The coalition’s decision to raise the personal allowance to £10,500 is a mistake. A better alternative would have been to reduce National Insurance Contributions across the board
The mood of today's Budget was one of tentative optimism, but the message was of continuing fiscal discipline. The Chancellor has done well to maintain his fiscal stance towards sustainability and has resisted the temptation for large giveaways in the face of the Office for Budget Responsibility’s uprated forecast of 2.7% growth in 2014.
This is difficult, but necessary if he is going to eliminate the deficit by the end of the next Parliament. The situation will only get more difficult as the General Election approaches.
Consequently, this has been a broadly cost-neutral Budget. The Chancellor recognises that he does not have the fiscal headroom for significant tax cuts and that, in order to lower public debt over the long term, tax burdens will need to remain at what are, by the standard of recent decades, high levels. OBR projections show that tax revenue is set to rise from 37.2% of GDP to 37.8% of GDP over the next 20 years, equivalent to an increase of £380 per family by 2033.
The problem with this Budget is that the changes the Chancellor has announced are moving in the wrong direction. Any change in the tax system should be done to limit the damage of taxation on growth. As Reform’s report, Mind the (fiscal) gap, shows, an efficient tax system relies upon a broad base, low-rate approach as high rates of tax have a distortionary effect on the economy.
One of the Chancellor’s major announcements was that he would raise the personal allowance to £10,500. He had previously announced that he would raise the personal allowance from £9,440 to £10,000, coming into effect next month. A further rise to £10,500 would cost, according to the OBR’s estimates, £1.4bn next year, £1.8bn the year after, and continue to rise in the years after that.
By Reform’s estimates, the total rise from £9,440 to £10,500 would take 1.5 million people out of the tax system.
This change reduces the size of the tax base, which means that the burden must increase on the remaining taxpayers. This tax exemption was balanced in the Chancellor’s statement by increasing the 40p rate of tax by just 1% next year – well below the rate of income growth. This fiscal drag will shift more taxpayers into this band.
Not only is this change distortionary, it is also poorly targeted and would do little to address concerns over living standards. Raising the personal allowance is disproportionately beneficial for high earners, and has no effect at all on people earning below the current threshold of £9,440.
Reducing the tax burden on the lowest earners is not only socially desirable, but also makes good economic sense as low earners are likely to spend a greater proportion of their income than high earners, who are more likely to save.
A better alternative would have been to reduce National Insurance Contributions across the board. This would benefit the poorest earners as well as mitigating the distortionary effects of tax increases elsewhere.
The Chancellor has once more committed to lowering public debt. This is the right thing to do, but will be difficult to achieve if the changes he sets out today mean he gains less money from the tax system while failing to improve living standards for the lowest earners.
Clare Fraser is a researcher at Reform
