15th September 2021
Tax Review – Expert Analysis
The ‘Tax Review’ will be debated by the States on 29 September. Already it has prompted lots of discussion, about how much tax we pay, do taxes really need to increase, who should pay more and should we have a GST? There’s no one simple answer, there are a lot of elements to the tax system, to the services funded by taxes and to the demographic changes that will soon impact both of those. So, ahead of the debate, States Treasurer Bethan Haines and her team of expert treasury officers and economic analysts look to explain some of those key underlying issues here:
Why have we carried out a ‘Tax Review’?
We’ve known for years now that the make-up of our society is changing. We call it the ‘ageing demographic’, and this is not because we want to blame older Islanders, or any particular age-group, but it does reflect how our population is changing. And it is a fact that this change is already putting pressure on the cost of pensions and health and care services. Previous States have tried to deal with this as a whole or in part but have not yet been successful in implementing a solution which will meet the scale of the challenge. We’ve already taken some steps to help mitigate the cost, such as the increase in the pension age to 70 by 2049, but the forecast deficit is still set to increase to an eye-watering £87m. So we need to do more to address it and the States is:
- Looking at whether spending on public services can be reduced or the speed at which some costs are increasing can be slowed down.
- Promoting economic growth so the base from which taxes are collected is larger, including looking at the role that the population and inward migration can play.
- Reviewing how taxes are collected from the economy and how much is raised
The Tax Review focuses on the last of these. Everyone will have their own view which of these is more important, but from our analysis and because of the size of the forecast deficit, it’s virtually certain that all three will ultimately be needed. While the total size of the deficit is forecast at £87m, the States own fiscal rules, which limit the total States revenues to 24% of GDP, mean that a maximum of £75m of this could be met by increasing taxes. This means £12m or more will need to be meet another way.
So if we can safely assume that, to some extent, we’re going to need to increase taxes in the next few years to avoid running out of money to pay for public services, how should that be done?
That’s the question the States will need to answer and the Review presents three illustrative solutions. These will form part of the Green Paper, but at the moment the States are only being asked to:
- Agree that the problem means that we will need to raise more money from taxes in the future;
- Agree that we should diversify the tax base and that, in order to do that in any meaningful way, we will need a GST;
- Agree that we should reform the Social Security Contributions system so that everyone is assessed on the same definition of income and has access to an allowance, which would make it fairer and more progressive.
What has stood out in the public conversation around these options is of course the inclusion of a GST (Goods and Services Tax). And that’s led to many highlighting how a GST is ‘regressive’. What we’ve tried to do is to demonstrate that if offset with other changes in the overall tax model, it is possible to create something that on the whole is ‘progressive’. This means that low income households could pay less, but more on that a bit later in this article.
Why is the population ageing and why does that mean costs are rising?
The ageing of the population originates between 1946 and 1964 when fertility rates were high. The “Baby-boom” generation is bigger than their parents’ generation and their children’s and grandchildren’s generations. They are now progressing into a well-earned retirement. People are also living much longer. Combined these factors mean the number of pensioners in the community is increasing.
The services people need change through their lifetime and more older people means more pensions; more hip replacements and heart by-passes, and more carers are needed to support people to live either at home or in care homes. At its simplest, providing the same level of care to more people and for longer costs more money. No-one is to blame for this, it’s a natural and inevitable outcome of the historical changes in the population and Guernsey success at improving living standards and health care over the last 50 years.
Because there are fewer young people entering the workforce to replace those retiring, the working age population, who pay the most in taxes, is falling. There were 1,500 fewer people aged 16 to 65 in Guernsey in 2019 than in 2009. All other things being equal, this represents a loss of about £9m a year in tax revenues. If the amount of net immigration continues to be too low to replace the natural downward pressure on the workforce due to people retiring, it will keep falling and there is a risk the tax receipts will fall further too.
How big is the deficit?
The current projections show that by 2026 the gap between the States revenues and the underlying cost of the services it’s providing and the investment necessary in the capital programme could reach £87m EACH YEAR! That includes setting aside enough to support the capital programme (that’s essentially the programme for building or replacing new buildings, and is different to revenue spending which is money that needs to be paid out every year. Think of it like the difference between the repairs to your conservatory which you paid for – hopefully – just once, and your annual spending on food or clothes). That’s a huge sum to have to make up, and that is after factoring in the inclusion of an estimated £10m of savings from making public services more efficient. The States are in a fortunate position whereby reserves have been built up in the past which will help smooth the impact of this gap. The Social Security Funds will be used for this purpose but will run out by 2039 unless other action is taken; other reserves will be depleted to fund things like NICE drugs; and the borrowing recently agreed by the States to invest in capital assets is a one-off solution which cannot be repeated as revenues are not sufficient to repay more debt. In the past, the States have decided to spend less on capital in the short term to balance the books but this just leads to underinvestment and the need to make up the shortfall in order to keep our infrastructure up to scratch. Eventually we will need a more sustainable solution.
The States does have rules which put a maximum limit on how much they’re allowed to raise from taxes, and even if they reached that limit it wouldn’t cover the full £87m. It only allows them to raise a further £75m by increasing taxes. At least £12m will need to be met by economic growth or cutting spending. The more we can expand on that £12m through growth or spending cuts, the less we’ll need to increase taxes. However, the forecasts already include £10m of savings to be delivered by making public services more efficient. If we need to save more money beyond this, it will mean that we will have to consider cutting what services are available or restricting who has access to them.
Where does government revenue come from at the moment?
In order to have a serious conversation about who, how or where increased taxes should come from, it’s important to understand the current sources for tax revenues.
The States raises about £720m a year in revenues (about 22% of GDP). 63% of this comes from income tax and Social Security contributions charged against personal income. 10% comes from corporate income tax. All other taxes (like duties and TRP) accounts for 12% and the remaining 15% comes from fees, charges and other income (like rent on States owned properties and charges for services like the hospital Emergency Department).
Given the scale of the challenge, the initial focus is on those elements of the tax system which could raise significant amounts of revenue. Namely, taxes on income (in the form of a health tax and/or a reformed social security contribution system) or on consumption (in the form of a GST). Other taxes might have a supporting role, but they are not generally able to raise revenues on this scale. This may be because they are intended to reduce damaging behaviour (like smoking), or because the increase necessary to raise significantly more revenues is unrealistic (eg doubling TRP for households would raise £10m).
The Organisation for Economic Cooperation and Development (OECD) is developing a global solution to reform the international corporate tax framework. 134 jurisdictions, including Guernsey, have reached agreement on proposals that ensure the largest multi-national enterprises pay a minimum effective tax rate on their profits. Technical discussions are continuing, meaning there is not enough certainty yet about how the rules will apply in practice. It is estimated that an additional £10m a year in revenue might be raised from implementing aspects of the proposals, but we need to be careful when making changes to the corporate tax system.
Guernsey’s corporate tax regime was not borne out of competitiveness but a need to meet international standards on fairness which are in place to prevent harmful tax practices. It is also designed to provide fiscal neutrality which is essential for the finance sector which is the engine room of our economy. The finance sector is one of substance, which means economic activities and employment, which in turn means that revenue is raised through direct and indirect taxation. Guernsey acts as a hub for the investment of global capital around the world. This means that financial services can be developed which ensure that tax is paid where it is due, when profits are remitted. This is facilitated by the highest standards of tax transparency to prevent tax fraud.
Not only are corporate tax systems subject to intense scrutiny to make sure they meet international standards, they facilitate the local economy and are also internationally competitive. If we make changes to the corporate tax system which impacts the way financial services are developed and managed in Guernsey, this could make us less competitive, we could risk disrupting our Financial Services sector on which our economy, and many people’s jobs, directly or indirectly, rely. There will always be a careful balance to be had to keep our economic competitiveness, meet international standards and raise revenue from corporate tax which must be kept continually under review.
Why can’t we just tax income?
What is a GST and what are the arguments for and against it?
A GST is a tax on things you buy. Some things, like rents and mortgages, would be exempt, but most things would be taxable, including imported goods above a minimum value – so your online shopping would also be subject to a GST. Because Guernsey is one of a very small number of jurisdictions that still doesn’t have a GST or VAT, introducing one would mean we’re less likely to put ourselves at a disadvantage when competing with other places for business. The competition all already have this in place. Raising income tax on the other hand comes with a bigger risk of making Guernsey less competitive, because our headline rate currently matches our closest competitors.
Because it would be applied to everything sold in Guernsey, a GST also offers an opportunity to gain some revenues (about £6m a year at 5%, about £10m at 8%) from visitors. Jersey also has an International Services Entity fee, which could gain some revenue from international finance providers in exchange for removing the need for them to register for GST in the normal way if the majority of their business is exported (and therefore not liable for GST). Replicating that system here could add a further £6m to the revenues.
Another benefit of a GST is it would allow Guernsey to make a significant step towards diversifying its revenues away from direct taxes on income. That is worth thinking about, because right now our tax system is one that has all our ‘eggs in one basket’ which means its more at risk if employment or wages specifically take a hit. Spreading out the sources of tax revenue is a little bit more secure. It’s a bit like not keeping all your life savings in just one bank account, in case that bank goes under. There is a lot of overlap between people’s income and consumption – most of us spend most of our income – however, at various times in people’s life they will save – spending less than their income. At other times they will use these savings and spend more than their income. For example, many people supplement their income by drawing on their capital assets after retirement and a GST would generate some revenue when they are spent.
On introduction, it’s likely that GST would increase inflation for a period of 12 months (e.g. a 5% GST is likely to increase inflation by 3%). However, this shock would work its way out of the system after that and there are no longer term economic impacts of such a tax.
If GST is introduced, it is very unlikely that it would be brought in at the levels we have illustrated in the models as the additional funding is not all required yet. It is more likely that it will be phased in over several years so there would be a smaller impact (including the inflationary impact) but spread over a longer period.
In isolation, a GST hits lower income households harder than those with a higher income, and that is what people mean when they describe it as ‘regressive’. This is because lower income households tend to spend a higher proportion of their income on essentials and are less likely to save money (for example by contributing to a pension) or spend money outside of Guernsey.
Two of the options set out in the green paper include a GST (Options 2 and 3) and have been designed so that this is offset by other measures which will benefit lower income households and make the overall package progressive. These measures include reducing the amount households may pay in income tax and social security contributions by increasing the allowances available. They also include increases to pensions and benefits which mean that in the round, most low-income households would be better-off.
A lot of the administration of a GST is done by businesses, who collect payment from their customers and then pay this to the States (less any GST they have paid on their supplies). While modern accounting and POS (point of sale) systems make this much simpler than it used to be it can still be a challenge for very small businesses. To help relieve this, most countries set a turnover threshold below which a business doesn’t have to register. An unregistered business would be liable to pay GST on their supplies, but they would not need to collect GST from their customers, and they would not need to complete any returns or pay any money to the States. In the UK the threshold is £85,000 but in Jersey it is set at £300,000, which keeps a lot of smaller businesses out of compulsory registration. If the States agree to developing a Guernsey GST, this level will need to be determined in the next phase of work.
What are Social Security contributions and why is a restructure being proposed?
Social Security contributions are essentially another type of tax, they are money you and your employer pay to cover the cost of pensions, income replacement benefits, long term care grants and some health care services. There are investment reserves which specifically support these benefits and services. The investment return on these reserves helps alleviate some of the annual costs, but they are managed as collective support schemes and the income from contributions is managed to match the long-term forecasts of the collective cost of paying for pensions and other benefits and services. People don’t have an individual pension “pot” in the way you might with a private pension.
The system has evolved over decades and it has developed some problems and unfairness which need to be addressed. At the moment contributors are put in one of four primary contribution ‘classes’, which are assessed very differently. The result is a system where people with the same income can pay markedly different amounts depending on how they earn their income as shown in this table.
One of the things the Tax Review proposes is making this part of the system fairer so that:
- Everyone is assessed on the same definition of income
- A personal allowance is introduced (similar to that for income tax) which makes the system more progressive
- A single, personal rate is applied to everyone of working age, with a reduced rate for pensioners (who are already claiming a pension)
- An employer’s rate is applied as in the current system, but with a reduced employer’s rate applied to self-employed individuals reflecting their dual role as both employer and employee.
The result would be a simpler and fairer system which would be more progressive. The introduction of a personal allowance would mean that, even to raise the same amount of money, the rates applied would be higher. However, the addition of the allowance would also mean that most people with an income of less than £50,000 would actually pay less and those with a higher income would generally pay more.
This restructure is important to make our system fairer, simpler and more progressive but is only really feasible if it is part of a wider programme of reforms to the tax system.
If the States agree – what happens next?
If the States agree the direction of travel on the Tax Review when it is debated later this month, the Policy & Resources Committee will be directed to undertake more consultation and engagement and come back with detailed proposals in July 2022. The next edition of the Government Work Plan will also include a framework to co-ordinate the Tax Review, with other workstreams such as the Review of Population Policy and Public Service Reform, which might reduce the amount of money that needs to be raised.
So there’s still a lot to do, and a lot of different pieces of work that need to come together to come up with the full solution. But the problem is big, it’s serious, and it’s fast-approaching. As one States Member has said, it’s ‘two minutes to midnight’ so we need to crack this now or it will be too late.