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As Chancellor Rachel Reeves prepares to unveil her autumn budget, the government is under pressure to boost revenue.
Economic analysis released in October shows that for the Chancellor, increasing income tax would be the “least damaging” option for the economy compared to increasing VAT.
The National Institute of Economic and Social Research (NIESR) found that increasing VAT would exert greater downward pressure on real incomes, while income tax increases would be less damaging.
The think tank, which analyzed income tax, corporation tax and VAT, also warned against seeking revenue beyond these “core” UK taxes, citing other methods as potentially damaging.
Of the three, the NIESR said that raising VAT would have the largest negative impact on the UK economy, as real personal disposable income (RPDI) would be reduced by around 3 per cent and real GDP (gross domestic product) about 1 percent in the first year the tax is implemented.
A higher VAT rate will also increase inflation more than other levers because of its impact on prices in stores.
According to the analysis, raising corporation tax – which is levied on profits made by businesses – will have little short-term impact but will hit the economy in the long run by reducing investment.
On the other hand, the impact of an income tax increase would be minimal, reducing GDP by about 0.05 percent in the first year after the tax is implemented.
The scenarios in the NIESR’s analysis are based on the assumption that the government aims to raise total net annual revenues by £30 billion by 2029–30.
Ms Reeves needs to raise this amount to plug the projected black hole in public finances.
The NIESR said the “least bad” option is therefore for the Chancellor to raise income tax in his next Budget.
The think tank acknowledged that doing so would mean the Labor government would break its manifesto promise not to raise taxes on “working people” – which it said was now broadly taken to mean income tax, VAT, Employee National Insurance contributions and corporation tax.
“We would argue that they could find other ways to raise tax revenues but doing so would be highly distortive, which would harm the economy in the long run,” the report’s authors wrote.
Ed Cornforth, NIESR economist and lead author of the analysis, said: “Our analysis clearly shows that an income tax increase is the least damaging option for the Chancellor to put the economy on a sustainable, secure footing.
“VAT will put downward pressure on prices, an undesirable option given current inflation expectations, and additional business taxes will harm investment incentives at a time when employer NICs have already undermined business confidence.
“Although politically distasteful, avoiding raising income tax will force the Chancellor into worse choices – tinkering around the edges will not shift the dial.”