HMRC's modelling of tax changes indicates challenge for Chancellor

HMRC’s direct effects of illustrative tax changes bulletin (January 2025) has recently been released and illustrates the potential impact on tax receipts of tax changes. With challenges around raising revenue to fund public services and filling the black hole in the Exchequer’s finances, the Chancellor’s choices to date have been limited by manifesto pledges to leave certain taxes at their current rates. The Chancellor largely pulled all the tax levers left at her disposal in the 2024 Autumn Budget, and it is difficult to see how much more can be generated by pulling similar ones in the future. 

This latest HMRC’s modelling highlights an uncomfortable truth that raising significant sums in tax often requires the burden to be borne by the many, rather than the few. Whilst proposed changes to inheritance tax, capital gains tax and employers’ National Insurance contributions (NICs) announced in the last budget are expected to raise significant funds in the years ahead, it is expected that most of the burden of this extra revenue will ultimately fall onto the shoulders of employees, due to the NIC increases. 

The Chancellor faces a difficult few months ahead and the prospect of a global trade war on tariffs is unlikely to represent positive news for the UK economy in terms of gilt yields and growth. How then might the Chancellor approach the challenge of having to raise additional taxes later in the year if she feels forced to do so?

One option may lie in hypothecated taxes, or in plain terms a new tax designated for a specific purpose. For example, a new healthcare duty to directly fund the NHS, which may bring back memories of the short-lived health and social care levy. Public opinion surveys have previously suggested that individuals may be prepared to pay higher tax bills in exchange for better public services. If economic growth proves to be weaker than expected this year, the Chancellor may need to think about testing the strength of that view. Such a hypothecated tax might in reality represent an effective increase in income tax but still maintain the contention that the manifesto commitments remain in place.

HMRC’s illustrations show the potential impact on the nation’s finances of the change of rates or reduction of allowances for a range of different taxes and provide inspiration for a new hypothecated tax. What is most stark is the impact of comparatively small changes to rates where they are less targeted and apply to more people. 

For example, an increase of 1% on the lower rate of income tax is forecast to raise £6.55bn in 2025/26 increasing to £7.9bn in 2026/27. The figure is so high as more people would be contributing more tax – so many contributing rather than a comparatively small number. When this is compared to an increase in the standard rate of inheritance tax (IHT) of 1%, the estimated increase in revenue would be £85m and £195m in the same periods as there is still a limited number of estates subject to IHT.

The other big hitters in terms of revenue raised in the illustrations would be a 1% increase on the standard rate of VAT, currently 20%. Per the figures, this would raise an additional £8.55bn in 2025/26 and £8.9bn in 2026/27. For most VAT registered businesses, this would not represent any additional costs, but would be payable by end users – notably individuals and non-VAT registered businesses. It seems unlikely that the Chancellor would want to introduce further taxes, or indeed tariffs that might have a similar effect, on consumption as it could encourage inflation and potentially impact those worst off the hardest.

There will be those that contend that hypothecated taxes could still be targeted on the wealthy few and that may yet prove to be a route the Chancellor is encouraged to pursue. The challenge with this is the uncertainty involved in generating the hoped-for tax receipts, due to the potential changing of behaviour of the small number of taxpayers targeted. If certainty of significant inflows of tax is needed, it may be the number of shoulders bearing the burden is more important than how broad they are.