Government is underpinned by a system of taxation. The amount of money that government raises from taxes, how it raises it and the ways in which it spends it largely determine the amount we can sustainably spend on public services and the quality of those public services. This means that taxation and public spending are a reflection of a government's priorities, societal values and future aspirations. 

Beyond its primary role of funding public services, taxation has evolved as a tool to mould societal behaviours and address pressing challenges. From the well-known 'sin taxes' on tobacco and alcohol to the contemporary sugar tax and the plastic packaging tax, the tax system has been leveraged to promote healthier choices, environmental consciousness and the broader push towards net zero.

The tax system isn’t without its controversies, debates and imperfections. In certain areas, it inadvertently skews the incentives for how people should behave, leading to unintended consequences such as stamp duty tax reducing people’s mobility to take up new jobs. In others, it introduces arbitrary distinctions that can be perplexing to the public such as how income is taxed differently depending on the person’s employment status.

Tax in the UK is complex and varies across the four nations. So what does the taxation system look like in the UK now and what could it look like by 2040? In order to answer this question, we have been working with the Institute for Fiscal Studies (IFS) to understand the fundamental facts about UK taxes.

1. Tax revenue is at historically high levels but will likely need to rise further to maintain current public services

Total tax revenue in 2020 stood at 32.1% of gross domestic product (GDP) in the UK. In 2021 it went up to 33.5%. This is high compared to many international comparators, but below other western European countries. It is relatively high for the UK in a historical context, but looming challenges such as an ageing population suggest that to maintain the quality of public services, this might need to rise further. 

Tough decisions are coming. Projections suggest that by the 2040s, spending might account for more than 45% of GDP, driven by demographic, economic and technological shifts.

Currently the state raises revenues of just under 42% of GDP. If the UK needed to raise revenues of 45% of GDP now, that three percentage point gap would be around £67 billion of additional revenue needed each year: around 1.5x what is raised in council tax each year. Tax revenues will need to increase substantially or there will have to be a reduction in the extent of, or quality of, public services.

Without major changes such as an acceleration in economic growth or a large downward shift in the country’s age distribution, most likely through inward migration of working-age people, it won't be possible to maintain public services and keep tax at current levels.

2. Borrowing is trickier than it has been in recent years

Borrowing can potentially plug gaps between total state expenditure and total state revenues. However, as the IFS report points out, it is more difficult to manage a higher debt burden in the UK now than in the recent past.

This is due to both weak GDP growth in the UK, which makes it harder to reduce the debt to GDP ratio, as well as rising interest rates over the last 18 months pushing up the cost of servicing government debt. This combination means that the interest the government has to pay each year on its debts is forecast to be at around 3.25% of GDP in 2027-28, a level last seen in the 1980s (see Figure 5 in the IFS report for more details). 

For most years since WW2, an annual deficit was consistent with a falling debt to GDP ratio. Both major parties have publicly committed to this falling debt to GDP ratio. But – as the IFS report explains – we now need government revenue to be higher than government spending (ie, to have an annual surplus) to stop the debt to GDP ratio from rising in the near future. This creates a major constraint on fiscal policy.

One option would be to consider a higher debt to GDP ratio in the short run in order to invest in assets that could support our long-run growth by 2040 and beyond. Higher growth significantly helps to reduce fiscal pressures. Indeed, considering both assets as well as debts through a measure such as public sector net worth could be sensible. For future generations, inheriting assets alongside debt is likely to be much more acceptable. Increasing debt for investment spending can be critical to increase GDP, while using debt to pay for everyday spending is potentially much less sustainable.

3. The tax system is structured in a way that creates arbitrary inequalities 

The UK’s tax system – which differs slightly across the four home nations – is broadly progressive overall, but often doesn’t feel fair to the people it affects. For instance, two people with similar incomes can end up with vastly different tax bills based on their employment status. This not only affects individual taxpayers but can also have broader implications for the labour market and economic dynamics. Tax rates are much lower on capital incomes than on labour incomes, which distorts the labour market away from employment and towards self-employment.

The UK's wealth landscape showcases a clear generational divide, and the tax system is not helping. Often, returns on wealth are undertaxed compared to labour income. Large capital gains on primary residences remain untaxed, exacerbating the wealth divide. The inheritance tax system, too, has its loopholes, benefiting the ultra-rich. While the debate on a wealth tax is complex and can dominate the discussion, a new tax wouldn’t replace the need to rectify existing capital taxes. 

Another distortion comes from council tax, a significant revenue source raising £44 billion a year, but which in England and Scotland is still based on property values from 1991. This results in arbitrary tax bands, often favouring regions like London and the South East. A modern, fair and transparent property taxation system is essential to address regional disparities.

4. Taxes are affecting behaviour – both deliberately and accidentally

Over the years, taxes have been introduced or adjusted to influence societal behaviours. More recent innovations like the sugar tax have been successful at reducing the amount of sugar consumed in the UK. However, their design needs careful consideration. For instance, while taxes on greenhouse gas emissions aim to reduce carbon footprints, their varied rates based on emission sources may make the process less efficient. 

It’s also worth noting that revenues of the longest-running ‘sin taxes’ are declining.

Conversely, some taxes could be seen as actively preventing the achievement of broader social goals. For example, some argue that by stifling the housing market and discouraging people from moving quickly for job opportunities, land transaction taxes such as stamp duty in England and Northern Ireland, reduce labour mobility and thus economic growth.

As economic growth is a top priority for most political parties, the UK's business investment scenario is also concerning. With estimates from our UK 2040 Options report on economic growth showing that the UK has a £100+ billion investment gap each year compared to Germany and the USA, there's a direct impact on productivity and living standards from a lack of investment. The fluctuating UK corporation tax policy might be further hampering long-term investments. Looking ahead, clarity and a well-defined plan could boost confidence and make a difference, given that uncertainty is the enemy of investment.

The taxation system serves as the foundation for government, in no small part shaping the direction and quality of public services, affecting the behaviours of individuals and businesses, and contributing to the distribution of resources. 

The amount of revenue we willl need for our public services to just stand still looks set to rise significantly, given demographic and economic challenges. Concurrently, the present tax structure creates inconsistencies across individual incomes, generations and geographic regions, leading to sometimes significant disparities. 

While some taxes intentionally direct societal behaviour towards government objectives, others inadvertently curb desirable activities or induce uncertainty, especially in corporate investment. 

As we think about the future and the kind of country we want to be by 2040, a clear plan for our public finances as well as wider tax reform should be front of mind.