Reforming Britain’s Tax System
6 January 2017
SUGGESTED
Economic Theory
5 January 2017
Markets and Morality
Economic Theory
11 November 2024
Most of us believe that some tax is required to fund government spending and some taxes are better than others. Given this starting point, how might economists weigh up whether a tax system is a ‘good’ system or a ‘bad’ system? In this article we look at the principles which underlie a good tax system, what taxes emerge from those principles (and which existing taxes would not), and what implications the implementation of such a system would have across income groups.
Principles
The principles on which a tax system should be based were laid out by Adam Smith in 1776 and have largely stood the test of time. They are: certainty, proportionality, convenience and efficiency. In summary, taxes should be known in advance, levied in proportion to ability to pay, payable in a convenient manner and inexpensive to administer.
These principles are sound, but further insight has been gained subsequently by economists including Gregory Mankiw and Sir James Mirrlees. Using their ideas, we can propose reformulating Smith’s lessons as follows:
Simplifying the UK tax system
How would applying these principles change the UK’s current tax system? Firstly, it would be radically simplified to maximise transparency and neutrality. So there would only be a single income tax, at a single rate, on all income types, however received. Corporation tax, national insurance and capital gains tax are all, fundamentally, variations of income tax and should all be abolished. Distributed profits (such as dividends) should be taxed like any other income. National insurance is effectively a duplicate income tax has no useful distinct function. And capital gains often arise from investors anticipating increases in the income an asset will produce and that will be taxed in the future – therefore capital gains tax is normally a double tax and should also be abolished.
Inheritances can be viewed as a transfer of income from one person to another. However, the income that is transferred has already been subject to income tax and should not be taxed again.
Transaction taxes such as stamp duty on shares and property depress values, gum up markets and lead to assets and houses being not being held by those who value them most. They should be abolished, along with business rates, which arbitrarily pushes business into unnecessarily cramped use of property.
So-called ‘Pigouvian taxes’, whereby we try to tax activities that lead to social costs that are higher than private costs or ‘externalities’ generally fail to stand up to the scrutiny – certainly if we consider those taxes which actually exist in the UK system such as taxes on alcohol and tobacco. Even in the context of socialised healthcare financing, the costs incurred by others associated with alcohol and tobacco are too weakly correlated to individual consumption to be useful. As a result, the relevant duties effectively operate as arbitrary and distortive ‘sin taxes’, reducing welfare and falling disproportionately on the poor. They should be abolished entirely.
Because wealth is normally so mobile, wealth taxes are particularly damaging. They should be avoided. An exception is a tax on the value of land which is attributable to solely to its location – a location value land tax. A property’s location value is the amount it would be worth if the land were found in a state of wilderness but the state of all other properties remained as they were. Taxing this value alone ought not to disincentivise landowners from improving land by clearing it or building structures and it has long been promoted by economists. A good tax system should therefore introduce such a tax in a phased manner, to account for the unfairness imposed on those who have previously bought land in good faith. This should replace a range of other taxes including council tax.[1] There should also be some further reforms to property taxes. These are discussed in part three of Tax, Government Spending and Economic Growth, published by the Institute of Economic Affairs.
Various other fiddly, opaque or distortionary taxes should also be abolished, such as air passenger duty, the television licence and the climate change levy.
Some taxes to be reformed
Consumption should be taxed with a broad consumption tax, probably a value added tax (VAT), as at present. VAT should apply universally to all consumption with no exemptions or reduced rates unlike currently where there are wide-ranging exemptions.
Although it has been suggested that existing Pigouvian taxes should be removed, there is one area where they could be retained but at a lower level – that is in the case of externalities caused by carbon emissions and other pollutants. Here, a single carbon tax would be the best way to ensure emitters cover the costs to others of their emissions. In addition, limited local fuel duties could be used to cover the cost to others of congestion, the impact on the local environment of car use and the cost of road building and maintenance. Current fuel duty rates are set at least twice as high as a reasonable estimate of the level necessary to deal with the externalities caused by cars (including reasonable estimates for the social cost of carbon emissions) and the rate should fall accordingly. Vehicle excise duty performs no useful function in most cases and should be restricted to particularly heavy vehicles which damage roads disproportionately compared with their fuel usage.
Impact of a reformed tax system
Reform of tax systems is often avoided on the ground that it creates winners and losers and the losers scream more loudly than the winners. Of course, if the overall tax burden is reduced, the discussion then becomes one of who wins the most – in other words, what are the distributional consequences of the change? It is often assumed that any reduction in taxes must disproportionately benefit the better off. However, a change of the kind of tax proposed has been modelled and this is found not to be the case.
It was assumed that there would be a 15 per cent single income tax above a personal allowance of £10,000; a 12.5 per cent VAT, including on both residential rental property and the rental value of owner-occupied property, and a location value tax aimed at capturing 75 per cent of the location value of land.
The impact on households would be largely progressive due to the substantial cuts in highly regressive sin taxes and the reform of property tax. 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, continuing to fall to 7 per cent at the fourth richest decile. The richest two deciles would enjoy tax cuts worth 13 per cent of gross income.
Conclusion
Tax need not be nearly as complex and incoherent as the UK system currently is. There are some sound economic principles that have, in recent years, been forgotten by politicians. Also, the poor pay more taxes than they think and a reduction in the tax burden in the context of a reformed system may well help the poor more than the rich.
This article will appear in the forthcoming edition of EA Magazine.
—
[1] There should also be some further reforms to property taxes as discussed in part three of Tax, Government Spending and Economic Growth, published by the Institute of Economic Affairs.
Principles
The principles on which a tax system should be based were laid out by Adam Smith in 1776 and have largely stood the test of time. They are: certainty, proportionality, convenience and efficiency. In summary, taxes should be known in advance, levied in proportion to ability to pay, payable in a convenient manner and inexpensive to administer.
These principles are sound, but further insight has been gained subsequently by economists including Gregory Mankiw and Sir James Mirrlees. Using their ideas, we can propose reformulating Smith’s lessons as follows:
- Taxes should be as transparent as possible, a core component of which is certainty.
- Taxes should be as neutral as possible, thus 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 ensure people pay for ‘externalities’ caused by their behaviour.
Simplifying the UK tax system
How would applying these principles change the UK’s current tax system? Firstly, it would be radically simplified to maximise transparency and neutrality. So there would only be a single income tax, at a single rate, on all income types, however received. Corporation tax, national insurance and capital gains tax are all, fundamentally, variations of income tax and should all be abolished. Distributed profits (such as dividends) should be taxed like any other income. National insurance is effectively a duplicate income tax has no useful distinct function. And capital gains often arise from investors anticipating increases in the income an asset will produce and that will be taxed in the future – therefore capital gains tax is normally a double tax and should also be abolished.
Inheritances can be viewed as a transfer of income from one person to another. However, the income that is transferred has already been subject to income tax and should not be taxed again.
Transaction taxes such as stamp duty on shares and property depress values, gum up markets and lead to assets and houses being not being held by those who value them most. They should be abolished, along with business rates, which arbitrarily pushes business into unnecessarily cramped use of property.
So-called ‘Pigouvian taxes’, whereby we try to tax activities that lead to social costs that are higher than private costs or ‘externalities’ generally fail to stand up to the scrutiny – certainly if we consider those taxes which actually exist in the UK system such as taxes on alcohol and tobacco. Even in the context of socialised healthcare financing, the costs incurred by others associated with alcohol and tobacco are too weakly correlated to individual consumption to be useful. As a result, the relevant duties effectively operate as arbitrary and distortive ‘sin taxes’, reducing welfare and falling disproportionately on the poor. They should be abolished entirely.
Because wealth is normally so mobile, wealth taxes are particularly damaging. They should be avoided. An exception is a tax on the value of land which is attributable to solely to its location – a location value land tax. A property’s location value is the amount it would be worth if the land were found in a state of wilderness but the state of all other properties remained as they were. Taxing this value alone ought not to disincentivise landowners from improving land by clearing it or building structures and it has long been promoted by economists. A good tax system should therefore introduce such a tax in a phased manner, to account for the unfairness imposed on those who have previously bought land in good faith. This should replace a range of other taxes including council tax.[1] There should also be some further reforms to property taxes. These are discussed in part three of Tax, Government Spending and Economic Growth, published by the Institute of Economic Affairs.
Various other fiddly, opaque or distortionary taxes should also be abolished, such as air passenger duty, the television licence and the climate change levy.
Some taxes to be reformed
Consumption should be taxed with a broad consumption tax, probably a value added tax (VAT), as at present. VAT should apply universally to all consumption with no exemptions or reduced rates unlike currently where there are wide-ranging exemptions.
Although it has been suggested that existing Pigouvian taxes should be removed, there is one area where they could be retained but at a lower level – that is in the case of externalities caused by carbon emissions and other pollutants. Here, a single carbon tax would be the best way to ensure emitters cover the costs to others of their emissions. In addition, limited local fuel duties could be used to cover the cost to others of congestion, the impact on the local environment of car use and the cost of road building and maintenance. Current fuel duty rates are set at least twice as high as a reasonable estimate of the level necessary to deal with the externalities caused by cars (including reasonable estimates for the social cost of carbon emissions) and the rate should fall accordingly. Vehicle excise duty performs no useful function in most cases and should be restricted to particularly heavy vehicles which damage roads disproportionately compared with their fuel usage.
Impact of a reformed tax system
Reform of tax systems is often avoided on the ground that it creates winners and losers and the losers scream more loudly than the winners. Of course, if the overall tax burden is reduced, the discussion then becomes one of who wins the most – in other words, what are the distributional consequences of the change? It is often assumed that any reduction in taxes must disproportionately benefit the better off. However, a change of the kind of tax proposed has been modelled and this is found not to be the case.
It was assumed that there would be a 15 per cent single income tax above a personal allowance of £10,000; a 12.5 per cent VAT, including on both residential rental property and the rental value of owner-occupied property, and a location value tax aimed at capturing 75 per cent of the location value of land.
The impact on households would be largely progressive due to the substantial cuts in highly regressive sin taxes and the reform of property tax. 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, continuing to fall to 7 per cent at the fourth richest decile. The richest two deciles would enjoy tax cuts worth 13 per cent of gross income.
Conclusion
Tax need not be nearly as complex and incoherent as the UK system currently is. There are some sound economic principles that have, in recent years, been forgotten by politicians. Also, the poor pay more taxes than they think and a reduction in the tax burden in the context of a reformed system may well help the poor more than the rich.
This article will appear in the forthcoming edition of EA Magazine.
—
[1] There should also be some further reforms to property taxes as discussed in part three of Tax, Government Spending and Economic Growth, published by the Institute of Economic Affairs.
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Rory Meakin is certainly right to say that the UK needs to simplify and shift taxes to more efficient revenue streams.
If we view taxation as an equal share that we each own from whatever revenue stream it is sourced, then it can be of no surprise that taxes on the fruits of work, effort and enterprise will reduce wealth producing incentives.
Most view Income, Capital, Corporation and Value Added Taxes as a necessary evil, but they are not actually in order necessary to fund public services.
Meakin implies that 100% Land Taxes would be confiscatory, but in fact the opposite is true. The failure to equally share the scarcity value derived from resources supplied for free by nature is confiscatory and fundamental abrogation of property rights. From which stems further injustice, like the need to tax produced factors.
We could very quickly replace all our bad taxes with a few simple user fees, like LVT, and some other Pigovian taxes. Which would greatly benefit our economy and our society. No to mention cutting out tax code down to a tiny fraction of its current size.
The only thing that is lacking is the political will to do so.
Congratulations on establishing that taxation and revenue raising needs a complete overhaul, its failure in so many areas:-
Fairly apportion tax raising from all sectors of society in afair and equitable means
Raise taxes from environmentally damaging activities and resource use
Promote economic activity across all sections of society
Promote empowerment to all social groups through their purchasing power
You also say that most areas of taxation needs to be overhauled and pick out a carbon tax as the one
Pigouvian tax that should remain , but really carbon is not the only polluter or damaging agent on the planet , it is the over and misuse of all Natural Resources and indeed I suggest that the whole taxation should be based on this alone with the scrapping of all other taxes as Meakin almost suggests.
This new Natural Resource Tax ,NRT, whereby all Natural resources are taxed according to the damage their use causes the planets ecosystems from minerals , fossil fuels, land water and air should all come under the same umbrella thereby simplifying the whole process and removing the personal income taxes and making everyone without exception equally responsible for the actual and potential damage of all their purchases of goods and services throughout the whole economic chain of industrial activity.
This should also be combined with a overhaul of all welfare services from health, pensions and benefits, with the addition of a Universal Basic Income, UBI, which would help fund the services, and make individuals more accountable for their own wellbeing.
Finally a death tax to prevent excessive transference of wealth from generation to generation which distorts social functions of society. and prevents lockup of monies , rather than recycling funds within the economy and reducing the need for QA and ever higher rates of GDP. Smart growth is needed not greedy growth.
We currently give significant subsidy to pension savings. It would be possible to reduce taxes in capital and subsidies or capital accumulation at the same time resulting is a simpler system.