What could happen with a painful budget?

Written by Corporate Tax Director, Ivan Woolgrove and Private Client Group Director, Helen Kent-Woolsey.

What could happen with a painful budget!

The Prime Minister in his speech in Downing Street on 27 August warned that tough action would be necessary to ‘fix the foundations of the country’, and that there will be difficult decisions ahead including a ‘painful’ first budget in October.

The Chancellor, Rachel Reeves, with her eyes on the prize of a stable economy and economic growth will deliver this painful budget in a few weeks’ time, on 30 October.

This budget will be delivered against the background of what Labour say is a £22bn black hole in the Country’s finances.  They say this black hole has been discovered since polling day, although this is disputed by the previous government. The Chancellor is also facing criticism of her decision to remove the winter fuel payments from all but the poorest pensioners, that was the first step in dealing with the black hole.

One way of plugging this black hole would be by reversing last year’s National Insurance rate reduction that cut taxes by £20bn, but the Chancellor has ruled out this out.

The Government is making it clear that those with the broadest shoulders will be asked to bear the greatest of the burden, so the question becomes what taxes/changes are in the Chancellor’s sights. 

What has been ruled out?

• We have been told that working people will be protected from additional taxes, with increases in Income Tax, National Insurance or VAT already ruled out. Also, the main rate of Corporation Tax will remain capped at 25% and capital allowance full expensing will remain for the duration of the parliament. 

• The Prime Minister defined working people as someone who earns their living, relies on public services and does not really have the ability to write a cheque when they get into trouble. It is not clear just who this definition is targeting, for example we can all be said to rely on the NHS (it is after all the only place where you can get an ambulance) and a person with a heavily mortgaged property may not have the cash flow to just write a cheque whenever they need to. Therefore, could this definition be quite wide?

• The Chancellor has stepped in and said it means someone who goes out to work and earns their money through ‘hard work’, and that it can also include someone who has savings from being able to save up while working.

• With this lack of clarity about who a working person is, does it leave us with an attempt to draw a line between a worker and someone who derives their income from some form of investment activity, or is it just that they are excluding pensioners (see the winter fuel allowance comment above) or are they suggesting someone who works in say a supermarket is a working person whereas a professional who earns more than the living wage or can make larger personal pension contributions is not a working person for these purposes?

The Chancellor also appeared to rule out the possibility of a wealth tax when speaking to the BBC on the second day of the Labour Party Conference. This would have been a bold step and would likely have required extensive consultation on the operation and collection of the tax together with a major exercise to value assets.

What could change?

After many years of fiscal drag, we are all aware that a headline of “not increasing taxes” does not necessarily mean that the population does not pay more tax. With the Chancellor already committed to the freezing of personal allowance and other tax thresholds until April 2028, a further extension of this freeze could be attractive to her. This is because income growth pulls more people into the higher and additional tax rate bands and so increases the tax take for the government without having to change rates.

Capital Gains Tax

One of the most likely tax changes would be to the Capital Gains Tax (CGT) regime where current CGT rates are lower than those for Income Tax, and as well there are a number of reliefs that operate to restrict the tax raised from CGT.

However, the Government has a difficult balance to strike when looking at proposals to increase the charge to CGT as their manifesto promises have been built on a foundation of increased economic growth and the activities of entrepreneurs will be a key factor in that growth. Making changes that put entrepreneurs off will likely restrict growth and cause the government other issues.

For example, if the new rules to increase CGT were to prompt changes in behaviour such as there being fewer transactions then not only may the over-all CGT yield fall, but there could also be a knock-on effect on other taxes such as Stamp Duty Land Tax.

What could we see for CGT:

• Rates of CGT being raised to equal those of income tax, this would follow the logic expressed by Chancellor Lawson in 1988.
• A return to taxing gains at a fixed rate of tax below the 45% additional rate.
• Reducing or abolishing current exemptions or reliefs
• A return to distinguish between rates of tax on short term gains as opposed to those on the longer term holding of assets.

It is anticipated, though by no means certain, that any changes would not come into effect until April 2025, allowing for a one-off boost in tax receipts as taxpayers look to sell assets before the rates rise. We can expect anti-forestalling rules designed to catch planning that triggers a notional disposal.

In terms of reliefs, currently if a taxpayer meets the requirements for Business Asset Disposal Relief (BADR) there is a beneficial tax rate of 10% on the first £1m of capital gains.  The operation of the relief has been tweaked over several years since its introduction in 2008. Although the benefit of this relief is no longer that significant we could see further changes to tighten up the qualification criteria for BADR especially if the gap between the main rate of CGT and the preferential BADR rate widens. Alternatively, there could be an increase in the lifetime limit alongside an increase in the rate of tax to be applied under BADR.

It is often said that death and taxes are the two certainties in life, but in the case of CGT at least you do not suffer that as well as Inheritance Tax (IHT) on a death.

There could be a change to introduce a CGT charge on death although we would expect this to be at a lower rate than those for lifetime gains. Alternatively, the current tax-free uplift to market value that occurs on a death for CGT is being widely trailed as being in the Chancellor’s sights to be abolished.

Inheritance Tax

Although Inheritance Tax (IHT) is suffered by fewer than 4% of estates it is the wealthiest individuals who are generally able to plan around it or use the valuable exemptions to prevent being exposed to the tax. We could, therefore, see a wider overhaul of IHT to focus the tax on the wealthiest estates.

We could see a tightening up on the IHT reliefs of Business Property Relief (BPR) and Agricultural Property Relief (APR). Some commentators are suggesting that a cap on the total amount of relief that could be claimed will be introduced, perhaps at the same limit as BADR at £1m.

The purpose of BPR and APR is to enable the continuity of businesses and so we think it is unlikely they would be withdrawn completely. However, it would be relatively simple to restrict the relief to exclude say AIM listed shares or to increase the current two-year holding period before the reliefs are available.

Further changes to the relief could include modifications to the dividing lines between trading businesses and investment businesses and aligning these with the similar rules that operate for CGT.

We could also see simplifications to the IHT nil rate band (NRB) and the residence nil rate band (RNRB) that could be merged to give a combined band of £500,000 at a relatively low cost. There may be other changes to IHT, such as the use of bands to calculate the IHT on death rather than the current single death rate, or we could see the combining of the different lifetime reliefs into one single gift relief as well as larger gifts out of income being included within death estates rather than being excluded.  

CGT and IHT together produce less than £25bn a year in total, so for the Chancellor to raise say £5bn in additional tax is going to take very substantial changes. For example, including 80% of defined contribution pension pots in taxable estates is expected to raise just £0.25bn, but at what political cost.

Non-Dom Regime

The Labour manifesto promised to go further than the announcement by the previous government in abolishing non-dom status and replacing it with a more modern scheme.

The full details are yet to be announced and commentary on Rachel Reeves’ plans in this area seems to be released on an almost daily basis with those against the idea suggesting the changes will cost the Exchequer rather than be a revenue raiser; indeed, there has been some talk of reigning back on any further changes.

Pensions relief and taxation

Currently tax relief is given for contributions as they enter a pension scheme, increases in value are tax free whilst in the scheme and then tax is charged when the pension is drawn out, except of course for the 25% lump sum that is tax free. Overall, it is believed that the yearly cost of this is in the region of £50bn, and because of the way the relief operates it is broadly for the benefit of wealthier individuals.

What changes could we see:

• A restriction to tax relief given to individuals for the contributions they make. This could be at a flat rate of say 30%.
• Limiting the amount of the tax-free lump sum to say £100,000.
• Imposing IHT on the value of pension funds on death, currently they are exempt.
• Reducing the annual allowance that applies to the amount that can be contributed into a pension scheme in a year from the current £60,000, or perhaps preventing the current system of carry forward relief.
• Reintroduce the lifetime allowance (that the previous government abolished) but maybe with an exemption for public sector pensions (protecting the NHS from losing Doctors to retirement).

All the above could raise significant sums of tax but have varying levels of political risk and introduce even greater complexity into the tax system as well as potentially stopping or reducing the amount individuals save for their retirement.

Therefore, purely form a pension viewpoint imposing National Insurance (NIC) on employer contributions could avoid the above, but raising costs on business has the potential to inhibit growth and so be counterproductive.

Some form of change to pension tax relief is highly likely, but where the Chancellor goes with it will depend on her political bravery on the day.

What else could there be:

• We can see the fuel duty escalator being reinstated but being deferred until the first quarter of next year thereby preventing inflationary pressures at the end of this year.
• Given the drop off in the sale of electric vehicles and with the government committed to the ban on the combustion engine could there be a significant increase in the benefit in kind for non-electric vehicle to come?
• The business taxation roadmap will be published on Budget Day.
• We could see much higher rates of SDLT being introduced for super high value properties.
• After the compliance activity into Research and Development tax credits it seems likely that there will be further changes to the way R&D tax relief operates.
• The government has published details of the imposition of VAT on private school fees, but we are hopeful that there will be further information on how this will be implemented. Even though there are challenges to the policy and a suggestion that it will not be a revenue raiser for the government, but rather it may produce a negative cash flow we do not see the policy being reversed.
• We are anticipating increases in the windfall tax on energy companies and the bank tax surcharge. Also, an increase on the residential property developer tax could be on the cards.

Finally, there are always measures to further counter tax avoidance. We have details of a £555m investment in HMRC to fund a further 5,000 compliance officers and collect an additional £5bn a year to close the tax gap. Could we see additional funds allocated to HMRC to crack down further on tax avoiders?

Overall, it feels like the Chancellor has few options available to her if she is going to close the £22bn gap that she has identified.