive pay. For example, there have been increasing calls for
the inclusion of non-financial targets in long-term incentive schemes, such as reduction in staff turnover,
meeting climate change targets and development pipelines. Most businesses report such key performance
indicators (KPIs) with some organisations already including them in their remuneration policy, particularly
for annual bonuses.57 These broader measures are generally overlooked in the criticisms of executive pay
that have been made in the media.
Rather than knee-jerk reactions the more fruitful approach is to consider the mechanisms used to
determine pay, i.e., how organisations measure improvements or success in ways which can guide payment
by performance. On this it is important to recognise that many companies are already increasingly using
Long Term Incentive Plans (LTIP) as a large component of corporate remuneration and implementing
deferral and drawback provisions. The advantage of such plans is that they could reduce potential for a
mismatch between incentives and pay.
A closed little club?
There has been concern that the way in which executive pay is set is a closed shop.58 Yet these concerns are
largely overstated. The majority of FTSE 100 directors sit on only one board and reciprocal board
membership occurs in just one case within the FTSE 100. Most cross-directorships were removed following
the introduction of the UK Corporate Governance Code independence criteria. In the wider FTSE All-Share
there are 98 remuneration committee posts held by currently serving executive directors of other FTSE
All-Share constituents. This is equivalent to 7.4 per cent.59
Table 13: FTSE 100 Cross-Directorships
Source: Manifest (2011), Crony Capitalism or Mass Hysteria?
Number
%
Sample of FTSE 100 companies analysed
97
Total number of directors serving at some time in year
1005
Number with one FTSE 100 directorship only
882
88
Directors on two FTSE 100 boards
105
10
Directors on three or four FTSE 100 boards
18
2
Executive directors on board of another FTSE 100 company (as a non-executive director)
52
5
…of which an executive director in turn serves on their board
0
0
…of which a non-executive director in turn serves on their board
1
0.1
53Farmer (2008), “Chief executive compensation and company performance: a weak relationship or measurement weaknesses?” 17th
EDAMBA Summer Academy, Paris.
54Deloitte (2011), Your Guide – Executive Directors’ Remuneration.
55Kaplan (2011), “Some Facts About CEO Pay and Corporate Governance,” University of Chicago, Booth School of Business.
56Obermatt’s Pay-for-Performance executive compensation and remuneration test for 2011 (<www.obermatt.com>, last accessed 7 March
2012). In the US this figure is 86 per cent (based on sample of 70 of the top 100 US stocks) and 77 per cent in Germany (based on a
smaller sample of 53 of the top 100 stocks).
57Local Authority Pension Fund Forum (2008), “Incentivising Executives, Non-Financial Performance and Executive Long Term Variable
Pay”, UN PRI Webinar.
58Hargreaves (2011). Cheques with balances: Why tackling high pay is in the national interest, High Pay Commission.
59Manifest (2012), “Executives on remuneration committees of other companies – drilling deeper,” http://blog.manifest.
co.uk/2012/01/5494.html, last accessed 7 March 2012.
21
2
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High pay is not the problem
Some cross-membership of boards is unavoidable. Rules for corporate governance in the UK control the
make-up of boards (at least half of a FTSE 350 company board should comprise independent non-executive
directors)60 which has shrunk the talent pool for board membership. Junior executives are often
encouraged to take on non-executive roles at other companies in order to broaden their experience. There is
no evidence that directors sitting on each other’s boards has significantly contributed to increases in
executive pay. Research in the United States indicates that board interlocks have had a negligible impact on
executive pay inflation.61
There is a perception that there has been a failure in corporate governance and shareholders do not have
sufficient power over pay. As the Deputy Prime Minister has argued: “Too often there isn’t enough
accountability. Shareholders don’t know what’s going on and how these decisions have been arrived at.”62
Yet shareholders already have the right to oppose pay policies. Shareholder groups and other stakeholders
in the investment and advisory community have their own guidance on the design of pay.63 Indeed, the UK
has been at the forefront of introducing directors’ remuneration reports and non-binding (i.e., advisory)
votes on pay, as specified in the Companies Act 2006, and evidence shows these powers are exercised.64
There is also concern over the diversity of the investor base and the length of time that shares are held. The
concern is that these features lead to a shareholder base that is not as active as investors would like. Even if
the position of shareholders was strengthened, e.g., through introducing a binding vote, it may prove
difficult to build a broad agreement among them. Shareholders may also be less willing to exercise a veto
than an advisory vote.65
Increasing shareholder power may not reduce growth in pay. Research suggests that at unlisted private
firms where owners have absolute control, top pay has risen at similar rates as at listed firms.66 Indeed,
government efforts to increase transparency over pay could actually drive up pay rates. Given the full
publication of remuneration reports it is easier for remuneration committees of an organisation to
benchmark CEO and executive packages against packages in the wider business environment. This can
result in a phenomenon known as the “Lake Wobegon Effect,” where similar companies choose to pay at or
above the average compensation of other CEOs in similar companies on the basis that their CEO is probably
above average and so should receive above average pay.67 The consequence of firms choosing to pay above
the median rate is that the median constantly rises. Even if pay structures were simpler this would still be
the case.
The global context
Pay not only reflects corporate governance but also factors such as market forces. Market forces appear to
have helped drive up the pay of CEOs and executives in many industries in both the public and private
sectors.68 Yet the Coalition Government and the Opposition have proposed a plethora of rules and controls
which would, if implemented, undermine the independence and competitiveness of large multi-national
businesses, in banking and the wider business community, running the risk of driving away investment and
talent from the UK. Unilaterally attempting to regulate bonuses in the UK will, for example, encourage
banks to place an increasing proportion of critical posts abroad.69
There is debate over the degree to which “pay must escalate in order to attract the best talent from
abroad.”70 However, the UK’s biggest firms are now multi-national organisations and global employers who
should be able to pay competitively to find the staff that they need. They also need to have the ability to
flexibly set levels of pay across all pay regions in which they operate and at each level of the organisation.
Given the wider scope of large firms they are inherently more difficult to manage and demand more
talented Chief Executives. The complexity and scale of modern companies has contributed significantly to
60Financial Reporting Council (2010), The UK Corporate Governance Code.
61Kim, Kogut and Yang (2011), Fat Cats or Best Athletes? Colombia Business School.
62BBC (2011), “David Cameron and Nick Clegg criticise directors’ ‘50% pay rise,” BBC, 28 October.
63Department for Business, Innovation and Skills (2011), Executive Remuneration: Discussion Paper.
64Shareholders of 15 FTSE firms protested in 2011 (up from 7 in 2010), as measured as a minimum of 20 per cent opposition to
remuneration reports or abstention (Independent (2011), “Investors staging record number of results,” 24 October).
65The Economist (2012), “Money for nothing,” The Economist.
66The Economist (2012), “Bosses under fire,” The Economist.
67Leblanc (2011), “Why CEOs earn 400 times average employee salaries,” http://www.yorku.ca/rleblanc/blog/?p=835, last accessed
7 March 2012.
68Kaplan (2011), “Some Facts About CEO Pay and Corporate Governance,” University of Chicago, Booth School of Business.
69Boys Smith (2009), A dangerous consensus: Where we are going wrong on banks and bonuses, Reform.
70Hargreaves (2011), Cheques With Balances: why tackling high pay is in the national interest, High Pay Commission.
22
2
Reformers not spenders
High pay is not the problem
the growth in executive compensation.71 The high concentration of large businesses in the UK means that
the number of people receiving high pay is relatively large.
As noted above it is important not to confuse pay levels in banks with pay in non-financial firms. There is no
question that executive pay in the banking sector appears to have been artificially high as banks were swept
along on a wave of rising asset prices, cheap money and high company leverage. Now that the bubble has
burst the system is readjusting.72 These changes, however, risk becoming counterproductive as banks need
to continue to reward staff appropriately within a global job market. Executive pay in Asia has already
passed European levels and is predicted to exceed US levels of executive pay by 2013, while pay in the
Middle East is already at European levels.73
More capitalism not less
There is a risk that the debate on executive pay and the distribution of wealth is distracting from the more
important question of what the country needs to do to encourage and generate more wealth and growth.
Attacks on business are harmful to entrepreneurs, small and medium-sized enterprises (SMEs) and large
businesses.
Some people argue that the financial crisis has shown the inherent instability of capitalism. This is not right.
The business cycle may be a feature of a capitalist system but the wilder fluctuations which we have
experienced stem from policy failures that led to a misalignment between the real rate of interest and
anticipated rates of return. If interest rates vary appropriately with rates of return, internal balance can be
maintained when rates of return change. But for interest rates to be free to move appropriately the
exchange rate must be free to move up and down. Indeed it is the freedom for a currency to appreciate and
depreciate that allows economic dynamism to be combined with some sort of overall stability.
However, two points are worth noting. First, quite prolonged periods of “stability” can be misleading and
this was certainly true during the Great Moderation. In the UK, Gordon Brown’s claims to have ended
“boom and bust” economic cycles have been seen to have been bullish.74
Second, within the overall stability of a properly functioning capitalist economy there will be considerable
instability in the sense that new firms will rise and others will die. Creative destruction is a feature of a
healthy economy.75 In the text book example the person that makes the new and better mousetrap will put
the old mousetrap maker out of business, even if the old mousetrap still functions. During the Great
Moderation everyone was a winner, borrowers and lenders, old mousetrap makers as well as new. Policy
makers should thus be wary of “stability” and of confusing “too much capitalism” with the policy mistakes
that caused the current crisis.
71Gabaix and Landier (2008), “Why Has CEO Pay Increased So Much?” Quarterly Journal of Economics, 123, pp. 49–100.
72New UK banking regulations require a larger capital base to be maintained while reducing the level of risk that banks are able to adopt.
This is causing banking revenue to fall, which is in turn suppressing the share price and forcing institutions to control payroll costs.
73Mercer (2011), “Global executive pay trends – Asian remuneration eroding West’s ability to attract scarce talent,” http://www.mercer.
com/press-releases/1427125, last accessed 7 March 2012.
74Haldenby et al. (2011), Off balance, Reform.
75Haldenby et al. (2011), The long game, Reform.
23
Reformers not spenders
3
Rescuing the public finances
Where the money goes
Health and education are the largest slices of departmental spending and account for 29 per cent and 15 per
cent of total departmental spending, respectively. The health budget has remained outside the value for
money agenda. Thus while budgets elsewhere will be frozen or face real terms cuts the health budget will
rise to 31 per cent of departmental spending by 2014-15.
Figure 3: 2011-12 Departmental Expenditure Limits
Source: HM Treasury (2011), PESA 2011 Section 1 – Budgets
Health
Health
Work
&
Pensions
Work &
Pensions
Education
Education
Ministry
Ministry
of Defence
of Defence
Home Office &
Ministry of Justice
Home Office &
Ministry of Justice
Transport
Other
Transport
Departments
Other
Departments
Figure 4: 2011-12 Annually Managed Expenditure
Source: HM Treasury (2011), PESA 2011 Section 1 – Budgets
Health
Health
Work &
Pensions
Work &
Pensions
Education
Education
Ministry
Ministry
of Defence
ofOffice
Defence
Home
&
Ministry of Justice
Home
Transport
Office &
Ministry of Justice
Other
Departments
Transport
Other
Departments
Annual Managed Expenditure is spending which cannot be planned and is largely demand driven. The
largest component of this is spending on social security benefits. Welfare currently represents around 57
per cent of the total spending on transfers.
24
Reformers not spenders
Rescuing the public finances
The Coalition’s fiscal consolidation
The reduction of the structural deficit is at the centre of the Coalition Government’s agenda. There has been
concern that the Coalition’s plans for fiscal consolidation (Plan A) may be cutting too much and too fast and
weakening the growth prospects for the UK. Yet there is clear evidence that countries with credible plans
that front load consolidation tend to return to long-term growth faster.76 While it is necessary to be cautious
when comparing international fiscal consolidation plans, given that the UK entered the recession with a
relatively high structural deficit there was a need for the country to go relatively far in its consolidation
efforts.
Table 14: Breakdown of Total Managed Expenditure (Nominal, £ Billion)
Source: HM Treasury (2011), Autumn Statement
Change,
%
Actual
Planned
2010 - 11
2011 - 12
2012 - 13
2013 - 14
2014 - 15
2015 - 16
2016 - 17
2010 17
TME
691.6
702.6
714.5
723.1
736.4
746.6
758.7
9.7
As % GDP
46.8
46.2
45.3
43.7
42.2
40.5
39.0
DEL
375.2
386.3
388.1
389.6
389.3
386.5
387.5
3.3
AME
316.5
317.3
326.5
333.5
347.1
360.1
371.2
17.3
Current
Receipts
551.4
575.5
594.4
623.6
657.4
693.5
735.2
Public
Sector Net
Borrowing
137.1
127.0
120.0
100.0
79.0
53.0
24.0
Public Sector
Net Debt
905.0
1,044.0
1,182.0
1,300.0
1,397.0
1,470.0
1,515.0
As % GDP
67.5
73.3
76.6
78.0
77.7
75.8
of which:
60.5
67.4
The Coalition Government’s plans for fiscal consolidation are reflected in two medium-term fiscal targets:
>To
balance the cyclically-adjusted current budget by the end of a rolling five-year period (currently
2016-17).
>For
public sector net debt to be falling as a percentage of GDP by 2015-16.
These fiscal targets differ from the targets that the Coalition originally set. A weakening of the outlook for
growth led the Coalition to revise its fiscal mandate. This is shown in table 15.
Table 15: Changes to Government Fiscal Targets for 2015-16
Sources: HM Treasury (2010), Budget 2010; HM Treasury (2011), Budget 2011; HM Treasury
(2011), Autumn Statement 2011
Budget 2010, % of
GDP
Budget 2011, % of
GDP
Autumn Statement
2011, % of GDP
Public Sector Current Receipts
38.7
38.4
37.7
Total Managed Expenditure
39.8
39.9
40.5
Cyclically-Adjusted Surplus on Current
Budget
0.8
0.8
-0.6
76OECD Economic Outlook (2010), Fiscal consolidation: requirements, timing, instruments and institutional arrangements, OECD, Paris.
25
3
Reformers not spenders
Rescuing the public finances
To reach these revised targets the Government plans a total consolidation of £126 billion a year by 2015-16,
consisting of total reductions in spending of £95 billion and a net increase in taxes of £30 billion. This
would cut public sector net borrowing by the equivalent of 8.4 per cent of GDP, from 9.9 per cent of GDP in
2010-11 to 1.5 per cent of GDP in 2015-16.
In the Autumn Statement 2011 the Government adjusted planned Total Managed Expenditure slightly
downwards and set plans for public spending for 2015-16 and 2016-17 in line with spending reductions for
the current Spending Review period. In line with this plan Total Managed Expenditure falls by 0.9 per cent
in real terms (though in nominal terms the budget continues to rise). As a percentage of GDP this
represents a fall from 46.8 per cent of GDP to 39.0 per cent of GDP by 2016-17, based on the Office for
Budget Responsibility forecast growth rates.
The scale of the Coalition’s fiscal consolidation should not be overstated. Although Total Managed
Expenditure is scheduled to fall in real terms and as a percentage of GDP during the current Spending
Review period, in money terms the budgets will increase by 9.7 per cent since the Coalition’s first budget in
2010.
The bulk of this growth will come from transfers, with departmental budgets growing by 3.3 per cent and
Annually Managed Expenditure growing by 17.3 per cent (in nominal terms). The increase in Annually
Managed Expenditure partly reflects the operation of the automatic stabilisers and partly policy decisions
(such as the increase in the generosity of the State Pension).77
The rate of consolidation outlined in the Coalition’s plan aims to reduce rather than just stabilise the debt to
GDP ratio. Reducing debt levels should help bring down interest rates on this debt.78 Reducing debt levels is
also important given the longer term outlook for the public finances given the changing demographic
outlook.
The long-term fiscal outlook
To illustrate the longer term outlook for the public finances Reform combined estimates of spending with
estimates for tax revenues and other spending. The resulting projections for the fiscal balance are shown in
figure 4. As with all long-term projections of this nature changes in the assumptions that underpin them
can lead to a material change in the projections. Nevertheless, the figure shows that, even with conservative
estimates, the overall outlook for the UK public finances is poor. Spending as a share of GDP is projected to
increase to 43.6 per cent by 2041. This is consistent with HM Treasury’s 2009 estimates that spending
would increase to 43.3 per cent of GDP by 2038.79 Indeed the Reform model estimates spending as a share
of GDP at 43.0 per cent for 2038.
77Cawston et al. (2011), Old and broke, Reform.
78To some extent, credible consolidation programmes can lower interest rates by reducing the risk of sovereign debt default and risk
premia on government securities (OECD Economic Outlook (2010), Fiscal consolidation: requirements, timing, instruments and
institutional arrangements).
79HM Treasury (2009), Long-term public finance report: An analysis of fiscal sustainability.
26
Reformers not spenders
Rescuing the public finances
Figure 5: The UK’s Long-Term Fiscal Outlook, 2011 to 2041
Source: Cawston et al. (2011), Old and broke, Reform
Year
2011
2016
2021
2026
2031
£20.0
2036
2041
46.0%
44.0%
£40.0
42.0%
£60.0
Cost as per cent of GDP
£0.0
Cost in £ billions
3
40.0%
£80.0
38.0%
£100.0
36.0%
£120.0
34.0%
£140.0
£160.0
32.0%
£180.0
30.0%
Fiscal balance (2007 reforms) (left hand axis)
Fiscal balance (2011 reforms) (left hand axis)
Spending share of GDP (2011 reforms) (right hand axis)
Revenue share of GDP (2011 reforms) (right hand axis)
These projections illustrate that even if the Coalition is to achieve its fiscal targets for its first term
significant reform will still be required. The challenge of rescuing the UK’s public finances has only begun.
As Reform argued in June 2010 the process of rescuing the public finances should not be seen as a task for a
single term of a Parliament.80
It is not surprising that, given the uncertainty that surrounds long-term fiscal projections, there are some
differences between these Reform projections and those of other researchers (such as the Office for Budget
Responsibility and PricewaterhouseCoopers).81 A key difference reflects the use of the current fiscal balance
in the Reform model versus the use of the primary budget balance by the Office for Budget Responsibility
(whose projections are the basis for the PricewaterhouseCoopers estimates). The current fiscal balance is
the measure most often reported and differs from the primary balance in that the primary balance excludes
interest payments.82
However, the differences in results are largely ones of timing and the overall messages are similar. Reform
shows the fiscal balance being broadly flat until around 2020 while the Office for Budget Responsibility and
PricewaterhouseCoopers show a small fall in net debt until the mid-2020s and then an increase in the debt
ratio. All studies argue that this will worsen so that the budget will be in deficit (Reform’s estimate, which
includes debt payments, is for 4 per cent by 2041). They also all note that these projections will be a floor for
spending so there will be little room to loosen future fiscal policy to respond to any major shocks.
This means that, under the Reform model, government accounts are projected to remain in deficit even
with an estimated increase in tax burdens from 35.5 per cent to 39.4 per cent of GDP in the three decades
from 2011 to 2041. A major reasoning for this worsening fiscal outlook is the increased spending on health
and social care and pensions given demographic and policy changes (such as the more generous indexation
of the State Pension). Under such a scenario public finances in the UK would not be sustainable as
governments would not run the surpluses required to stabilise debt. This is even before account is made for
dynamic effects of changes in policy settings, such as increases in tax burdens.
80Bassett et al. (2010), Budget 2010: Taking the tough choices, Reform.
81PricewaterhouseCoopers (2011), UK Economic Outlook July 2011, Chapter 4: “How sustainable are the UK’s public finances in the long
run?” and Office for Budget Responsibility (2011), Fiscal sustainability report.
82IMF (1995), “How should the fiscal stance be assessed?”, Guidelines for fiscal adjustment, pamphlet no. 49.
27
3
Reformers not spenders
Rescuing the public finances
Implications of slowing growth
The ability of the Coalition to meet its targets for fiscal consolidation also depends on growth. If growth is
lower than Office for Budget Responsibility forecasts then the Government will find it harder to meet its
fiscal target. To achieve the same reduction in Total Managed Expenditure with a lower growth scenario
government spending would need to be cut further or more tax revenue raised.
For every one percentage fall in growth as a share of GDP, over a 5 year period, the Treasury is
approximately £42 billion further away from their target of getting Total Managed Expenditure down to 39
per cent of GDP.83 This means that if the cumulative annual growth rate in GDP between 2011 and 2016 falls
to by half a percentage point the Treasury would be required to find an additional £21 billion in savings
across government departments. If the growth rate was to fall even further, say by 2 percentage points, then
additional savings of £84 billion would be required.
The bulk of the work in rescuing the public finances should come from reducing government spending. The
UK has been spending more than it has been collecting in taxation in practically every year for the last five
decades. In only 8 of the 52 years from 1964-65 to 2016-17 will the government have received more than it
has spent.84 While this problem is not new, since 2001-02 the gap has grown to large levels (peaking in
2009-10 when government spending exceeded receipts by £156 billion), reflecting the significant growth in
spending since 1998-99. The link between taxation and spending has been broken with the public
appearing to believe that ever increasing public services and welfare benefits can be made available to them
at little or no extra cost. Even under current plans government current receipts will still be lower than levels
of expenditure.
Implications of departmental ring-fencing
The Coalition has committed to protecting the budgets of some government departments. This shields them
from the need to innovate. The successes of the first 18 months of the Coalition Government are found in
those services subject to real terms budget cuts. In the areas of policing, justice and local government, real
change is being adopted following a process of rethinking and reforming to achieve policy goals. Conversely,
those services with protected budgets, such as health, are coasting or becoming less effective in their
delivery of public services.85
The average fall in nominal departmental resource budgets is 7.0 per cent between 2010-11 and 2014-15
(the period for which departmental breakdowns are available) and 8.5 per cent on annually managed
expenditure.86 These figures do not include changes in capital departmental expenditure limits. Resource
budgets in some departments are, however, set to rise in nominal terms over this period.
The average fall in budgets does not account for the relative size of these budgets. As some of the largest
budgets are protected from reductions (ring-fenced) the overall change in resource Departmental
Expenditure Limits is an increase in nominal terms of 2 per cent. Total resource Annually Managed
Expenditure increases by 3 per cent in nominal terms. Although these are increases in nominal terms they
imply reductions in real terms.
83
Reform calculations. These calculations do not include any feedback between Total Managed Expenditure and GDP.
84HM Treasury (2012), Public Sector Finances Databank.
85Bassett et al. (2012), 2012 Reform Scorecard, Reform.
86Excluding departmental budgets that have undergone structural changes in the way that they are composed and which skew the average
if included.
28
3
Reformers not spenders
Rescuing the public finances
Table 16: Plugging the Fiscal Gap by Reducing Major Ring-Fenced Budgets (nominal, £ Billion)
Source: Reform calculations based on HM Treasury (2011), Public Expenditure Statistical
Analysis, Tables 1.1 and 1.6
Current Spending
Plans 2011-12
to 2014-15, %
Nominal Change
Current Spending
Plans 2011-12 to
2014-15, £ Billions
2014-15 Spend
with total budget
increase(1),
£ Billions
2014-15 Spend
with 0% Increase,
£ Billions
Health Resource DEL
8.2
102.8 to 111.2
104.9
102.8
Health Resource AME
17.9
19.7 to 23.2
20.3
19.7
Education Resource DEL
4.9
51.5 to 54.0
52.5
51.5
Education Resource AME
15.5
11.9 to 13.7
12.2
11.9
202.1
189.9
185.9
Saving, £ Billions
12.2
16.3
Of Which, Health
9.2
11.9
Of Which, Education
3.0
4.4
Spending on these
Protected Budgets,
2014-15
Note: (1) 2 per cent for resource DEL and 3 per cent for resource AME
However, if spending on health was to grow at the average rate of growth of combined DEL and AME
spending in nominal terms, the health budget would increase by £9.2 billion less. If this budget was to
remain static in cash terms then the resources saved would be £11.9 billion. Likewise, if spending on
education was to grow at the average rate of growth of combined DEL and AME departmental spending in
nominal terms, the education budget would increase by £3.0 billion less. If this budget was to remain static
in cash terms then the resources saved would be £4.3 billion.
Implications of protecting low value for money in welfare
Further savings could also be made in the welfare budget. Some hard decisions have already been made on
this budget. Ministers have made significant savings on benefits such as the Housing Benefit in the face of
strong opposition. Efforts have also been made to reduce some of the cost of middle class welfare benefits.
This includes a proposed policy of withdrawing the Child Benefit from households that contain a top rate
taxpayer. This policy is more complex than necessary and risks undermining the principle of meanstesting.87 Poorly targeted pensioner gimmicks have not been addressed (although a temporary increase in
the Winter Fuel Allowance was allowed to expire).
Table 17: Plugging the Fiscal Gap by Reducing Middle Class Welfare (nominal, £ Billion)
Source: Reform calculations based on HM Treasury (2011), Public Expenditure Statistical
Analysis, Tables 1.1 and 1.6
Current Spending
Plans, % Nominal
Change
Current Spending
Plans 2011-12 to
2014-15, £ Billions
DWP Resource DEL
-0.7
7.8 to 7.7
DWP Resource AME
6.5
Spending, 2014-15
Saving, £ Billions
2014-15 Spend
with 3% Increase,
£ Billions
2014-15 Spend
with 0% Increase,
£ Billions
157.5 to 167.8
162.3
157.5
175.5
169.9
165.2
5.6
10.3
(1)
Note: (1) Resource DEL is assumed to fall in line with current plans
87See Cawston et al. (2010), The money-go-round, Reform. This complexity arises as the Child Benefit employs a definition of entitlement
based on the household while the tax system assesses liability on an individual basis. A simpler approach proposed by Reform and a
number of other commentators would be to remove the Child Benefit and to compensate lower income families through an existing
means-tested programme (the Child Tax Credit).
29
3
Reformers not spenders
Rescuing the public finances
Table 18: The Poor Targeting of Selected Benefits
Sources: Cawston et al. (2010), The money-go-round, Reform; Cawston et al. (2009), The end of
entitlement, Reform
Percentage of Spending on Middle
Percentage of Spending on Middle
and Higher Income Families (1998-99) and Higher Income Families (2008-09)
Maternity Pay
68
78
Child Benefit
32
43
Disability Living Allowance
22
33
Winter Fuel Allowance
N/A
31
Retirement Pension
16
24
Child and Working Tax Credits
N/A
22
Housing Benefit
4
11
Student Support
40
22
Yet the welfare budget is still forecast to increase by £10.2 billion in nominal terms between 2011-12 and
2014-15. This not only reflects the operation of the automatic stabilisers (with larger numbers of people out
of work leading to greater spending on out of work benefits), but population ageing and policy decisions,
such as the decision to increase the generosity of the indexation of the State Pension and to allow other
pensioner benefits to remain outside of the value for money agenda.
If spending on welfare was to grow at the average rate of growth of total departmental spending in nominal
terms the budget would increase by £5.6 billion less. If this budget was to remain static in cash terms then
the resources saved would be £10.3 billion. Much of these savings could be found by reducing spending on
middle class welfare. Reform has highlighted the large cost of middle class welfare. Spending on wealthier
households has been estimated at around £31 billion.88 Savings that could be made in this area dwarf
savings that could be made in other parts of the welfare budget. These savings could be made without
compromising the living standards of poorer families.
88See Cawston et al. (2010), The money-go-round, Reform.
30
Reformers not spenders
4
Strengthening the tax system
Tax revenues
The primary purpose of the tax system is to generate government revenue. As Ruth Richardson, former
Finance Minister of New Zealand, has noted this means that “no sensible debate can occur about tax
systems and their optimal design without the prior scrutiny of the level and the quality of state
expenditure.”89 This also means that revenue should be raised in a way that is least economically damaging
and consistent with ideas of fairness. Yet the global financial crisis has highlighted structural problems in
the UK tax system. The system has significant gaps in the tax base, rates are rising unevenly, and the tax gap
is becoming an increasing concern. The link between taxes and government spending has become broken
and politicisation and short-termism has increased complexity.
While there was a significant fall in tax revenues following the global financial crisis,90 between 2008-09
and 2010-11 tax revenues increased by £1 billion. This can be attributed to an increase in tax revenues from
VAT following the introduction of the 20 per cent rate. The Coalition plans for tax receipts to continue to
grow in line with GDP, representing over 36 per cent of GDP during this Parliament.91
Table 19: Forecast Net Taxes and National Insurance Contributions 2011-12 to 2016-17
Source: HM Treasury (2012), Public Sector Finances Databank
Cash, £ Billion
% of GDP
2010-11 (actual)
£518
35.2
2011-12
£554
36.4
2012-13
£571
36.2
2013-14
£599
36.2
2014-15
£631
36.2
2015-16
£664
36.0
2016-17
£702
36.1
Table 20: Corporation Tax Receipts by Industrial Sector (£ Billion)
Source: HM Revenue and Customs (2011), Corporation Tax Statistics, Table T11.1A
2000-01
2005-06
2009-10
2010-11
Change
2000-01 to
2010-11
Financial Services
11.3
11.2
5.6
7.2
-4.0
Distribution
3.9
4.3
4.8
5.7
1.7
Manufacturing
5.5
4.8
4.5
5.4
-0.1
North Sea Companies
2.3
7.3
5.6
7.3
5.0
Other industrial and commercial 9.8
14.3
15.3
16.5
6.7
Total net receipts of corporation
tax
41.8
35.8
42.1
9.7
32.4
Corporation tax receipts have risen in the ten years to 2009-10. The other industrial and commercial
category accounts for the largest share and largest increase in tax receipts. Financial services accounted for
the next largest share, although this share had decreased between 2000-01 and 2009-10. The common
claim the UK tax system had increasingly relied on tax revenues from financial services was not correct.
89Richardson (2012), “Seismic shifts in politics and policy,” in Seddon (ed.) (2012), The next 10 years, Reform.
90Total taxes were £21 billion less in 2008-09 than in 2007-08, which was equivalent to a fall of 2 per cent of GDP. Similar dips in receipts
can be seen during previous recessions in 1974-75, 1980-81 and 1991-92. Falls in tax revenue during a recession are a feature of the
automatic stabilisers that help to smooth the economy.
91HM Treasury (2012), Public Sector Finances Databank.
31
4
Reformers not spenders
Strengthening the tax system
The Coalition Government has emphasised that some of the burden of rescuing the public finances must
come from increasing tax revenues. The Chancellor of the Exchequer, George Osborne, has a ratio of 80:20,
where around 80 per cent of the consolidation comes from reductions in spending and 20 per cent from
revenue raising. Given this, if growth falls by half a percentage point then the government needs to raise an
additional £5 billion in revenue to remain on target (this is based on additional measures to reduce
spending by £20 billion). This is equivalent to 0.3 per cent of GDP and 0.9 per cent of tax receipts in
2011-12.
Value for money of tax cuts
Commentators on both the left and the right of the political spectrum have begun arguing that a weakening
of the fiscal position should lead the Government to introduce tax cuts. Yet the economic case for such a
position is weak.
Taxes can weaken consumption more than spending cuts as taxes reduce the spending that individuals and
households undertake while spending cuts reduce spending by government. In cases where individual
households have a better understanding of, and information on, their own wants and needs than central
government planners, lower taxes would usually lead to greater spending on goods and services that have a
real economic benefit.
Yet the need for a clearer and more transparent tax policy applies equally to changes that reduce tax
burdens as well as those that increase them. It is wrong to assume that tax cuts will always and everywhere
expand the tax base and be, at least partially, self-financing. Indeed, as Professor Arthur Laffer noted in a
2007 interview, “I’ve never said that all tax cuts pay for themselves” and “the Laffer curve should not be the
reason you raise or lower taxes. It is a consideration, but it’s not the reason.”92
This can be shown in the case of an increase in personal allowances. On top of the £1,000 increase to the
income tax personal allowance for 2011-12, the Government announced plans in the Budget 2011 to further
increase the income tax personal allowance by £805 to £8,105 in 2012-13, and to make further increases
towards a personal allowance of £10,000. As Reform showed in 2010 and 2011, the bulk of this relief
actually goes to people above the level of the personal allowance.93 In particular, the major beneficiaries of
this policy will not be those people who are its supposed target.94, 95
Further, this relief is unlikely to grow the tax base. For most people this poorly targeted tax relief only has
an impact on already earned income and does not improve the return from additional work. The
implication of this pattern of incentives is that for most people incentives to work are actually worsened and
not improved.96 The increase in personal allowances also increases incentives for tax avoidance and
evasion.
Introducing temporary tax cuts would also be a mistake. These tax cuts have been widely recommended as a
fiscal stimulus tool yet the evidence suggests that they are ineffective:97
>For
employment taxes, evidence suggests that tax subsidies have a very high deadweight cost, i.e.,
they subsidise firms for hiring workers that they would have hired anyway. Many firms also look
through the temporary nature of these cuts (as the hiring decision is largely permanent) and any
increase in employment tends to displace new employment elsewhere.
92Haldenby et al. (2011), The long game, Reform.
93Bassett et al. (2010), Reality check, Reform and Nolan (2011), The fairness test, Reform.
94As Nolan ((2011), The fairness test, Reform) showed, much of the benefit of this change goes to people who are above the threshold and
who are not often seen as being in the target group for these reforms. All of the spending on this change (based on a static analysis) goes
to individuals earning above the current level of the personal allowance. Of this total the large majority (£13.2 billion of £14.2 billion) goes
to people who are above the new personal allowance. Only £1 billion goes to people on individual incomes below £10,000.
95Replacing personal allowances with a tax free threshold would improve the targeting efficiency of this tax relief (although spill-over to
people not in need would still be high). Although a personal tax allowance and a tax free threshold may appear very similar, there is a key
difference in that an allowance reduces taxable income and then calculates tax paid while a tax-free threshold leaves taxable income
unchanged. In practice this difference means that a tax allowance provides more support to higher marginal rate taxpayers. Removing
personal allowances and introducing a tax free threshold of an equivalent amount would mean that no basic rate taxpayers would be any
worse off and that the revenue collected through the tax system (before accounting for behavioural changes) would increase. This
additional revenue could fund deficit reduction and the removal of more damaging taxes.
96It may be argued that, in the longer term, any changes to improve the incentives to work could mean that the fairness of this policy would
improve. Yet this policy would largely be damaging to work incentives. Only people with incomes between £7,500 and £10,000 would
experience a reduction in marginal tax rates, while these people (and all people on incomes over £10,000) would experience a fall in
average tax rates. This is important as a reduction in average tax rates can create an income effect which damages incentives to work (as
it is possible to reach a desired level of income at a lower level of work effort). In other words, for most people the change is “inframarginal” and will not improve efficiency.
97Haldenby et al. (2011), The long game, Reform.
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4
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Strengthening the tax system
>For
indirect taxes such as VAT, the evidence of impact is stronger although still weak overall. Other
factors have a much larger impact on price changes.
>Temporary
tax cuts could discourage investment because they increase uncertainty. As the
Chancellor of the Exchequer has argued: “A country with an almost double-digit deficit cannot add to
its deficit in the middle of a sovereign debt storm to cut tax, presumably on a temporary basis,
because you would have to then put it back up again to deal with the deficit.”98
One of the ambitions in the Treasury’s Plan for Growth is to create the most competitive tax system in the
G20,99 with the corporation tax rate for the UK set to fall to 24 per cent in 2013. It is argued that reductions
in corporate tax rates may (at least partly) fund themselves through growing the tax base. Yet a review of
the evidence suggests that arguments that the headline corporate rate needs to fall further misses more
critical issues regarding the taxation of businesses.100 The real issue with the UK’s corporation tax regime is
not an overly high headline rate. Rather, it is the lack of certainty caused by constant changes as well as
poor transparency that discourages investment and expansion. The unpredictability of UK tax policy and
the lack of consultation with stakeholders is damaging to the country’s reputation as a good place to do
business.
Broadening the tax base
Any increases in tax revenues should be raised in the least damaging way. A good rule of thumb for this is to
generate additional tax revenue through broadening tax bases rather than increasing rates. A broader base
would ensure that similar goods and activities are taxed in the same way. This approach would avoid the
economic costs associated with higher tax rates – taxes become more damaging as rates increase – and it
would allow for lower rates in the longer term. A broad base, low rate approach also tends to result in less
political interference as it is harder for governments to introduce tax policies targeted towards particular
groups.
A further way to raise revenue in the least damaging way is to shift the burden of taxation away from mobile
and productive elements of the economy, such as labour and capital. Consumption, particularly of goods,
will generally remain in the UK economy even if it is taxed. This means that consumption taxes are likely to
be a relatively reliable source of revenue and less likely to cause economic harm than taxes on income and
capital. Higher income taxes create disincentives to work and high marginal rates can discourage people
from working and earning more, as well as causing “mobility blocks.” Consumption taxes apply only to the
portion of income that is spent and do not create a direct disincentive to work. Increasing revenue from
VAT (through broadening the base) would be preferable to increasing the burden of income tax.101
VAT
Revenue from VAT in the UK is lower than the European Union average with only five EU-27 countries
generating less revenue as a percentage of GDP.102 The UK VAT is levied at a relatively high rate yet revenue
is low as the base is very narrow. The zero-rating and reduced-rating of VAT for certain items lead to a
substantial revenue loss. The economic costs created by these exemptions means that the UK’s
“C-efficiency” rate, which measures the efficiency of consumption tax systems, is one of the lowest (worst)
in the OECD.
HM Revenue and Customs estimates that almost £40 billion will be lost in 2011-12 from zero-rating and
reduced-rating items with food, the construction of new homes and domestic gas and electricity accounting
for the largest sources of lost revenue. Britain is one of only three EU countries to apply a zero rate to food
(with Ireland and Malta) and is only one of four G20 countries to do this. It is only one of three EU
countries to apply a zero or reduced rate to children’s clothes (with Ireland and Luxemburg), and is alone in
applying a zero rate to the construction of new homes (although other countries apply reduced rates). Only
seven member states have reduced rates for gas or electricity.103
98
The Daily Telegraph (2011), “George Osborne: we can lead our country out of this,” 30 September.
99HM Treasury and Department for Business, Innovation and Skills (2011), The Plan for Growth.
100Effective rates are more important than headline rates in terms of what companies actually pay. The actual taxes that businesses face
reflect the interaction of headline rates with other features of the tax system, such as allowances. Comparisons of different tax
jurisdictions cannot just be made on the basis of headline rates. Further, it is counterproductive to finance reductions in company taxes
through increasing taxes on internationally mobile labour. Competitive employment taxes are particularly important to businesses as
workforces are responsive to changes in taxation. Businesses will benefit from more competitive taxes on employment because they
need to attract mobile and talented workers.
101Bassett et al. (2010), Reality check, Reform.
102Eurostat (2012), Tax Revenue in the European Union.
103European Commission (2012), VAT rates applied in member states of European Union.
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Strengthening the tax system
Table 21: Broadening the VAT Base (Estimated Lost Revenue 2010-11 and 2011-12 Tax Years)
Source: HMRC (2011), Estimated costs of the principal tax expenditure and structural reliefs
2010-11, £ Million
2011-12, £ Million
Food
13,450
15,700
Construction of new dwellings(1)
5,000
6,250
2,750
3,200
International passenger transport
150
200
Books, newspapers and magazines
1,450
1,700
Children’s clothing
1,350
1,550
Water and sewerage services
1,650
1,900
Drugs and supplies on prescription
1,950
2,300
Supplies to charities
200
250
Ships and aircraft above a certain size
500
600
Vehicles and other supplies to disabled people
500
550
Domestic fuel and power
4,550
5,450
Certain residential conversions and renovations
200
250
33,700
39,900
Zero-rated items
Domestic passenger transport
(1)
(1)
Reduced-rated items
Estimated total
Note: (1) These figures are particularly tentative and subject to a wide margin of error
Many commentators believe that taxing consumption hurts poorer families most, since a greater proportion of
their income is spent on consumer goods and services than that of the rich. This argument suggests that
broadening the base to include items such as food and children’s clothes would hit the poor particularly hard.
Yet zero-rating and reduced rating of items is of much less benefit to the lowest income families than often
expected. As the IMF has argued, reduced rates and exemptions are “inherently limited as distributional
devices: even if the poor spend a larger proportion of their income on some item, the better off spend
absolutely more.”104
Rather than inefficiently trying to use the VAT system to help the poorest, an increase in benefits could
offset the regressive effects of broadening the VAT base. Reform has calculated that the Government could
scrap the zero and reduced rates of VAT while compensating the poorest and still raise approximately
£15 billion extra revenue.105
Wealth taxes
There is increasing interest in introducing additional taxes on wealth to broaden the tax base. It is
important to recognise, however, that the UK already has a range of wealth taxes that are applied on
transfer of assets. These include:
>Capital
Gains Tax: This is charged if a gain is realised on disposal of an asset. Annual gains above a
current exempt amount of £10,600 per individual are taxable at 18 per cent or 28 per cent. The lower
rate is levied for total taxable gains for taxpayers below the upper limit of the basic rate of income
tax.106 In 2010-11 Capital Gains Tax raised £3.6 billion in revenue for the Treasury. The estimated tax
gap is £300 million.
>Inheritance
Tax: Levied at a flat rate of 40 per cent on estates above a prescribed threshold (£325,000
since April 2009). Gifts to charities and spousal transfers are exempt, as are certain property
classifications and trading businesses. Gifts to individuals are also exempt if the donor survives the gift
by seven years. Typically inheritance tax is paid using funds from the deceased’s estate. In 2010-11,
inheritance tax raised £2.7 billion in revenue for the Treasury. The estimated tax gap is £50 million.
104IMF (2011), Revenue mobilisation in developing countries.
105Bassett et al. (2010), Reality check, Reform.
106The 28 per cent rate was introduced in 2010 by the Coalition Government as a concession to the Liberal Democrats who had promised a
rise to 40 per cent as part of their 2010 general election manifesto.
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Strengthening the tax system
>Stamp
Duty Land Tax: Payable on the purchase or transfer of property or land in the UK. This tax is
based on a range of thresholds. The highest rate is 5 per cent on properties over £1 million. Relief is
currently available in a range of circumstances, including charities and zero-carbon homes. In
2010-11, Stamp Duty Land Tax raised £8.9 billion in revenue for the Treasury. The estimated tax gap
is £250 million.
>Council
Tax: Cook (2012) estimates that Council Tax of £27 billion will be charged in England in
2011-12.107 This tax is set at local authority level to raise taxes for local government services. There
are currently eight council tax bands. The Coalition’s policy of freezing council taxes and any
attempts to change bands would go against principles of localism. Revising bands would require
councils to review the value of housing assets.
These wealth taxes do not only impact on the wealthiest families. The rise in owner-occupation of property
since the early 1980s was accompanied by a rise in house prices (house price growth outstripped income
growth). As a result property wealth in the UK increased significantly, particularly amongst older
generations. Since 2001 alone the value of housing stock in the UK has increased by 84 per cent or £68,500
per household,108 with 68.5 per cent of all main residences in the UK being owned either outright or with a
mortgage.109 Although mortgage balances have doubled during this period, the value of housing assets has
outstripped this growth in debt. As a result, housing equity (value of housing assets minus the total value of
outstanding mortgage balances) is currently £2.1 trillion.110
There is a commonly held view that the wealthiest families routinely avoid these wealth taxes through the
use of corporations, trusts and holding vehicles for both their assets and income. The wealthiest are able to
seek advice on how to protect their wealth through complex arrangements to reduce their income tax
liability and circumvent taxation on the sale or transfer of assets.111 Individuals may, for example, be able to
move property “offshore” or to transfer the ownership of property from the individual to a company.112
However, it is important to not overstate avoidance of wealth taxes. Indeed, HMRC data indicate that the
tax gap for wealth taxes is lower than for other taxes.
One specific form of additional wealth tax that has been proposed is a “mansion tax” (a tax on high value
residential property). Yet as Cook (2012) argued, introducing additional taxes on high value residential
property would be very complex to administer and collect. Reasons include the lack of “comparative
transactional evidence” and the wide range of factors (some of which are intangible) in determining an
individual property’s value. Such a tax would thus generate a relatively small amount of revenue and risk
causing significant damage to the UK tax system.113 Introducing such a tax would also raise practical
difficulties – with the tax base and liability likely to be assessed locally but the revenues presumably paid to
HM Treasury.
Pension tax relief
Reform to the system of tax relief for pension fund contributions could provide an opportunity for
efficiency-enhancing base broadening. Tax relief is currently provided on contributions to pension funds.
Relief is also provided for a one off draw down of a lump sum of up to 25 per cent of the value of the fund
when it matures. Figures from the Pensions Policy Institute suggest that total tax relief on private pensions
is over £39 billion or 2.8 per cent of GDP (the net cost of tax relief is estimated at £30 billion or 2.2 per cent
of GDP).114 However the UK’s savings rate remains below many other developed countries, with only 37 per
cent of working age women and 42 per cent of working age men currently accruing a non-state pension.115
Tax relief on pensions is complicated by the other pension entitlements, such as the Pension Credit, other
social security means-tests, and frequent changes in its design.116 Yet specific tax concessions can also add to
the complexity of the tax system, increase administration and compliance costs, and undermine the
system’s overall fiscal integrity (for instance, once one particular group is provided with a concessionary
treatment, it is hard not to introduce concessionary treatment for other groups). Specific tax concessions
are poor value for money, provide little support for the people of most concern and are unlikely to have a
107Cook (2012), Taxing mansions: the taxation of high value residential property, Centre for Policy Studies.
108Halifax (2012), “Value of UK Housing soars by £1.8 trillion in last decade,” news release, 11 February.
109Office for National Statistics (2011), Wealth in Great Britain: Main results, 2008-10.
110Halifax (2012), “Value of UK Housing soars by £1.8 trillion in last decade,” news release, 11 February.
111HM Treasury (2011), General Anti-Avoidance rule study: final report.
112This reduces stamp duty liability to 0.5 per cent rather than the 5 per cent that would be levied on properties over £1 million.
113Cook (2012), Taxing mansions: the taxation of high value residential property, Centre for Policy Studies.
114Pensions Policy Institute (2011), Pension Facts.
115Pensions Policy Institute (2011), Pension Facts.
116Bassett et al. (2010), Reality check, Reform.
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Strengthening the tax system
substantial effect on increasing national savings rates. They are likely to damage the integrity of the tax
system and cannot remain outside the value for money agenda.
Any changes to pension tax relief should be developed in a way that is free from political whim and
consistent with a set of principles. This is especially important for pensions as saving for a pension is a
long-term decision and requires a stable and certain tax environment. This means an open process of
consultation and robust scrutiny of policies. This also means that the potential for changes to double tax
pensions and the relatively high economic costs of taxes on savings (as opposed to, say, taxes on
consumption) must be recognised.
The tax gap
The tax gap is the difference between the tax collected and the theoretical liability (amount that should be
collected). The tax gap arises from fraud (such as tax credits), error (lack of understanding of the rules),
anti-avoidance (artificial structures for the sole purpose of avoiding tax) and the hidden economy (workers
not registered or failing to declare all sources of income).
HMRC first published an estimate of the total UK tax gap in December 2009 as part of the Pre-Budget
Report and further updates have been released annually. Estimates of the tax gap require care in their
calculation and interpretation.117 The estimated tax gap for 2009-10 was £35 billion or around 8 per cent of
total revenues collected. These data are subject to debate and have been seen as potentially understating the
scale of the tax gap.118 Nevertheless, looking at HMRC data in more detail shows that:
>Inaccurate
returns from individuals and indirect taxes like VAT make up the biggest proportion of
the tax gap.119
>The
>When
share of the tax gap which could be attributed to corporation tax, especially of large and very
large businesses, was relatively small.
considered by customer group, around half of the 2009-10 tax gap can be attributed to SMEs,
with around a quarter from Large Businesses.120 The remainder is split fairly equally between
criminals (17 per cent) and individuals (11 per cent).
Table 22: Breakdown of the Tax Gap (£ Billion)
Source: HMRC (2011), Measuring tax gaps 2011, Official Statistics Release, HMRC
Point Estimate, £ Billion
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
Income Tax, National Insurance
Contributions, Capital Gains Tax
13.5
12.4
13.3
13.9
13.9
14.5
Value Added Tax (VAT)
9.7
13.1
12.1
11.6
14.6
11.4
Corporation Tax
5.8
5.2
5.3
4.7
5.0
4.8
Of which, very large and large
businesses
2.3
2.2
2.2
1.3
1.3
1.2
Excise Duties
4.5
4.1
4.6
4.3
4.3
3.8
Other Direct Taxes
1.2
1.3
1.6
1.6
0.9
0.6
Total Tax Gap
35
36
37
36
39
35
117As Mazur and Plumley noted, for example, estimates of the tax gap may be influenced by uncertainty about the true liability imposed by
the tax code (and differences in interpretation of this code) and difficulties in collecting information (Mazur and Plumley (2007),
“Understanding the Tax Gap,” National Tax Journal, Vol. LX, No. 3).
118See, for example, Malry (2010), “The four fatal flaws in ‘Why HM Revenue & Customs have got the Tax Gap wrong’”, FCA Blog, http://
www.fcablog.org.uk/2010/07/the-four-fatal-flaws-in-why-hm-revenue-customs-have-got-the-tax-gap-wrong/, last accessed 7 March
2012.
119VAT accounts for a significant proportion of the tax gap. As HMRC note two key concerns regarding the VAT tax gap are VAT debt (the
amount of VAT declared by businesses but not yet paid to HMRC) and missing trader intra-community (MTIC) fraud (HMRC (2011),
Measuring Tax Gaps 2011, p. 20).
120HMRC argue that a number of assumptions have been used, which may mean the estimate for Large Businesses has been overstated
and the estimate for SMEs understated (HMRC (2011), Measuring Tax Gaps 2011, p. 11).
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Strengthening the tax system
Table 23: Breakdown of the Tax Gap (per cent lost per tax)
Source: HMRC (2011), Measuring tax gaps 2011, Official Statistics Release, HMRC
% Tax Gap
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
Income Tax, National Insurance
Contributions, Capital Gains Tax
6.2
5.4
5.4
5.2
5.2
5.8
Value Added Tax (VAT)
11.7
15.2
13.5
12.4
15.5
13.8
Corporation Tax
14.7
11.1
10.6
9.3
10.3
11.7
Excise Duties
8.6
7.8
8.6
7.7
7.7
6.5
Other Direct Taxes
8.4
7.2
7.5
7.5
6.5
4.9
Total Tax Gap
8.5
8.3
8.0
7.4
8.1
7.9
Of which, very large and large
businesses
HMRC uses a bottom-up approach to produce estimates of the tax gap for direct taxes.121 HMRC estimates
the total tax gap for Income Tax, National Insurance Contributions and Capital Gains tax at £14.5 billion in
2009-10. This is equivalent to 41 per cent of the overall tax gap.122 The HMRC data also show that:
>Around
>Around
>In
30 per cent of self-assessment returns have under-declared tax liability.
12 per cent of self-assessment returns had an under-declared liability of £1 to £500, 5 per
cent had £501 to £1,000 and 14 per cent had under-declared liabilities of over £1,000. For business
taxpayers who submitted self-assessment returns the figures were higher: 46 per cent of returns
submitted by business taxpayers under-declared their true tax liability, 24 per cent under-declared
their liability by over £1,000, 8 per cent by £501 to £1,000 and 15 per cent by up to £500.123
2008-09 (the year of the most recent data) 24 per cent of small and medium sized employers were
found to fail to meet PAYE scheme obligations. Of this, 13 per cent had under-declared liability of £1
to £1,000 and 11 per cent had under-declared liability of over £1,000.124
The Government is right to set out to reduce the tax gap. Closing the gap could support growth, help
allocate the burden of taxes in a fairer way and generate tax revenue in a stable way.
>Closing
the tax gap could mean that business decisions are based on prospects for growth,
employment and exports, rather than the opportunity to exploit loopholes. Activity directed to
exploiting tax loopholes is, from a national perspective, unproductive.
>Fairness
>The
could also increase as tax burdens would be allocated in a less arbitrary way.
extra tax revenue generated from closing the tax gap could support deficit reduction and future
reductions in taxes.125
The Coalition has been considering a general anti-avoidance rule (GAAR) to help close the tax gap. Yet a tax
gap is to some degree inevitable, and trying to reduce the gap is not a costless exercise.126 It is not simply a
question of “finding a way to get bankers and multinationals to pay their fair share of taxation.” There has
been high profile concern that a number of larger corporations are able to avoid corporation tax but, as
Worstall (2011) outlined, the facts on these cases tell a different story. His arguments on three high profile
cases are summarised below:
>Vodafone
(a UK company) has been criticised for not paying £6 billion of tax on the profits made by
its German operations. Calculations must recognise the fact that Vodafone had paid the relevant tax
121HMRC (2011), Measuring Tax Gaps 2011, p. 34.
122HMRC (2011), Measuring Tax Gaps 2011, p. 37.
123HMRC (2011), Measuring Tax Gaps 2011, p. 40.
124HMRC (2011), Measuring Tax Gaps 2011, p. 42.
125It is also important to note that each pound of uncollected tax does not directly equate to one pound less spending on public services.
While tax avoidance is not to be advocated, paying less in tax may increase spending power which generates tax revenue elsewhere.
126Efforts to reduce tax avoidance and evasion may, for example, incur unacceptable administration, compliance and economic costs or too
heavily infringe on taxpayers’ privacy and rights.
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Strengthening the tax system
required in the countries in which the subsidiaries were operating.127
>Boots
(a Swiss company) has been criticised for not paying taxes on its UK profits. Yet this reflects
the level of debt of the company and the deductible nature of the interest on this debt. Failing to treat
interest as deductible would increase the cost of borrowing and hold back company investment and
growth.128
>Barclays
(a UK company) has reduced its corporate tax bill by offsetting losses made in previous
years. Taxes are paid on companies’ profits and losses over time, so that corporation tax is paid only
on total profits and not on an artificial division of profits into any one year.129
Data on the tax gap highlights that closing the gap should not only require a focus on larger companies and
high wealth families but on the activities of small to medium enterprises and many families. The entire tax
system needs to be simpler and less open to abuse.
How the Coalition has increased incentives for tax avoidance
The Coalition has increased incentives for tax avoidance. By introducing high and variable tax rates the
potential rewards from tax avoidance have been raised. This is particularly the case for families that own
small businesses. Incentives have been increased by policies such as the 50p tax rate, the clawback of
personal allowances and of pension tax relief, reduction in company tax and increased personal allowances.
It is important to note that the ability to avoid tax will largely depend on personal circumstances, yet recent
policy changes have clearly reduced the integrity of the income tax system.
Personal allowances create a major hole in the direct tax base. A key component of the Coalition’s agenda
for fairness is to increase the level of the personal tax allowance to £10,000. However, the actual effects of
this policy are likely to differ from those commonly assumed. Not only would the major beneficiaries of this
policy not be those people it is supposed to be helping but it would also create incentives to split income
between family members to make multiple use of personal allowances. As the level of the personal
allowance increases the incentives to engage in tax avoidance also increase.
There is evidence that the use of personal allowances for tax avoidance purposes is relatively common.
Based on HMRC data for 2006 there are close to 800,000 individuals with total earned taxable incomes of
below £1, and just under 10 million individuals with total earned taxable incomes of between £1 and £6,475
(the level of the personal allowance in that year). Given that there are a total of 40,695,011 people with tax
records in the UK, this means that close to one quarter of these people earn between £1 and the level of the
personal allowance. There is little economic explanation for the income distribution having such a large
mode at around this income level. This suggests evidence of tax planning with, for example, families who
are able to manipulate their taxable incomes effectively making multiple use of personal allowances by
paying out income from their businesses to different family members. The potential use of personal
allowances for income splitting purposes can also be shown by the difference in the measured poverty
incidence and living standards of children in self-employed families.130
To illustrate the increase in incentives for tax avoidance two hypothetical approaches to minimising a
family’s income tax bill are shown in the table. One example relates to the use of personal allowances and
another relates to the use of a company as a holding vehicle for income.
127The Controlled Foreign Company (CFC) rules require UK companies to pay tax on the profits of foreign subsidiaries. This is to stop
companies relocating their profits to tax havens. CFC rules also, however, recognise the tax paid in foreign jurisdictions. Failing to do this
would mean that profits would be subject to double taxation. Thus, rather than £6 billion of tax (based on £18 billion in profits and a
corporation tax of approximately 30 per cent), the tax at stake was the difference between the German and UK tax, closer to the £1.25
billion Vodafone paid to HMRC (Worstall (2011), UK Uncut Unravelled, Institute for Economic Affairs).
128The international takeover of Boots was funded by debt (borrowing against the asset value of the various companies that were merged). A
large amount of interest had to be paid on the money that was borrowed. Interest that is paid out is a cost of doing business and is
therefore not part of a company’s profit. This interest is thus deductible from profits and so reduces the company’s tax. Failing to treat
interest as deductible would increase the cost of borrowing and hold back company investment and growth. Further, while the
deductibility of interest reduces corporation tax, these interest payments are taxed in the hands of the people who receive them. The
overall revenue loss to the Exchequer will thus be less than the reduction in company tax (Worstall (2011), UK Uncut Unravelled, Institute
for Economic Affairs).
129It has been reported that although Barclays has reported £11 billion in profits it has only paid £100 million or so in corporation tax. Taxes
are paid on companies’ profits and losses over time, so that corporation tax is paid only on total profits and not on an artificial division of
profits into any one year. A similar thing is done within a company – if one part of a company is losing money then we net that off against
another part that is making a profit. Banks lost large amounts of money in the 2008 crash and so had tax losses which they could carry
forward into the next tax year. If we did not allow a company to offset previous losses against profits, a company that has a steady profit
stream would be taxed much less than one which had a variable profit stream. Yet of this £11 billion in profits £7 billion was not taxable
due to the Substantial Shareholding Exemption (SSE). If a company sells a subsidiary, or a substantial part of one, then no tax is payable
on any profits from doing so. There are two major reasons for this. This allows companies to reorganise themselves without having to
worry about the tax implications of doing so. This also makes it near impossible to claim a tax deduction on a loss when a subsidiary is
sold (Worstall (2011), UK Uncut Unravelled, Institute for Economic Affairs).
130Nolan (2011), The fairness test, Reform.
38
4
Reformers not spenders
Strengthening the tax system
Table 24: Impact of Tax Arrangements on Net Pay
Source: Reform
Gross Income Levels(1)
£26,000
Income
Splitting
Company
Vehicle
£50,000
2009-10
2012-13
2009-10
2012-13
Individual (PAYE)
£18,968
£20,214
£34,337
£35,781
Splitting income equally
between spouses(2)
£20,894
£22,747
£36,626
£39,067
Benefits from tax
planning
£1,926
£2,533
£2,289
£3,286
Individual (PAYE)
£18,968
£20,214
£34,337
£35,781
Retaining earnings in
company(3)
£21,920
£23,842
£39,932
£43,042
Benefits from tax
planning
£2,952
£3,628
£5,595
£7,261
Notes: (1) Incomes adjusted for assumed 5 per cent wage growth between 2009-10 and 2012-13; (2) Income split between two adults in the same
household; based on relevant personal allowances for the year; (3) Employees draw smallest salary to avoid income tax and NI payments
(£5,730 in 2009-10 and £7,605 in 2012-13) and leave remainder of earnings in company vehicle, retained earnings taxed under small business
rate as profits below £300,000.
Income splitting
In some cases the family income can effectively be split between different family members. This provides a
tax advantage as it means that a family can make multiple use of personal allowances and lower personal
tax rates.
In the case of a family with a gross income of £26,000 for example, if this income was taxed in the hand of a
single wage and salary earner, in 2012-13 this person would benefit from a personal allowance of £8,105
and would face the basic rate of tax on the remainder of their income (£17,895). They would also face
National Insurance Contributions at the lower rate, meaning a total tax and National Insurance burden of
£5,786.
However, if this family was able to split its income 50:50 between husband and wife then the tax paid would
fall to £3,253. This fall occurs as the family can make use of the personal allowance twice (reducing its
taxable income by a further £8,105 before taxes are levied). The family also pays less in National Insurance
Contributions.
The increase in personal allowances has increased the benefits from this tax planning. As shown in the
table, the benefit to a family on £26,000 has increased by £607 to £2,533 since 2009-10. Increasing the
personal allowance further to £10,000 would mean that a married couple could reduce their tax liability by
a further £750 through engaging in this tax planning. The benefit from this tax planning increases as
marginal rates increase, so the benefits from tax avoidance are greater for higher than lower income
families.
Company vehicle
Coalition policy is increasing the wedge between the rates of corporation tax and personal income tax rates.
Currently at 26 per cent, the UK already has the lowest corporate tax rate of the G7 (Japan, USA, France,
Italy, Germany and Spain).131 Lowering the company tax rate further will widen the margin between the
treatment of personal and company taxation and increase incentives for tax avoidance.
A small business owner, or a self-employed individual, could seek to reduce their tax bill through retaining
earnings in a business or holding company rather than being paid a wage or salary.
If a person then pays themselves a wage or salary from this company that is less than £7,605 (in 2012-13)
then they will not pay any income tax or national insurance contributions on this income. By paying
multiple members of the family up to £7,605 the family could withdraw a reasonable income that is free of
income tax and National Insurance.
131OECD (2011), Tax Database: Table 11.1 Corporate Income Tax Rate, 2011. The main corporation tax rates of the other G7 countries are:
Italy 27.5 per cent; Spain 30.0 per cent; Germany 30.2 per cent; France 34.4 per cent; USA 39.2 per cent; Japan 39.5 per cent.
39
4
Reformers not spenders
Strengthening the tax system
If the company has no overheads (and so no deductible expenses) and the profits are below £300,000 then
the retained earnings are taxed at the small business rate. If this income is withdrawn from the company in
a later year (in the form of dividends) then this will be taxed. There will, however, be a deferral advantage to
this (e.g., the company owner may be able to withdraw the dividends at a time when their income is
relatively low and so they face lower tax burdens).
In comparison to the case where the family has a single earner who is paid a salary and wage, families that
are able to use company vehicles to plan their tax affairs can face much lower tax bills. An individual on
£26,000 would (in 2012-13) face £5,786 in tax and National Insurance charges and thus have an income in
the hand of £20,214. A family with two salaries that uses a company vehicle would (under the assumptions
above) face a company tax bill of £2,158 and an after-tax income of £23,842. As with the example of income
splitting, the benefits from this tax avoidance increase with income.
Note that the benefit from tax avoidance has increased from 2009-10 to 2012-13. This increase return from
tax planning can be attributed to the Coalition’s policy to lower company tax rates and, at higher income
levels, increase personal tax rates. Increasing the disparity between these rates has increased the incentives
for tax avoidance.
Big bang reform
The UK tax system has been referred to as a “fiscal chess game, but with an ever-increasing number of
moves and pieces.”132 The system has a complex structure. This complexity makes the system difficult to
understand, which causes errors in tax calculations and returns.
Yet complexity may be based on good intentions. Complex rules may, for example, reflect a desire to close
opportunities for tax avoidance. An example could be ensuring that people cannot avoid tax by being paid
through share schemes rather than salary. Complexity may also reflect a desire to vary taxes by differences
in circumstances, with the complex VAT system reflecting the very high number of zero-rated and exempt
products.
Trade-offs in reducing complexity are made even more difficult when the process of change is considered.
Frequent changes to the tax system are a major concern for business. The current tax system may have
many problems but at least businesses are used to working with it. Yet this should not be seen as an
argument for resisting changes that would improve the tax system – rather it highlights the need for
changes to be transparent and free of political whim.
There is almost universal support for the idea that the tax system should be simpler. The Government’s
current approach to simplification is a gradualist, or bottom up, one. This can encourage valuable changes
– such as the more consistent use of definitions throughout the tax system and a simpler interface between
the tax authority and taxpayers (administrative simplification). Yet while the work of the Office for Tax
Simplification led to the abolition of 43 outdated tax reliefs in the 2011 Budget, with a starting point of 1,042
reliefs this work has barely begun.
There are limits to a gradualist approach. As Sir Roger Douglas, the former New Zealand Minister of
Finance who substantially simplified their tax system in the 1980s, has noted: “do not try to advance one
step at a time – quantum leaps will be required where you remove privileges of various groups all at one
time. It is simply harder for them to complain this way.”133 Making quantum leaps will require asking hard
questions: do we need certain taxes and reliefs and, if they serve a useful role, could this role be provided for
in other ways?
It is important that Ministers, officials and commentators drive forward with the task of tax simplification.
A simpler tax system could support growth and lead to fairer taxes. Businesses would be able to focus more
on growth, jobs and exports, and less on complying with taxes. Tax burdens would be less arbitrary and not
based on the ability to pay for tax advice. Taxes would be easier to administer. And taxpayers might find it
easier to understand and subsequently follow. Finally, a simpler tax system could reduce avoidance and
help to close the tax gap.
132HM Treasury (2011), General Anti-Avoidance rule study: final report.
133Douglas (2010), “Reform New Zealand Style,” presentation to Reform conference Reducing the deficit and improving public services, in
Nolan (ed.) (2010), The first hundred days, Reform.
40
Reformers not spenders
Bibliography
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Reformers not spenders
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Greener, K. and R. Cracknell (1998), “Child Benefit”, House of Commons Library.
Gregg, P. et al. (2011), Executive Pay and Performance: Did Bankers’ Bonuses Cause the Crisis?
Haldenby, A. et al. (2011), Off balance, Reform.
Haldenby, A. et al. (2011), The long game: increasing UK economic growth, Reform.
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Hargreaves, D. (2011), Cheques With Balances: why tackling high pay is in the national interest, High Pay
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HM Treasury (2011), OBR central economic forecast, Autumn Statement 2011.
HM Treasury (2011), Public Expenditure Statistical Analyses 2011.
HM Treasury (2012), Public finances databank, January.
HM Treasury and Department for Business, Innovation and Skills (2011), The Plan for Growth.
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Kaplan, S. (2011), Some Facts About CEO Pay and Corporate Governance.
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Lansley, S. (2009), Middle Income Britain Survey for the TUC, YouGov, January.
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Local Authority Pension Fund Forum (2008), Incentivising Executives, Non-Financial Performance and
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44
Reformers not spenders
Annex 1: facts on pay
Measuring pay is a surprisingly difficult thing to do. The results you get will often vary widely depending on
the method and data used. Data are often incomplete and subject to lags. For example, estimates of the
percentage increase in the FTSE 100 CEO total remuneration award varies widely with the Income Data
Service estimating this at 43.5 per cent and Manifest estimating this at 14 per cent.134
When calculating average values the distribution of the data set must be considered. When the distribution
is symmetrical it is most appropriate to use a mean average. However when a distribution is skewed it is
more appropriate to use the median as outliers in a skewed distribution can distort the average. This is
important for remuneration as most executives receive small pay increases and a smaller proportion of
executives receive very large ones. This means that the smaller number of very large increases distorts the
average.
Manifest data (based on the median) indicates that in September 2011 CEO salaries for all companies
(based on a sample of 665 companies) averaged 2 per cent. This is lower than the salary increases observed
in 2010 and 2009. Income Data Services salary increases are based on changes in the mean. These are the
metrics used by the High Pay Commission.
Table 25: Executive Remuneration Data 2009-2011
Source: Manifest (2012), “‘Remunerationgate’ – the median isn’t the message”
AIM
Small Cap
FTSE 250
FTSE100
Sept 2011
2
2
2
2
May 2011
2
1
0
2
2010
8
3
3
4
2009
9
7
5
8
Sept 2011
0
2
7
13
May 2011
0
3
16
17
2010
0
0
0
7
2009
0
0
0
0
Sept 2011
0
0
4
4
May 2011
0
0
2
5
2010
0
0
0
7
2009
0
0
4
11
CEO Salary Increase (%)
Bonus Increase (%)
LTI Awards (Expected Value) Increase (%)
There was, however, a marked increase in bonus payments in 2011, although these were reduced between
May and September 2011. The values of Long Term Incentives issued to CEOs have also reduced in value
since 2009 (reflecting share price performance).
The trend of falling bonuses is set to continue. In 2011-12 total bonus pay-outs are expected to fall by 38 per
cent,135 and are expected to remain broadly flat until 2013-14. At the same time the size of the workforce has
fallen around 9 per cent.136 Bonuses in the City of London are not expected to reach 2007-08 highs in the
medium-term.
134Income Data Services (2011), “FTSE 100 directors get 49% increase in total earnings,” news release, October 26; Manifest (2012),
“‘Remunerationgate’ – the median isn’t the message,” http://blog.manifest.co.uk/2012/01/5375.html, last accessed 7 March 2012. Total
remuneration awarded is total of salary, cash bonuses, deferred bonuses, pensions, benefits-in-kind and the realised value of shares and
options vested in the year of calculation.
135CEBR (2011), “Fat cats become skinnier,“ new release, 28 October 2011.
136CEBR (2011), “City jobs in 2011 slashed back to 1998 levels”, news release, 27 October 2011.
45
Reformers not spenders
Annex 1: facts on pay
Table 26: City Bonuses (Current Prices, £ Million, financial year)
Source: CEBR (2011), “Fat cats become skinnier“
£ Million
% Change
2001-02
3,921
2002-03
3,329
-15.10
2003-04
6,400
92.25
2004-05
6,950
8.59
2005-06
9,653
38.89
2006-07
11,383
17.92
2007-08
11,565
1.60
2008-09
5,332
-53.90
2009-10
7,336
37.58
2010-11
6,749
-8.00
2011-12
4,182
-38.04
2012-13
4,165
-0.41
2013-14
4,215
1.20
2014-15
4,441
5.36
2015-16
4,648
4.66
Table 27: City Jobs (calendar year)
Source: CEBR (2011), “City jobs in 2011 slashed back to 1998 levels”
Number of City Jobs
46
% Change
1998
289,666
1999
312,745
8.0
2000
323,018
3.3
2001
312,232
-3.3
2002
307,678
-1.5
2003
317,102
3.1
2004
324,830
2.4
2005
326,868
0.6
2006
342,968
4.9
2007
354,134
3.3
2008
323,714
-8.6
2009
305,375
-5.7
2010
315,000
3.2
2011
288,225
-8.5
2012
287,937
-0.1
2013
288,801
0.3
2014
292,675
1.3
2015
296,084
1.2
2016
299,799
1.3
Reformers not spenders
Annex 2: means-testing the Child Benefit
In October 2010 Reform noted that the Coalition’s approach to withdrawing the Child Benefit from higher
rate taxpayers would not work. Given their relevance to the current political debate the key issues
highlighted by Reform in 2010 are summarised below.
The Coalition’s approach to withdrawing the Child Benefit from higher rate
taxpayers would not work
The proposed approach is to withdraw the benefit immediately once a family has an income earner who
faces the 40p tax rate. This would create very high Effective Marginal Tax Rates (EMTRs). To illustrate,
Reform presented modelling of the combined clawback of the Child Tax Credit and Child Benefit under the
policies in place prior to Budget 2010, in 2013 (once the changes announced in Budget 2010 and the
planned changes to the Child Benefit are introduced), and with Reform’s alternative proposals for reform.
This modelling shows that the effect of withdrawing the Child Benefit from 40p taxpayers would mean that
(for a single income family) at £43,375 (based on a threshold of £35,900 and a personal allowance of
£7,475), families:
>With
>With
>With
>With
one child would face a combined clawback of 105,560 per cent on the next pound of earnings
two children would face a combined clawback of 175,240 per cent on the next pound of
earnings
three children would face a combined clawback of 244,920 per cent on the next pound of
earnings
four children would face a combined clawback of 314,600 per cent on the next pound of
earnings.
As these very high EMTRs apply over a very small range of incomes they are unlikely to have a significant
impact on decisions to supply labour. They are, however, likely to become relevant to tax planning
considerations and to significantly increase the incentives for income splitting for tax purposes.
The combination of reduced government revenue as a result of greater incentives for income splitting and
the cost and complexity of policies designed to address the anomalies in the approach to means-testing the
Child Benefit (for example, introducing poorly targeted tax relief for married couples) mean that the
Coalition’s proposal is unlikely to generate significant savings.137
A better way to means-testing
Reform previously proposed abolishing the Child Benefit. This would save £12 billion. As removing the
Child Benefit would increase child poverty Reform also proposed directing around £5 billion of these
savings into the Family Element of the Child Tax Credit to compensate families on low incomes.138 The
Child Tax Credit is already widely received by low income families and has been estimated to have a take up
rate among families out of work around 97 per cent. Implementing this reform would be administratively
simple as existing systems are already in place (indeed, this would represent a simplification of the system
through reducing duplication with the Child Tax Credit).139
137Similar problems face the other option of taxing the Child Benefit. This approach was suggested in 1998 by the then Chancellor, Gordon
Brown (Hansard (1998), Col.1108, 17 March. Also see, Greener and Cracknell (1998), “Child Benefit”, House of Commons Library). More
recently, David Blunkett, the former Home Secretary has advocated taxing Child Benefit for the highest earners (The Daily Telegraph
(2009), “David Blunkett: tax child benefit and give up nuclear arms”, 28 September). However the savings from taxing the Child Benefit
would only be in the order of £0.11 billion. Such an approach would also add to the already excessive complexity of the welfare system.
For example, if this programme was taxed in the hands of the mother (to whom the benefit is paid) then little revenue would be clawed
back. If this programme was taxed on a household basis extra complexity would be created for married couples (as a decision would
need to be made on whose income the payment would be taxed). Given that the Child Tax Credit is already in operation and widely
received among those families with children in need, taxing the Child Benefit would, while recognising the need for means-testing, simply
be an ineffective half measure.
138These estimates do not consider the effect of housing benefit. The Child Benefit is disregarded for Housing Benefit purposes, while the
Child Tax Credit is included in assessable income for the purposes of this benefit. The switch towards Child Tax Credit could thus reduce
the Housing Benefit received by some families.
139A more complex approach would be to tax the Child Benefit (Cawston et al. (2009), The end of entitlement, Reform). This reform would be
complex as either the Child Benefit would have to be taxed in the hands of the mother (generating few savings as there are relatively few
higher rate mothers) or features of household taxation would need to be introduced into the personal income tax system.
47
Reformers not spenders
Annex 2: means-testing the Child Benefit
To illustrate the redistributive impact of these changes the effect on a number of scenario families Reform
modelled the transfers received by and the rates of clawback facing families for different policy scenarios:
>Policies
in place prior to Budget 2010
>The
Reform’s
>
effect of the changes announced in Budget 2010 and the planned changes to the Child Benefit
alternative proposals for reform.
This modelling illustrated that the thresholds at which families would be no worse off are (under the
Reform proposal) around:
>£22,000
for families with one child
>£28,000
for families with two children
>£40,000
for families with four children.
It would be possible to shift these thresholds upwards by increasing the Family Element by more than the
level of the Child Benefit. While this would reduce the fiscal savings of the reforms, this would also mean
that all families below the new thresholds would be net gainers from the change.
While there is an increase in effective marginal tax rates (EMTRs) from the change, the increase in
disincentives occurs relatively high up the income distribution and so any behavioural response to them
(particularly on the participation margin) is unlikely to be strong, with the strongest effect likely to be on
second earners. These disincentives also need to be evaluated against the economic benefits (particularly
strengthening labour demand) of helping restore the public finances.
48
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