The St Andrews Economist

Let Them Eat Cake, Not Biscuits: Why The UK’s Tax System is Broken

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by Jack Parbrook

Is the Jaffa Cake a cake or a biscuit? The question is of such significance that in 1991 the matter had to be resolved in court. Manufacturer United Biscuits found itself before a VAT (Value Added Tax) tribunal in 1991, sparring with the tax authorities who asserted that the treat was a biscuit. In the ensuing struggle, many points were made: Jaffa Cakes are usually displayed with biscuits, not cakes; Jaffa Cakes harden when going stale, like a cake; Jaffa Cakes are packaged like biscuits et cetera. Eventually the tribunal decided that Jaffa Cakes are, in fact, cakes. This was fantastic news for United Biscuits. For VAT purposes, cakes are zero-rated, meaning you have to pay 0% tax on them. Biscuits, on the other hand are standard-rated, requiring 20% of the sale price to be paid in tax. This story, despite being over thirty years old, is a potent illustration of the absurdity of the UK’s tax system and how woefully unfit for purpose it is.  

An effective tax system must allow the government to finance its operations (along with debt), without distorting incentives for social and economics goods (e.g. investment, donating to charity etc). It also ought to be fair, which for the purposes of this article will be interpreted as one where those with more wealth do not pay less in tax than their poorer counterparts. By these definitions the UK’s tax system in not an effective one.  

Many of the tax system’s problems stem from its complexity, which provide perverse incentives for businesses and individuals. In fact, the UK is world beating when it comes sheer volume of legislation. In 2009, there were over 11,000 pages of it. More than any other country. The quantity of arcane tax legislation has not diminished since then. This creates myriad problems and leaves the door open for all sorts of skulduggery. 

Consider VAT rules. Cakes are zero-rated, meaning 0% VAT is paid on them. This is distinct from being VAT exempt, where no VAT is due. The question that inevitably follows is why there are two different categories of VAT that result in the exact same tax liability. The answer lies in VAT registration. If the VAT taxable turnover of a business exceeds £85,000 per annum, your business must be VAT registered. This means you have to pay the appropriate VAT to HMRC (HM Revenue and Customs – i.e. the government) on all goods sold. VAT exempt goods do not count towards this total, whereas zero-rated goods do. Where things get interesting with VAT registration is the ability to claim reliefs. When a business pays VAT to another VAT registered business, it can claim relief against the VAT it owes to HMRC. If the VAT relief claimed is greater than the VAT owed to HMRC, HMRC will give the business the difference.  

Two groups benefit from this absurdity. The first are the accountants who can bill their clients for the time spent ensuring compliance. The second group are the fraudsters. Missing trader fraud is a classic example. The details lie beyond the scope of this article, but the result of the scheme is that the government transfers its money to the scammer as relief on fictional VAT transactions. This scheme only exists and is only profitable because of nonsensical VAT regulations.  

The ability of the system to raise proportional amount of taxes from incredibly wealthy individuals is also impeded by its complexity. Ostensibly, the system is progressive, with the top 1% of earners paying approximately a third of the taxes. However, closer inspection exposes substantial inefficiencies exploited by those in the upper echelons of the 1%. The median amount of tax paid between 2008 and 2018 by someone earning two million pounds a year was around 35% of earnings, with the bottom 10% managing to pay a mere 10% of their earnings. This contrasts those at the lower end of the 1%, who earn £200,000 per annum. On average, they pay around 45% of earnings. This lower burden is acquired by skilled navigation of labyrinthine legislation. A useful illustration of this are inheritance taxes. More specifically, how they are avoided.  

In the tax year 2020-2021 (the tax year ends of the 5th of April, not the 31st of December), just 3.73% of deaths resulted in taxable event. This is because inheritance tax is progressive. If the estate of the deceased is worth less than £325,000, no tax is paid. Generally, 40% tax is paid on the value of the estate in excess of this threshold, but, as inevitable with taxation in the UK, there is a panoply rules that can alter this figure. The cunning and extremely wealthy have used this to their advantage. A particularly notable case arose in 2016. The Duke of Westminster had died. His son stood to inherit around 9 billion pounds. Using the rule earlier, approximately 3.6 billion of this inheritance would be paid in taxes. However, through clever usage of trusts (of which family members were beneficiaries) set up long before the Duke’s death, the family was able to avoid a considerable tax burden.  

Complexity also warps incentives for those earning closer to the national average. In fact, one can be saddled with a marginal tax rate of 20,000%. Imagine a single income family living in London with two children. The single earner makes £99,999.99 per annum from their job, which is their only source of income. They are able to get childcare benefits of around £20,000 as a result. Unfortunately for them, they are about to get a pay rise of one pound. Now they earn over £100,000 a year and are no longer eligible for the childcare benefits. Their pay after tax has fallen by £20,000 despite the tax increase. In fact, in order to be better off after the pay rise than before, they would have to have their pay increase to £145,000. In this case, the tax system provides a reason to earn less money. 

Council Tax further illustrates how ineffective the tax system is. Council tax exists to allow local governments to finance their operations (note councils also receive funding from business rates and government grants). These services include bin collection, police services and social care amongst other services and they vary between different parts of the UK. The tax liability is based on the value of one’s property (in April 1991). However, there is glaring flaw here. Different councils have different funding needs and the relationship between their funding needs and the wealth of the area is often inverse. The finances of councils that cover a small area with little crime and where people do not need social care bear a smaller burden than their larger and more deprived counterparts do. This means councils that cover prosperous areas can extract less tax from their residents. In the wealthy Westminster, for example, the total council tax bill on a property worth over £320,000 (the highest band) is £1,824.10; In Birmingham an equivalent property would incur a liability of £3,811.45. This is preposterous and a clear example of regressive taxation, falling afoul of this article’s definition of fairness. Why should a multi-million pound property in Westminster (where on average houses sell for over 1.7 million pounds) have a lower tax burden attached to it than a property in Birmingham lived in by someone of far humbler means? Making this perversion even harder to forgive is that the current system fails to allow local governments to finance their operations. Birmingham went bust early this year and a further 26 councils are at risk of bankruptcy in the next two years.  

With the tax levels forecast to reach their greatest height since the 1960s (as a percentage of GDP) now is a critical time for companies and individuals in the UK to ask if their taxes are raised as effectively as possible. What is evident is that the current system falls short of the mark in many respects. Towering complexity wastes resources, prevents governments from fulfilling their constituents’ needs, and struggles to be fair. It is obvious that the UK’s tax system needs reform. However, debate on the issue in has been lacklustre. All of the major parties have been unable or unwilling to grapple with the changes necessary for an effective system, with the very complexity of the system impedes the reform it desperately needs. It is not an easy task, but it is a damming indictment of the political class that they have failed to conduct or induce the calibre and size of debate the issue merits.   

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