Why is it getting harder to raise taxes in the UK?

IMF argues that major reform is needed of Britain's tax complexity and competitiveness

Britain faces warnings from the IMF and its own fiscal watchdog that it is running out of space for tax rises unless they are accompanied by major reform.

The country sits in the middle of the pack of advanced economies in terms of its overall tax burden, with revenues relative to the size of the economy well below those of France, Germany and Italy.

But Rodrigo Valdés, director of the IMF's fiscal affairs department, told the FT this month that "unless fundamental reforms of the tax system were to be envisaged, tax space appears to be constrained".

As chancellor John Healey prepares to present his first Budget, why is it getting harder for the UK to raise taxes?

How does the UK rank on tax?

A freeze on income tax thresholds since 2022 and a series of tax increases since 2024 mean the country's tax burden is on track to reach a record postwar high. The gap between UK and EU government revenues as a share of GDP has narrowed to its smallest on record this year, according to new IMF data.

The UK stands out particularly when it comes to some areas of taxation. For example, tax revenues from property relative to the size of the economy are the highest of 38 OECD countries.

But that still leaves the UK with a lower overall tax burden than many other countries according to OECD figures.

The UK ranks poorly in tax complexity and design, however, says Stuart Adam at the Institute for Fiscal Studies. Examples range from the length of the tax code to the complex ways in which work is taxed and the labyrinthine system of exemptions and reliefs from VAT.

As such, the country is close to the bottom of the ranks of richer economies for tax competitiveness, according to the Tax Foundation, with an even lower position for property taxes "due both to its high rates and bad design".

The UK's tax problems are "not really about revenue; it's about structure," said Alex Mengden, economist at the Tax Foundation, noting that the overall best performers were those with broader bases and lower distortions.

"Most countries have some problem somewhere [in the tax system], but we have problems everywhere simultaneously," said Arun Advani, a professor at the University of Warwick.

Higher earners are hit hard

Income tax rates for typical earners, excluding social security contributions, are higher than the OECD average, but the gap widens for higher earners.

Britain also has a series of tax cliffs that are "unusual" among advanced economies, explained Mengden. These include the withdrawal of childcare benefits and the gradual loss of the £12,570 tax-free personal allowance for people earning more than £100,000 a year.

These can lead to very high marginal rates that act as a disincentive to extra work. Adam said, for example, that losing childcare support for incomes above £100,000 is "just an insane thing to do".

On the other hand, UK social security contributions relative to wages are lower than in most other countries.

The difference reflects different social security systems, particularly pensions. In Germany, France and Italy, a larger proportion of retirement income is provided through mandatory public pension schemes financed by social contributions.

In the UK, social security contributions are lower and more loosely linked to benefits, but the figure excludes the automatic enrolment pension scheme, which creates additional pension-saving commitments for most eligible workers.

Why is it getting harder to raise tax?

David Miles of government watchdog the Office for Budget Responsibility said that when tax rates rise high enough within a broadly unchanged structure of taxation, it can create damaging distortions in the economy.

The IMF has issued similar warnings, saying that meeting the UK's increased spending demands through tax measures alone "would risk amplifying distortions and undermining growth prospects".

Room for higher rates is restricted in several areas, it said. For example, the VAT rate of 20 per cent is already above the OECD average. Attempts to raise taxes on capital are "particularly sensitive to avoidance" as individuals shift assets across jurisdictions.

The chancellor has rejected calls by senior Labour figures to raise capital gains tax to the same level as income tax, as he seeks to preserve the country's attractiveness to investors.

While the UK could increase taxes on labour further, it is "approaching a point where labour supply responses could become sizeable," the IMF warned.

"The higher taxes get, the more economically damaging additional tax rises are," said Adam at the IFS. This is because the higher rates become, the greater the incentive people have to change their behaviour to mitigate the impact.

What about the Labour manifesto?

Labour's 2024 general election manifesto is also making it harder to boost taxation as Andy Burnham has declared he remains bound by its pledges.

The manifesto states that a Labour government will not increase taxes on working people -- meaning National Insurance, income tax or VAT.

As a result, former chancellor Rachel Reeves opted for an increase in employer National Insurance contributions that many economists say damaged incentives to hire workers. The manifesto also takes increases in corporation tax beyond the current 25 per cent off the table.

The result is the government has to "scrabble around and have lots of little changes" to raise revenue, said tax expert Dan Neidle. "That is sub-optimal."

The government wants "to raise tax in a way which is politically as easy as possible. And that normally means as complicated as possible in tax terms," added Neidle.

The answer, according to organisations like the IMF, is for Britain to bite the bullet and embark on deeper reform of its tax system. Among its proposals: broadening the VAT tax base by removing certain exemptions and reduced rates, or replacing Council Tax with a recurrent property tax based on updated valuations.

Such ideas have been floated for decades. But what politicians have yet to figure out is how to take these radical steps and get re-elected afterwards.