Get ready for nasty tax hits!

With the government set to overspend by £178 billion this year, Britain faces spending cuts and tax hikes. Here's how your tax bill could leap...

On Tuesday morning, official confirmation arrived that Britain had exited its longest recession. In the final quarter of 2009, the economy grew by 0.1%, finally ending a 1½-year decline in our national output.

However, this feeble growth disappointed pundits who had hoped for a return to solid economic expansion. What's more, having got used to growth of 2% to 4% a year, low growth will still feel like a recession to millions.

Britain's biggest problem

Negative growth, rising unemployment and falling company profits have contributed to a major slump in our government's income. In addition, rising public spending has produced a vast gap between our national income and spending: £178 billion in 2009/10 alone.

As a result, any incoming government (a General Election must be held before 3 June) faces some hard decisions on where to raise taxes. Alas, to balance the books, the government would have to increase all taxes by a third (33%).

Of course, tax rises on this scale would be economic and political suicide. So, here are some ideas as to which taxes could be hiked in the next Parliament:

Income tax

At nearly £157 billion, income tax is the biggest slice of the pie, accounting for over three-tenths (30%) of taxes collected in 2008/09. Nevertheless, any mention of increases to income-tax rates gives government ministers a collective heart attack.

Therefore, any new government is unlikely to tinker with basic-rate tax (currently 20%) or higher-rate tax (currently 40%). After all, a 50% tax rate to 'soak the rich' comes into force from 6 April 2010 for those earning £150,000+ a year.

I suspect that the tax take will go up thanks to 'fiscal drag' by leaving tax bands and allowances will remain at current levels. As earnings rise and the economy recovers, this drags increasingly more people into high tax bands. Already, allowances for 2010/11 are the same as those for 2009/10, so continuing this freeze would help to raise more income tax.

National Insurance Contributions (NICs)

In 2008/09, NICs contributed £98 billion (19%) to the Treasury's chest. Unfortunately, National Insurance rates are fairly complicated, as you can see from the following table (from HM Revenue & Customs).

The 'primary Class 1' NIC rate for employees has already gone up from 10% to 11%, plus a 1% band has been introduced for higher earners. In addition, employers pay 'Class 1A' NICs at 12.8% of band earnings.

Increases to NICs usually upset both employers (who argue that it lowers hiring rates) and employees, too. Thus, I can't see the next government increasing NICs beyond the rises already put in place -- unless they target high earners, of course. Indeed, freezing NIC bands at their current levels is by far the easier option.

Value Added Tax (VAT)

After a temporary reduction to 15% between 1 December 2008 and 31 December 2009, VAT has now reverted back to its standard rate of 17.5%. Even at 17.5%, VAT is modest when compared to sales taxes on the Continent -- as high as 25% in Denmark, Norway and Sweden. Furthermore, many everyday items are excluded from VAT, including food, books and newspapers.

Consequently, it seems likely that a rise to a 20% VAT rate could well be on the cards, together with a widening of the VAT net. Retailers may howl and wail, but our budget shortfall has to be filled somehow.

Council Tax

Of course Council Tax will keep going up. It always has (it doubled between 1999 and 2009) and it always will. Next!

Sin taxes

Drinking alcohol to excess is bad for you, as is smoking, and vehicles have a profound impact on the environment. Thus, the government can display its caring and 'green' sides by whacking up taxes on alcohol, tobacco and fuel.

Already, these goods are among the most heavily taxed items on Earth. For example, when you buy a packet of 20 cigarettes for, say, £5.85, £4.45 goes to the Treasury in the form of duty and VAT. In other words, more than three-quarters (76%) of ciggie money goes to Alistair Darling.

(Luckily, we've rounded up some brilliant booze bargains for you to take advantage of while you still can.)

Similarly, petrol and diesel are taxed to their limit. As I warned in Get ready for higher petrol prices, taxes account for two-thirds (66%) of the petrol price. Nevertheless, the government is addicted to sin taxes, so expect above-inflation rises for taxes on alcohol, tobacco and fuel for years to come.

Dividends

Only about an eighth (13%) of the shares of UK-listed companies is owned by individual investors. As a result, share ownership is often seen as a 'rich person's game' -- and Joe Public doesn't make a fuss about higher taxes for well-off folk.

At present, dividends (the income paid by shares) are taxed much less heavily than earned income. Thanks to a 10% tax credit, basic-rate taxpayers have no additional tax liability on dividends. Higher-rate taxpayers must fork out 32.5% (22.5% after the 10% tax credit).

It seems to me that politicians will have few qualms in raising these tax rates closer to those which apply to other income. Hence, shareholders should brace themselves for lower dividends due to higher taxes.

Capital Gains Tax (CGT)

In 2008/09, CGT (which is levied on profits made from shares and other investments) totalled £5 billion, or less than 1% of the total tax take. Again, it's seen as a rich person's tax, as very few of us make gains in excess of the £10,100 tax-free annual allowance for individuals.

What's more, the rate for CGT is just 18%, compared with rates of up to 50% on income. Thus, making capital gains instead of income is an easy way to 'game' the tax system. Given this, I fully expect the next government to whack up the rate of CGT towards its former level of 40%, while freezing CGT allowances for a year or two.

In summary

Obviously, I'm not suggesting that all of the above tax changes will happen all at once. However, our government is overspending to the tune of £8,000 a year per household. This massive overspend, if unchecked, would eventually lead to a collapse in the UK's credit rating, a run on the pound, and financial misery for millions.

The harsh reality is that, after a dozen years of binging on borrowing, it's time to take our tax medicine. It won't taste nice, but what doesn't kill us makes us stronger...

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