Free Lunch (15 page)

Fiscal rules

In place of fine-tuning, governments now tend to operate on the basis of so-called fiscal rules. In the case of the countries that have adopted the European single currency, the euro, the rules come under the so-called Stability and Growth Pact. This requires that countries usually run a balanced budget – with spending and taxation roughly equal – and should not allow deficits to exceed 3 percent of GDP in other circumstances. The Labour government elected in 1997 adopted two such rules. The first was the ‘golden’ rule, that over the economic cycle it would borrow only to invest – build new hospitals, schools and roads – and not to finance current spending on, for example, the wages and salaries of public sector workers. The second was what it called the sustainable investment rule, which was to hold government debt, the national debt, at a ‘stable and prudent’ level – in practice below 40 percent of GDP. The national debt, which dates back to the Napoleonic wars and before, is currently around £300 billion, or 30 percent of GDP. Governments have reduced it but never quite succeeded in paying it off. Britain’s debt is low by international standards. The Maastricht criteria for countries joining the euro required that they reduce their debt to less than 60 percent of GDP.

Fiscal rules are in fashion and nowadays any fine-tuning occurs through interest rate changes, through monetary policy. The purpose of taxation is rather different. What is it?

Taxes and behaviour

At its most basic the purpose of taxation is to raise the money governments need to finance their spending. The effects of taxation, however, go well beyond that. Adam Smith gave us the four ‘canons’ of taxation: that it should be based on ability to pay; that it should be ‘certain’ – taxpayers should know how much they have to pay and when; that it should be convenient to pay; and that taxes should be relatively cheap to collect – relative to the amount of revenue they raise, they should be ‘economical’. Ability to pay is perhaps the one that features most prominently in modern tax debates. ‘Progressive’ income tax regimes – where higher earners pay higher marginal rates (the rate of tax on the last pound of income) and therefore a greater proportion of their earnings in tax – exist in the majority of countries. In Britain there is a starting rate of income tax of 10 percent and a top rate of 40 percent. Such regimes have faced a challenge, however, from mainly right-wing advocates of a flat-rate income tax, in which the amount paid would simply rise in line with income. Under a flat tax of, say 30 percent, the £100,000 earner would pay the same marginal rate as a £20,000 earner but would also, because of higher earnings, face a bigger tax bill. The ability to pay principle would be satisfied, although not to the same extent as with a progressive tax.

All taxes distort. Many people will have seen some of the windows of otherwise pristine old houses in Britain bricked up, a legacy of the infamous window tax, introduced in 1696 and abolished in 1851, under which properties with ten or more windows were subject to additional taxation. More recently the poll tax or community charge, brought in as a form of local government taxation in 1990 (and widely seen as a factor behind Margaret Thatcher’s downfall), led many young people to remove themselves from the electoral register, thus depriving themselves of the opportunity of voting, rather than pay the tax.

The precise way in which income tax distorts will depend on circumstances – an increase in income tax rates could either make people work more to maintain their previous post-tax income, or work less because the incentive to earn more has been reduced. Taxes on employment, such as the National Insurance contributions employers have to pay, will, by raising the cost of each worker, tend to reduce numbers employed. The high social security costs – the equivalent of NI – faced by employers in much of Europe are one reason for lower levels of employment, and higher unemployment, there. Indirect taxes such as VAT or excise duties on alcohol, tobacco and petrol will, other things being equal, have the effect of reducing the consumption of such products by raising their price. This was recognized in the principle of the regulator, described above. The extent to which changes in such taxes increase or reduce consumption will depend both on what is happening to income and whether demand for the product is ‘elastic’ (highly responsive to price changes) or inelastic. Indexation, merely increasing duties in line with inflation, is unlikely to have much impact on consumption. Indeed, if earnings are rising faster than prices, as is usually the case, the effects of indexation will be to make the product cheaper in relation to income. Say earnings are rising at 5 percent a year and inflation is 2.5 percent. Increasing duties by 2.5 percent would still leave them cheaper relatively to earnings. They need to rise by at least 5 percent. This is one reason why duties on goods regarded as bad for health or the environment – tobacco, alcohol, petrol – are often ‘over-indexed’, raised by more than the inflation rate. The trouble with this is that, thanks to the EU Single Market and some well-organized smuggling operations, UK consumers of tobacco and alcohol have access to cheaper supplies. Smuggling costs the Treasury billions each year in lost revenues. Legal and illegal imports of such products may mean that the unintended consequence of raising duties for health reasons is that increasing numbers of consumers have access to them at lower prices than before.

VAT, 17.5 percent at the time of writing, is not formally indexed but the revenue from it will tend to rise in line with the level of spending, reflecting both inflation and changes in the volume of purchases.

Laffer and the ‘right’ level of tax

Under Margaret Thatcher in Britain and Ronald Reagan in America, the supply-side revolution of the 1980s, there was a deliberate rejection of the idea that taxation should be used for fine-tuning purposes. An important part of that revolution was a powerful belief that high taxation in general, and high taxes on income in particular, distorts. Tax the rewards of success too heavily, it was argued, and people will have no incentive to take the risks necessary to achieve success. High tax rates on company directors will stifle enterprise. Ability to pay, in other words, can go only so far before it starts to do some damage. Moreover, if tax rates are set too high, their effect will be to
reduce
the amount of revenue the government receives.

In the late 1970s Arthur Laffer, an economics professor who held positions at the universities of both Chicago and Southern California, was having lunch in a Washington restaurant with Jude Wanniski of the
Wall Street Journal
. Laffer sketched out on a napkin the way in which high tax rates could cut revenue. If the income tax rate is zero, then the government gets no revenue. But if it is 100 percent, the government is also penniless, because there is no point anybody working for a zero post-tax income. Between those two points, Laffer demonstrated, there will be a rate of tax above which revenue starts to decline. Initially, say from zero to 50 percent, higher rates swell government revenues. Somewhere around that point, however, the opposite will occur and the government will find itself, having raised tax, worse off. The Laffer curve, which is usually dome-shaped, with the optimum tax rate somewhere in the middle (although Thatcher, Reagan and the supply-siders would always think of anything like a 50 percent income tax rate, even as the top marginal rate, as too high).

The idea that raising tax can reduce revenue is not confined to direct taxes and their disincentive effects. When, under the European Single Market, the rules governing personal imports of cigarettes, wine, spirits and beer into Britain from the rest of the EU were relaxed, the tobacco and drinks lobby argued, with some conviction, that increasing taxes on these items in Britain was having precisely this effect. The more the British government taxed, the more the incentive for individuals, as well as organized gangs of smugglers, to exploit the ‘Calais run’. By the year 2001 the Treasury was losing £3 billion a year in tobacco taxes alone.

Earmarking or stealth?

When the Labour government took office in 1997, it immediately set about raising taxes. Mostly it did this in a subtle, or ‘stealthy’, way. It fulfilled an election promise by imposing a £5 billion one-off, or windfall, tax on the former nationalized industries such as gas, electricity and water that, it said, had made excessive (monopoly) profits in the private sector. It also announced a change that would be worth £5 billion a year by abolishing a tax credit on company dividends previously enjoyed by pension funds. This was a stealthy change because most individuals would not become aware of it until retirement, by which time it would have been wrapped up in a series of other factors affecting long-term pension fund performance. Stealth taxes can, however, backfire. One of the others the government used was to take advantage of weak world oil prices to sharply increase the duty on petrol. Because falling world prices were compensating for rising tax, nobody noticed. But in September 2000, when the world oil price surged higher, petrol prices also increased and the government, not the Organization of Petroleum Exporting Countries, got the blame. In a humiliating climb-down the Chancellor, Gordon Brown, was forced to cut the duties.

The opposite of a stealth tax is one that is raised for a specific purpose – an earmarked or ‘hypothecated’ tax. In November 2001 the government published an independent report, the Wanless report, which said that the National Health Service needed substantial additional resources. This sparked a debate about introducing a hypothecated health tax. The Treasury rejected it, saying it would be wrong to link health spending to the revenue from a tax that could vary from year to year. Instead it raised National Insurance in the Budget a few months later. The Treasury’s real reason for caution about hypothecation, which is a long-standing objection, is that while people might be prepared to pay a health tax, they might object to a tax that had as its purpose raising the money to pay out welfare benefits. Even defence, a traditional public good, might struggle to raise money if it were given its own hypothecated tax.

Taxes, credits and reliefs

In the past two or three decades there has been a tendency in most countries to move from direct to indirect taxes, for supply-side, or incentive reasons – the idea being that if people keep more of what they earn they will work harder. Even so, direct taxes are still more important in terms of raising revenue. The top marginal rate of income tax in Britain was reduced from 83 to 40 percent between 1979 and 1988, while the main rate of VAT increased from 8 percent in 1979 to 17.5 percent in 1991.

Another favoured shift has been to achieve lower tax rates by limiting tax reliefs. A tax relief is an amount that can be set against the amount of tax an individual or company pays. Every taxpayer in Britain has a personal allowance – £4,535 in 2001–2 – the amount that can be earned before any tax is paid. Until relatively recently, most households also benefited from tax relief on their mortgages. For borrowings of up to £30,000, mortgage interest attracted tax relief. At times of high interest rates this implied a hefty bill – in terms of lost taxation – for the Treasury. The relief was pared down before being abolished entirely by the Blair government. So too was the married couple’s allowance, effectively an additional tax relief received by married men. The writing had been on the wall for that relief since the introduction in the 1980s of separate taxation for husbands and wives.

While tax reliefs have been scaled back, tax credits have come into vogue. What is a tax credit? For a long time the holy grail of tax reformers was a negative income tax. The idea was a smooth transition from low earners, who not only did not pay tax but also received money back from the tax authorities, to higher earners who paid tax. Tax credits work a little like that. The working families’ tax credit, introduced in Britain by the 1997 Labour government, directly replaced a welfare benefit (family credit), the difference being that low earners received a top-up not from the social security office but from their employer in their pay packet (the money being subsequently refunded by the Inland Revenue). The working families’ tax credit, due to be renamed the working tax credit in 2003–4, will operate alongside a child credit – payments through the tax system for lower- and middle-income families.

That’s probably enough about tax and public spending. As always, there is no shortage of information on this subject, nor limits to the scope for change. Chancellors have a Budget once a year and usually find a way of tinkering with the system, often by introducing new taxes. The best independent guide through the tax and spending maze is the Institute for Fiscal Studies (www.ifs.org.uk). Its annual Green Budget, published a little in advance of the actual Budget, is an invaluable aid. The site also contains useful information on comparative tax systems.