Following Labour's election victory in 1964, the government faced a serious balance of payments problem. Labour's tax policy was aimed at achieving structural change in industry to boost exports and redress the trade deficit. At the same time, the new Cabinet aimed to use tax policy to achieve a greater degree of social justice and agreement between employers' organisations and trade unions.
James Callaghan's 1965 budget, influenced by the economist Nicholas Kaldor, incorporated a major reform of the tax system. Callaghan combined profits tax with income tax on company profits into a single corporation tax. Profits were now taxed at 40 per cent, while dividends were taxed at the standard rate of income tax. Now shareholders receiving dividends paid income tax without a credit for the corporation tax already paid by the company. In effect, this reintroduced differentiated taxation on retained and distributed profits, as the latter were taxed twice. The objective was to encourage the maximum investment of profits. The 1965 budget also introduced a long-term capital gains tax, so that retention of dividends would not merely lead to the enrichment of a relatively small number of shareholders. For Kaldor and his colleagues, this was important for social equity, as capital gains would not be treated differently than income.
Kaldor advised that a general sales or Value Added Tax (VAT) should be used to replace flat-rate social security contributions. Officials were, however, generally hostile to VAT, believing that it would entail great administrative difficulty.
Callaghan's response in April 1966 was a further fiscal innovation in the form of the Selective Employment Tax (SET). This was a means of shifting labour from service industries with low productivity into higher productivity sectors, such as manufacturing. SET was a levy on employment in low productivity sectors, while 'desirable' industries were exempted. This, it was hoped, would redirect labour to manufacturing, reduce costs in the sector and make exports more competitive. SET was implemented under the Selective Employment Payments Act 1966.
Edward Heath's Conservative government in 1970 faced structural problems in the tax system. Britain relied more heavily on direct taxes than other European countries, with people on middle incomes being particularly hard-pressed. Indirect taxes were still narrowly based on the purchase tax and taxes on beer, tobacco and petrol. The bulk of expenditure on social services and security derived from general taxation, so any increases in spending strained the system. The Conservatives aimed to reduce direct taxation on profits and income, and increase indirect taxes, shifting the funding of welfare to contributions.
The abolition of SET was an important priority, the favoured method of replacement being the establishment of a general tax on the sale of goods and services - Value Added Tax (VAT). VAT was initiated in 1973, with only essential goods, such as food, fuel and housing exempted. The tax was a requirement for Britain's entry into the European Economic Community (EEC) into which Heath was determined to go, but was also seen as an effective means of introducing greater flexibility into the system. Labour's corporation tax was amended so that distributed profits were no longer taxed at a higher rate. In the context of widespread industrial conflict, given that the shift to VAT reduced the progression of the tax system as a whole, Conservative policies were interpreted as an attack on labour and Heath lost the general election in 1974.
After his appointment as Labour Chancellor in 1974, Denis Healey announced his intention to introduce a wealth tax on the rich. The question was referred to a Select Committee, which failed agree recommendations. Healey then dropped the proposal on the grounds of administrative difficulties. Apart from ineffectual attempts to capture death duties, Labour was able to achieve little in the pursuit of equality.