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Tax policy after Brexit

The opinion polls were wrong again; Brexit has won (and as a Lancastrian I was delighted to see the North stay solid for out).  But now the hard work begins of building alternative structures, and deciding what to do with the UK’s new freedom of independent action.

One aspect that didn’t get a mention in the campaign was the huge extent to which the EU already influences the UK’s tax agenda. The most obvious is VAT, but the EU has also controlled or influenced many other areas of tax policy, where the UK will soon be free to choose its own direction.

The next couple of years will determine whether the post-Brexit UK becomes an outward-looking global economy or retreats into nationalistic tariff wars.

VAT

VAT has been almost entirely an EU-level tax; not only is it compulsory to have a VAT, of at least 15%, but also the vast majority of the details of the system are governed from Brussels, through Directives and the integrationist interpretation of the European Court of Justice.

The UK can now decide whether it wants to keep VAT at all, and if we do keep it whether we make changes to the system.

VAT is actually one of the less bad taxes, not as economically damaging as income taxes or taxes on capital (although that does not necessarily mean that having a VAT as well as an income tax is the best option), and it raises £115 billion a year in the UK, 22% of total tax revenues, so we can assume that it will be with us for a while.

But what sort of VAT will we have?

We currently have a rather old-fashioned VAT system with lots of reduced rates, zero rates and exemptions.  In contrast; newer systems have a much flatter structure that taxes (almost) everything, which allows a lower rate to raise the same amount of revenue.

But the reduced and lower rates are not generally a good idea.  Not only do they add to the complexity of the system (after 43 years we are still having appeal court cases arguing about what qualifies for the zero or lower rates), they are also distortionary (favouring some products over others, often with no good reason) and they do not give the help to those on lower incomes that they are supposed to do (the package of zero and reduced rates and exemptions actually make very little difference to the amount of VAT paid by those on different income levels, compared to having a single, lower rate applied to everything).

This is one area where the EU has actually been pushing the UK in the right direction; although we were allowed to keep our existing zero rates (most food, children’s clothes, books, etc.), any new ones needed EU approval, which was rarely granted (see, for example, the “tampon tax” row when the government wanted to remove VAT from women’s sanitary products).

Now it has the choice, will the UK government give in to every demand for reduced rates for “special” products, or will it stand up for a sensible, modern VAT?

International tax

First, don’t panic; the UK has a double taxation treaty with every member of the EU. These were agreed bilaterally and separately with each country, independently of the EU system, and so will continue whatever our post-Brexit relationship with the EU is. Although not perfect, these largely prevent double taxation of cross-border business and investment and generally help simplify tax administration for international trade.

We will lose the parent-subsidiary directive and the interest and royalties directive, which largely stop other EU countries from levying withholding taxes on interest, royalties and group dividends paid from their businesses to UK companies, and of course stop the UK from charging withholding tax on royalties and so on paid out by our companies. That will be a pity, because the directives were quite useful in moving profits out of the UK into lower taxed jurisdictions.  But generally the role of the directives will be replaced by the double tax treaties (which, as we saw above, will not be affected by Brexit), which do much the same job, at least reducing and often eliminating withholding taxes.

There is a risk that the UK will adopt a protectionist attitude, using the rhetoric of “tax justice” to tax overseas payments made by businesses based here. But that would be to go against the direction of UK tax policy for thirty years, and would involve renegotiating all of our international tax treaties. The hope is that little will change here.

A more exciting move is that we will no longer have to comply with the EU’s Code of Conduct on Business Taxation.  The Code was an attempt to stifle tax competition, by preventing EU countries from introducing advantageous tax regimes to attract foreign investment. Removing it gives the UK much more freedom to design its own tax system to make us a better place for both domestic and foreign investors, countering any negative Brexit effect on investment.

What’s more, Brexit doesn’t just benefit the UK; several of our associated territories, such as the Channel Islands, were also forced to comply with the Code of Conduct. These islands, with which we have very close business and historic connections, already channel huge amounts of investment into the UK. Once the UK leaves the EU they will also be free of the Code of Conduct and other EU restrictions, allowing us to work together to create a positive tax regime for business and attract investment.

I have written before for the IEA on the advantages of tax competition, of allowing different countries to experiment with different tax systems, and the removal of the Code of Conduct will strengthen that beneficial process.

Various aspects of our tax system, including the recent diverted profits tax (dubbed the “Google tax”), have been attempts to get around the EU rules on what we can and cannot do to tax multinational businesses. Escaping the EU’s restrictions on our tax system should hopefully allow the UK to design a more rational tax system.

The future

Brexit is the start of a process, not the end, and the UK could use its newly regained freedom to move in different directions. Hopefully we will see a better-designed tax system, more open to investment and new business, more internationalist. It would be a great pity if this opportunity ended up with our tax system being used to effectively close our borders and shut out foreign competition.

A lot will depend on who is in charge of tax and public finance. Osborne has not been an impressive Chancellor; having initially been enthusiastic about flat tax and other tax reforms as Shadow Chancellor, he ended up following the Gordon Brown model of huge borrowing and obsessive fiddling with the tax system. What we need now is not another Gordon Brown but another Nigel Lawson or even another Alistair Darling.

Let us hope that the post-Cameron government will be one that takes the best parts of Brexit, the enthusiasm and international openness, and uses this opportunity to design a tax system to encourage that expansive attitude.

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As in all IEA publications, the views expressed in this blog are those of the authors and not those of the Institute (which has no corporate view), its managing trustees, Academic Advisory Council or senior staff.

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