A change of direction in tax policy?

As was widely predicted, Liz Truss won the Conservative leadership contest and is the UK’s new Prime Minster. She has quickly appointed her leadership team, including Kwasi Kwarteng as Chancellor of the Exchequer. 

From the start of her campaign, Truss announced there would be some form of fiscal event in September if she won. However, her appointment as Prime Minister was quickly overshadowed by the tragic passing of Queen Elizabeth II. 

We now know that there will be a fiscal announcement on 23rd September 2022, just a few days after the Queen’s funeral. In this article, we set out our expectations of what may or may not be in the announcement, which is likely to be a more muted occasion than normal. 

No one can deny the difficult fiscal and economic challenges the Government faces. Spiralling energy prices and inflation have produced a cost-of-living crisis not seen for decades. Other economic and societal issues have not gone away. These include an ageing population and its associated pressures on the NHS and social care, climate change and the challenge of meeting net zero, and ongoing geographical inequalities. 

A Truss-led Conservative Government could represent a major change in policy direction from the previous Johnson/Sunak partnership, with the more Thatcherite instincts of Truss and Kwarteng potentially at odds with the populist and Keynesian shift of the party over the last few years.

Under Sunak’s Chancellorship, we saw a more interventionist approach coupled with generally higher taxes. The new Prime Minister was elected on a platform of deep (and expensive) tax cuts, coupled with regulatory loosening. 

Few would question the need for the Government to step in and help with the current energy crisis, but beyond this, the new ideology seems to be one of a smaller state.  

Liz Truss campaigned on a promise to reverse the planned increase in corporation tax to 25 percent from April 2023. As it was such a key plank of her leadership campaign, we expect this promise to be kept. 

The Government estimates this would cost £17 billion, although this does not consider the tax receipts from any additional investment that arises from keeping the rate at the current 19 percent.

The UK financial sector will want to see what happens to the banking surcharge. When the rise in the corporation tax rate was announced, it was accompanied by a reduction in the banking surcharge from 8 percent to 3 percent to ensure the sector remained internationally competitive. If the proposed corporation tax rate increase is cancelled, it is likely the reduction in the banking surcharge will also be cancelled.

The amount of corporation tax a business pays is a function of both the headline rate of tax and the tax base (the ‘taxable profit’ to which the rate is applied). 

For a long time, the Conservative Party has pursued a low rate and broad base approach, with George Osborne, Chancellor under David Cameron, proudly claiming the UK had the lowest headline corporate tax rate in the G7. 

Rishi Sunak, on the other hand, favoured higher rates supplemented by targeted reliefs, such as freeports.

We now seem to be swinging back towards Osborne’s approach.

There is an ongoing debate about the best ways to attract investment – whether to have a low tax rate and broad base, or a higher tax rate and smaller, perhaps more targeted, base. 

There is also continued discussion about whether the right lever to encourage investment is taxes or grants, a question which arguably becomes more important as we move towards implementing a global minimum tax. This debate looks set to continue as we wait to see how the new Prime Minister’s tax-cutting agenda unfolds.

The cancellation of the planned rise in the rate of corporation tax will undoubtedly help investment, but international businesses will want more in the current competitive global environment. 

Of particular interest to potential investors will be what might replace the super-deduction, which ceases at the end of March 2023.

The super-deduction gives a temporary 130 percent deduction for the acquisition of certain assets. While the headline rate was expected to increase to 25 percent, this represented a timing benefit only. Interestingly, if the rate rise is cancelled, part of the super-deduction will become a permanent benefit.

Over recent months, the Treasury has been consulting on whether the super-deduction should be replaced and, if so, with what.   

One issue was that it was not targeted in relation to either location or activity. As such, it went against Sunak’s ideology of more targeted interventions. In addition, the agnostic nature of the super-deduction meant it contributed nothing to the levelling up agenda or other Government priorities, such as net zero. 

Cancelling the corporation tax rate rise reverts to Osborne’s ideology, but it also pitches the interests of the Southeast against those of other regions of the UK.

Truss has said she wants to make freeports ‘truly low tax’, as well as introducing investment zones. A lower corporation tax rate, however, affects all regions equally. This means incentives will have to work harder (or be more generous) to drive investment into regions outside the Southeast.

Despite being a flagship policy under Boris Johnson’s leadership, the levelling up agenda never really got going, arguably overshadowed by the more pressing matters of the pandemic. But ‘red wall’ votes were critical in giving the Conservative Party its 80-seat majority in 2019. The current cost of living and energy crises will increase the need for real tangible progress on this issue as the next general election moves closer. 

Net zero is another priority area for the Government that has failed to launch. In October 2021, the Government published its strategy to achieve net zero. The Treasury subsequently issued a report setting out some of the costs and trade-offs of the net zero transition. But this has yet to be translated into a roadmap of policies. 

The super-deduction arguably missed an opportunity by not specifically incentivising the net zero agenda. Climate change is a major concern for voters and encouraging green investment would be received positively by businesses as well.    

Any deliberations around tax incentives will need to consider the OECD Pillar Two global minimum tax rules. These impose a top-up tax for certain large businesses where a jurisdiction fails to impose an effective tax rate of 15 percent or more.  If tax incentives reduce the effective tax rate below 15 percent, as calculated under these rules, this effectively neutralises the impact of the incentive and exports tax revenues overseas. 

There have been some media reports indicating that Truss was considering pulling out of the OECD’s global tax deal, of which Pillar Two is a key part. This would be a bold move. While it is understandable that the new leadership will want to take a fresh look at the UK’s current position, in our view any change in the UK’s stance is unlikely.

On 9^th September, the governments of France, Germany, Italy, Spain, and the Netherlands issued a joint statement to express their full commitment to moving ahead with implementing the Pillar Two rules during 2023 through any possible legal means, despite the fact that Hungary is currently blocking the relevant EU directive. Once a few major economies have implemented the global minimum tax there will be a disadvantage to countries that do not implement it. If some countries implement and the UK doesn’t, then the UK Treasury risks losing tax revenues to them. 

We believe it is more likely the UK will continue on its current path, which is to push forward with the legislative process to implement the global minimum tax rules, while also monitoring what is happening in other jurisdictions.  

How to grow the economy and increase productivity in a tight labour market will be a key issue facing the new Chancellor. 

In her campaign, Truss championed supply-side productivity measures to support business investment. These included regulatory loosening and a removal of EU ‘red-tape’. She also pledged to overhaul business rates and review the IR35 regime. 

But these potential reforms, as well as the freeze in the corporation tax rate and any replacement for the super-deduction, need to be integrated into the tax regime in a coherent and consistent way that supports the wider economic objectives of net zero and levelling up. 

Other jurisdictions will also be facing similar challenges, so the position of the UK relative to other jurisdictions will be a critical consideration as the Chancellor develops his business tax strategy. 

One of the UK’s key tax frameworks for attracting investment is the R&D regime for large businesses. Historically, this has worked well because it operates as an above-the-tax-line incentive. But with the onset of the global minimum tax, other jurisdictions are beginning to move incentives above the line, which will dilute the attractiveness of the UK’s regime.  At the same time, recent changes to narrow the relief to UK-based activities has seen businesses questioning whether to invest in the UK.

Lessons could be learnt from other countries. For example, some countries have more extensive R&D regimes that also give relief from certain payroll taxes for those engaged in R&D activities. This provides a holistic approach to R&D that embraces different taxes. Another option might be to extend enhanced tax relief to manufacturing that arises as a consequence of UK R&D, provided the manufacturing activity remains in the UK. 

It is not an easy task, but a holistic, transparent, and coherent strategy that covers the whole lifecycle of a business will go a long way to helping investment decisions.

Windfall taxes

In May 2022, Sunak introduced a windfall tax on UK oil and gas profits. This increased the headline rate for affected businesses to 65 percent. Alongside the levy, he announced a super-deduction style of allowance to encourage investment in UK extraction and to support energy security. 

Truss has ruled out further windfall taxes on the sector and so we do not expect any windfall taxes in the September fiscal statement. 

As energy bills will be capped for households, with the cost apparently being added to the national debt, it is likely there will be more calls for further windfall taxes on the sector to reduce so-called ‘super-profits’.    

However, the desire to encourage investment in the sector to aid energy security and prevent future shocks would likely take precedence over calls for any further windfall taxes.

VAT and indirect taxes

Tax cut announcements have not been limited to direct taxes. Tax cuts to VAT and other indirect taxes were also discussed during the leadership campaign.

Truss announced her intention to suspend green levies to help with the energy crisis, and this has been included within the energy cap. 

The most expensive VAT policy being considered is a temporary but significant cut to the headline rate of VAT. We last saw this in 2008 in the aftermath of the global financial crisis, when VAT was temporarily cut from 17.5 percent to 15 percent. 

Some media outlets have reported that Truss is considering cutting VAT by 5 percent across the board to help with the cost-of-living crisis, at an expected cost of £28 billion a year. This would be an eye-watering loss of tax revenue alongside a broad energy price cap, so we believe it is unlikely. 

Other ideas include a temporary VAT reduction for the hospitality, tourism, and agriculture sectors, which is more likely. Or possibly an extension or increase to the 5p cut in fuel duty that is due to end in March. Although the Chancellor may want to look for measures that have a more immediate impact on household budgets.

From early on in her leadership campaign, Truss has trailed a reversal of the rise in national insurance contributions (the Health and Social Care Levy, or HSCL). 

A full reversal would cost approximately £13 billion a year, but there has been some speculation as to whether it would be only reversed for those on lower incomes (under £50,270), which would reduce the cost. 

Shortly before the HSCL began, Sunak announced an increase to the threshold at which an individual pays national insurance. This lifted many people out of the levy altogether. It is unlikely that Kwarteng would return the thresholds back to their previous levels with lower-income households under so much pressure, but a reversal of the levy without reducing the threshold would mean some will end up paying less in national insurance than before the levy was announced.

Other expensive personal tax cuts have been hinted at.  

One suggestion has been that income tax thresholds might be increased. These were frozen from 2022/23 to 2025/26. At the time, the Treasury’s budget report indicated this would raise an additional £1.56 billion in 2022/23, rising to £8.18 billion by 2025/26. In fact, far more has been raised due to the effects of inflation. In March 2022, the Office of Budget Responsibility (OBR) estimated that freezing the thresholds would now raise £2.9 billion in 2022/23, rising to £18.0 billion by 2025/26. These figures will have increased further since that date.

There are a number of options the Chancellor may choose if he does want to revise the thresholds. He could merely ‘unfreeze’ them and provide for an inflation-based increase to the point at which 40% tax kicks in. With double digit inflation, this could still be a significant and expensive tax cut. 

Some commentators, however, have indicated something bolder is being considered – an increase in the 40% threshold from £50,270 to £80,000. This proposal was mooted by Boris Johnson during his 2019 leadership campaign, but never implemented.

The idea could be politically interesting. The opposition parties would be expected to criticise the move as 'pandering to the wealthy’, but most people earning up to £80,000 do not consider themselves well off, particularly at the moment, and would be grateful for the tax break. Nevertheless, it would be an expensive policy and, in light of the announced cap on domestic energy bills, it is difficult to see how such a radical increase in the 40% threshold could be justified.

Looking further into the future, the Prime Minister has stated her intention to review inheritance tax. But we believe this is only likely to remain a statement of intent for the time being.

It is not often that tax forms such a pivotal part of an election or leadership campaign, but it has been central to Liz Truss’s journey to PM. 

At this fiscal statement, we do not expect to see large amounts of detail to support the headline tax announcements. Reversing the corporation tax rate rise and the HSCL are not complex to implement, but will cost £30 billion. Add to that the current state of the economy, the risk of recession, the ongoing impact of the energy crisis and the war in Ukraine, and the economic impact of this fiscal statement becomes the main story.

We understand that no OBR forecasts will be available for the announcement but that the government will be providing costings on the energy package.

The impact of these announcements (and the energy cap) on inflation will also be watched closely. The energy cap is expected to flatten the inflation curve – reducing or capping it in the short term, but causing it to last longer. The headline tax cuts already announced would be expected to be inflationary.  

A year ago, it was almost inconceivable that, in the wake of the pandemic, we would be discussing a Government programme of tax reductions and further bailouts. But there is a sense that, under Truss’s leadership, we will see a radically different economic approach.

The trend over the last few budgets has been about a permanent and necessary transition to a higher tax society. Partly to pay for the pandemic, but also due to wider societal issues, such as an ageing population that needs more health and social care. 

These underlying issues have not gone away, nor will they. Undoubtedly, the current crisis justifies a significant Government intervention. But once the cost-of-living situation has stabilised, which may still take several years, the impact of the pandemic and the current crisis may result in a permanent increase to tax burdens in the future, similar to that seen after the two world wars. And while support is needed at the moment, we must also consider the legacy we are leaving to future generations.