But what are the wider implications of all this complexity and what would a better system look like? The Institute of Economic Affairs’ ‘tax and growth’ project has looked into these questions from the bottom up. First it assessed the history of tax and spending in the UK, demonstrating the steady rise of government as a share of national income over the past 150 years. Then it surveyed the economic evidence to see what the data suggests that the scope of an ideal tax system would be from the perspective of maximising growth and welfare.
Next it assessed the flaws in the literature regarding the link between tax and growth before presenting new data and analysis, demonstrating the links more robustly than ever. Finally, using the overall parameters for the scope of tax in the economy, it looked into the literature to derive a tax system which would be best suited to promote welfare and growth.
The resulting tax system would entail a radical shake up of the way government interacts with taxpayers, substantially loosening the system’s stranglehold on economic growth while transforming the system from a Byzantine labyrinth of complexity into a modern machine for efficient government finance.
Expanding on principles first laid out by Adam Smith, we propose three sequential rules:
- Taxes should be as transparent as possible, a core component of which is certainty
- Taxes should be as neutral as possible, applying the same tax at the same rate to different activities wherever possible
- Marginal tax rates should be as low as possible, except for taxes designed to cover costs imposed on others
A special fourth rule should also be followed: taxes designed to charge for costs imposed on others should be set at a level to cover those costs alone, discounted to reflect uncertainty.
How would applying these principles change the system?
A single income tax, at a single rate, would apply to all income types however received, above a personal allowance to avoid tax on de minimis earnings and to minimise tax on subsistence income. Corporation tax, national insurance and capital gains tax are all, fundamentally, duplicated variations on income tax. Distributed corporate income (dividends, interest, share buy-backs etc) should be taxed like any other income. But profits left with companies are investment – either reinvested by the business itself or put in a bank and lent on to others – and this investment should not be taxed. National insurance is effectively a duplicate income tax which has no useful function. All these additional taxes on income should be abolished.
The intrusiveness and scale of administrative requirements necessary to fairly and comprehensively tax gifts made while living strengthens the case that both lifetime gifts and bequests on death should be seen as already-taxed transfers of income. Inheritance tax should consequently be abolished.
Consumption should be taxed with a broad tax, probably a VAT, applied universally to all consumption (including housing with a return to a system like domestic rates) with no exemptions or reduced rates.
A single, neutral carbon tax could ensure emitters cover the costs to others of their emissions. In addition, limited local fuel duties would be acceptable to cover the cost to others of congestion, the impact on the local environment and the cost of road building and maintenance. However, current fuel duty rates are at least double reasonable estimates for these factors, and the combined rate should fall accordingly. But vehicle excise duty performs no useful function in most cases and should be restricted to particularly heavy vehicles which damage roads disproportionately.
The costs incurred by others associated with alcohol, tobacco and gambling consumption are very weakly correlated at an individual level. As a result, duties effectively operate as arbitrary, distortive ‘sin taxes’ for most consumption, reducing welfare by encouraging sub-optimal consumption levels, while failing to charge users for the full costs in the limited number of cases where third-party costs can be attributed to individual consumption. They should be abolished entirely.
Wealth and land
Transaction taxes like stamp duty on shares and property depress values, gum up markets and cause distributional frictions. They should be abolished, along with business rates, which arbitrarily pushes business into unnecessarily cramped use of property.
Finally, because wealth is normally so mobile, wealth taxes are particularly damaging, breaching all three design rules. They should be avoided. An exception is a tax on the value of land (LVT) which is attributable to solely to its location – its location value. A good tax system should therefore introduce such a tax in a phased manner. LVT should replace council tax, the community infrastructure levy and “section 106” payments by developers for affordable housing.
Various other fiddly, opaque or distortionary taxes should also be abolished, such as air passenger duty (APD), the television licence and the climate change levy.
In addition, the approach to taxation policy should also be fundamentally reformed. A formal tax strategy should map out how the Government wants the system to evolve while annual budgets should be replaced with simple statements of accounts. Thresholds should be indexed and policy decisions should be made separately from financial statements to enable proper scrutiny, enhanced by full dynamic analysis of all measures.
Our proposals were modelled using 2014/15 numbers with a 15 per cent single income tax above a £10,000 personal allowance, a 12.5 per cent VAT, including on rental and imputed rents on residential property, and LVT aimed at capturing 75 per cent of the location value of land. These rates should capture approximately 22.5 per cent of national income at market prices, around £410 billion in 2015/15.
The impact on households would be largely progressive due to the substantial cuts in highly regressive sin taxes and reform of property tax outweighing the impact of regressive changes to taxes on income. The biggest winners would be households in the bottom three income deciles, gaining tax cuts worth 26, 19 and 17 per cent of gross household income.
Rory Meakin is a co-author of ‘Taxation, government spending and economic growth’. This article was first published on Conservative Home.