Taxation - Retrospection hampers fairness

The Budget may still be five months away, but we can be sure that some fireworks have already been arranged for us. We may even look forward to a little display in the November pre-Budget report.

On past form, plenty of the proposals will lead us to cry ‘foul’. And the worst type of foul is retrospection. But what, exactly, counts as retrospection? What should we condemn?

The most explosive example from the 1998 Budget was the instantaneous withdrawal of the foreign earnings deduction. This not only hit people who had just signed contracts to work abroad, but also those already working abroad.

A slower-burning bit of retrospection from the last Budget lurks in section 97A of the VAT Act. This ensures that future changes to VAT rules on place of supply will apply to services performed after the date of change, even if the price was agreed and payment made earlier.

Too late to do anything about it

These two examples have one thing in common: they change the value of existing contracts, when it is too late for the contracting parties to do anything about it. If they had known about the change in advance, they would have negotiated a different deal.

But defining retrospection as changes that interfere with existing contracts is too narrow. Another measure in the 1998 Budget was the withdrawal of capital gains tax retirement relief over the period from 1999 to 2003.

This did not interfere with existing contracts. It was still retrospective, however, because business people had been building up gains for years, planning to retire in (say) 2005 and expecting the gains to be tax-free.

Indeed, their retirement planning may have depended critically on the gains being tax-free: tax at an effective rate of 16% (which is what tapering relief will give by 2005) could take a big bite out of a pension. This example tempts us to swing to the other extreme from looking just at contracts.

We might cry ‘retrospection’ whenever a tax change affects the future value of past decisions. But if we go that far, we rule out most of the things chancellors like to do. Increases in petrol duty may make you regret having just bought a car. Even a change to income tax rates changes the value of having worked to get qualifications in order to get a job.

So saying that all tax changes that change the future value of past decisions are retrospective is going too far. Some tax changes are simply accidents of life: we cannot expect the tax system never to change, any more than we can expect technology or markets never to change.

Indeed, we would not want the tax system to be fossilised. Who would want us to have been stuck with the pre-1995 rules on rental income?

How much will we lose?

There is a very delicate balance to be struck here, especially for a chancellor like Gordon Brown who wants to modernise the tax system. Changing the rules often produces losers. Even if there are no losers in cash terms, there are losers relative to winners: if Fred pays #100 less tax and Joe, on a similar income, pays #200 less, Fred will bear an increased percentage share of the burden of public services.

Gordon Brown is hardly going to be paralysed by fear of losers in relative terms.

He should even be allowed to do some things that produce modest losers in cash terms, where the benefits to taxpayers as a whole justify it. But we should all be made fully aware of what is going on.

When changes that generate losers are announced, we should be told how many people or companies will lose out, and by how much, as well as how many will win. The government cannot always be sure: people may change their behaviour to avoid loss, though it is very hard for them to do so in response to retrospective changes. But so far as the information is available at all, it is already available to government.

Ministers do not make Budget decisions without asking their officials how many losers there are likely to be. And officials have access to the best database on taxpayers in the country – the Revenue’s own records.

If the chancellor is proud of his policies, he should not fear disclosing their costs as well as their benefits. That really would be a firework for Budget day.

Richard Baron is deputy head of the Policy Unit at the Institute of Directors.