By Larry Elliott Economics editor The Guardian UK

With a rise in VAT, national insurance and income tax off limits, the Treasury has picked up on the idea that the financial sector is under-taxed

Solemn commitments have been made. David Cameron and Ed Miliband have wrung promises out of each other. The tax arms race has escalated to the point where the options available to Labour and the Conservatives for raising extra revenue are narrowing.

Yet, taxes are still likely to go up once the election is over. Traditionally, political parties that say “they have no plans” to raise taxes before polling day find a compelling reason to do so as soon as voters have made their choice. As the Institute for Fiscal Studies has noted, if a government is going to raise taxes, it does so in the first budget after a general election.

That’s not always the case. Nigel Lawson announced cuts in both the basic and the higher rates of income tax in the budget that followed the 1987 election and overcooked an already booming economy in the process.

But this is not 1988, when the Treasury was rolling in it. A big hole was punched in Britain’s public finances by the deep recession of 2008-09 and the repair job is only half done. A deficit that stood at 10% of annual national income five years ago is now 5% of GDP. According to George Osborne’s original plan, everything was supposed to have been done and dusted by now. It isn’t, which is why the debate over state of the economy and the future path of deficit reduction is so critical in deciding the result of the election. And it is why voters should treat “cast-iron pledges” with scepticism.

So what are the options? Well, most of the big money-spinners appear to be off limits. Cameron has said he will not raise VAT, backing Miliband into a position where he had to say the same about national insurance contributions. No government has raised the basic rate of income tax in decades, so that’s a non-starter. Raising the higher 40% rate is tricky, since it hits the aspirational voters in marginal seats that the politicians spend much of their time wooing. Labour says it will raise the top rate of tax back up to 50%, but this doesn’t raise nearly as much money as, say, increasing VAT from 20% to 21%.

The solution to this problem is simple: tax the financial sector more aggressively. The International Monetary Fund sees it as an anomaly that there is no VAT on financial services, leading to a bigger financial sector than would otherwise be the case.

James Mirrlees, a Nobel prize winning economist, said in his review of taxation in 2011 that there was no reason financial services should be treated any differently from the provision of other services on which VAT is payable, such as having a car repaired or a boiler fixed.

The reason banks, for example, are exempt from VAT – in the US and the rest of the EU as well as the UK – is that the tax authorities have found it difficult to assess exactly how much the customer is paying for the services they get. The bank doesn’t explicitly charge for opening an account or for providing a debit card or for the use of an ATM machine. Instead, it makes its money by offering a much lower rate of interest on the deposits it takes than on the loans it grants.

Even so, the Mirrlees report said it would be possible to construct a tax system capable of assessing financial services for VAT, and produced a rough estimate that doing so would raise £10bn a year. Even allowing for the fact that insurance premium tax has been levied as a less lucrative version of VAT on financial services, it would still raise around £7bn a year – money well worth having for a government short of cash.

Neither the Conservatives or Labour are even talking about putting VAT on financial services, perhaps because it would prompt speculation that they also had their eyes on other currently exempt goods and services. One for the future, perhaps.

It is, though, clear that the Treasury has picked up on the idea that the financial sector is under-taxed. Osborne’s raid on the banks in his pre-election budget was more aggressive than expected: the chancellor raised £3.7bn from the bank levy and a further £900m by making the tax system less generous to banks.

It was once famously said by Jean-Baptiste Colbert, finance minister to Louis XIV, that the “art of taxation was in so plucking the goose as to obtain the largest possible amount of feathers with the least possible amount of hissing”. Osborne failed to obey this rule in his first budget, which raised VAT from 17.5% to 20%, but over the years has seemed to grasp its wisdom.

His budgets have been neutral in that they neither stimulate nor remove demand from the economy, but money has been found to raise the personal tax threshold and to abandon planned increases in excise duty by taxing sectors of the economy unlikely to hiss too much. Banks fall squarely into this territory, as do rich people and corporations that use sophisticated methods to avoid paying tax. Osborne’s deficit reduction plan for the next parliament involves raising £5bn by targeting tax avoidance, which looks optimistic but gives a clear indication of his thinking.

Labour has plans for a bankers’ bonus tax and would tighten up the regime on stamp duty for share transactions. ProfAvinash Persaud says high frequency traders and hedge funds are abusing something known as intermediary relief, which exempts someone from stamp duty if they are buying a share on behalf of someone else. He estimates a tougher approach by HMRC could net just shy of £2bn a year.

The intriguing question is whether Labour is prepared to go the next step and announce that it is joining the group of EU countries planning to introduce a financial transactions tax (FTT). A group of 11 countries, including France and Germany, will finalise their proposals a few days after the election, but opposition from Osborne means Britain will not be one of them.

There are arguments against an FTT, such as that it will make it more expensive to raise capital for businesses. It is also said that the financial sector will pass on the costs to its customers, but that is true of any tax.

The argument in favour is that that stamp duty is an FTT and has been since it was first introduced in 1694. For more than 300 years, governments of all persuasions have found it a reliable source of revenue. In other EU countries, and among Democrats in the US, interest in an FTT has increased for three reasons: the financial sector is undertaxed; the financial sector caused the crisis; and that crisis has left governments skint. They see the chance to pluck feathers from an exceedingly plump goose. Miliband in power might find the temptation equally irresistible.

IMAGE: The Cayman Islands, a tax haven, is the world’s fifth-largest financial centre and hosts almost two-thirds of the world’s hedge funds.
The Cayman Islands, a tax haven, is the world’s fifth-largest financial centre and hosts almost two-thirds of the world’s hedge funds. George Osborne’s deficit reduction plan for the next parliament involves raising £5bn by targeting tax avoidance, which looks optimistic. Photograph: Gary Hershorn/Reuters