Sunday 19 December 2010

Dealing with the Deficit (4) - Tax is always bloody taxing.

On Tax Avoidance, Robin Hood, Bashing the Bankers, VAT, cabbages and Kings (and why the sea is boiling hot and whether pigs have wings - well, not really.)

This article follows on from previous articles outlining the economic arguments around the Coalition's budget plans, introducing the structure of the public finances and the plans for reducing the deficit, and looking at the feasibility of closing the deficit by cutting military spending. It's followed by a final article on the distributional impact and fairness and (my) opinion of the government's plans.  I've separated them out to try to keep them shorter.

In dealing with our country's financial problems taxation is the obvious other element of the equation, along with spending and borrowing.  Even if we as a country manage to agree how much and how quickly we should reduce the deficit there is still the question of Tax; how big a contribution it should make to deficit reduction and what taxes should be raised.  The government does not currently get enough money in taxes, at previously agreed rates, to pay all its bills.  It must, hence, tax more, or spend less, or go on borrowing forever.  But no-one really thinks that last one is a viable option. In one form or another this is one of the eternal issues of politics, seeing as it relates to one of the most important things in human society: money.  It is one of the fundamental arguments of the Left and Right in politics.  Pretty much wherever you are, and whatever the precise figures and names involved, those on the right will be arguing that we should be taxed less and those on the left will be arguing we should be taxed more.  And this is one of those occasions, though the exact details are, as always, considerably more complicated.

The first question that must be answered is the extent to which a change in tax policy is required.  Most of the £155 billion deficit the UK currently has exists because tax revenues have collapsed due to the recession at the same time as spending on social services and welfare have dramatically risen due to the increase in unemployment.  Taxation is generally a skimming off the surface of economic activity.  It is the icing on top of the cake.  Things that are taxed strongly are things like profits, employment, income, capital gains, luxury spending, rather than the underlying substance of economic transactions and existing wealth.  Because of this when recession occurs and economic activity falls the decrease in tax revenue is proportionally much larger.

However, this in itself is not necessarily a good reason to increase tax rates, because after the recession economic activity will return to previous levels, and tax revenue accordingly. If this was all that happened then we could just borrow to make up the shortfall in the meantime until economic activity and tax revenues returned to normal and closed the gap. Unfortunately there is more to it than this. A deficit of this type, caused by a temporary fall in economic activity is the cyclical deficit, as it is caused the temporary affects of the economic cycle rather than any intrinsic mismatch between taxation levels and spending commitments. It is estimated that this accounts for around £50 billion of our deficit. The Other part of the deficit is the structural deficit, so called because it is down to the structural feature of our tax and spending system, rather than a transitory effect of the recession. This part of the deficit will not go away when the economy returns to normal. It must be dealt with either by raising tax rates permanently or by cutting spending. This is the serious part, and it is estimated that it is about £100 billion. But where has it come from?

Firstly, we were running a £30 billion deficit even before the recession. Secondly, the realisation that the boom in the housing and banking sectors was in fact an unsustainable bubble. Thus meaning the record tax revenues from these industries were also a bubble that will not be returning, lowering the estimate for the sustainable tax revenues under the current system.  This is about another £30 billion. The final element is the interest payments for all the debt we've built up due to the recession, which even if we eliminate the deficit we have already piled up and hence must pay interest on until we ever pay the debt off (unlikely), and which hence sucks up tax revenue we could otherwise use for services. This spending has increased from about £30 to £60 billion.  I have gone into this all in a bit more detail here. So that is the structural deficit. And it is what we cannot rely on a return to economic growth to remove. We have to cut spending commitments and projects and/or raise tax rates to get this hole filled in future. So what is the current role of Tax rises in the government's deficit reduction plan?

The government plans £110 billion of 'fiscal consolidation' over the next 5 years, of which £29 billion is tax rises and £81 billion is spending cuts.  That is a ratio of 24% tax rises to 76% spending cuts.

These figures are not in nominal money terms (actually figures spent), or in inflation adjusted real terms, but rather in real terms in comparison to current expectations if current policy is not changed.  In terms of the actual figures of pounds and pence the government plans to spend the plan is quite different.  Spending is forecast to rise by £70 billion from today.  Even in real terms this is equivalent to spending falling by only £25 billion, a fall of about 3.5%.  Tax revenue on the other hand is forecast (in nominal terms) to rise by £170 billion.  In other words the plan is to hold overall spending as roughly flat as possible, bringing it down slightly in real terms, while waiting for the economy to recover to bring tax revenues up until the point where they close the gap. This plan seems very different to the position in the popular media understanding, where 'savage cuts' are going to bring down the deficit.  The truth is though, that this plan does require hefty cuts, just to keep spending level, due to the constant upward pressure on government spending from changing demographics, the constant demand for more resources and rising interest payments.  Even under this plan many areas of spending will continue to naturally expand, thus necessitating the deep cut in programs and jobs to hold spending down sufficiently in some areas for it to naturally rise in others.

The Coalition is planning £29 billion of tax rises, which involves taking the £21 billion of tax rises Labour planned and adding £8 billion onto them.  Labour's plan basically involved whacking the rich with various schemes that massively reduced the generosity of pension rebates, removed personal allowances, and brought in a 50% tax rate; and pushing up NI, Labour's tax rise of choice, roughly from 11->12%.  NI is the 2nd largest tax in the UK and is very useful for raising money because it is paid by everyone and, in fact, paid twice for each person, by them and then again by their employer.  Hence raising NI brings in lots of money, and does it without raising the headline rates of income tax or VAT.  To this mix the Coalition kept all Labour's taxes on the rich, but removed part of the NI increase, while adding the increase in VAT (Britain's 3rd biggest Tax), a hike in Capital Gains Tax and a Bank Levy.  On the tax cut side they cut Corporation Tax, NI for businesses outside the South and raised the income tax threshold, giving a net increase of £8 billion on Labour's plans.

The Coalition's plans represent a continuation of Labour's, retaining significant tax rises on the rich. However it also steers the emphasis by giving cuts to businesses and employers while widening the rises through VAT. Basically they had a preference for raising VAT and cutting NI and Corporation Tax, rather than raising NI and leaving VAT and Corporation Tax. They also have some minor new tax rises, on CGT and the Bank Levy, which Labour didn't have the courage to bring in.  

The argument for cutting taxes on business is simple.  Business will be the driving force that brings new growth and creates the jobs we need to bring unemployment down.  This should be incentivised in the tax system.  Labour approach in raising NI could be particularly harmful.  NI is a direct tax on jobs, a tax on employing people.  To raise NI discourages job creation in a way that raising other taxes does not.  Hence it is a better idea to steer clear of NI.  The idea behind the Corporation tax cut is that it is an incentive for business itself and also a powerful signal that the UK is committed to creating a business friendly environment, crucial for creating the growth and jobs we need to recover from the recession.  The different composition of the tax rises has political reasons.  The scale of the tax rises, higher than Labour's, shows the greater ambition of the Coalition in cutting the deficit more deeply, more quickly.

In terms of the composition of the deficit reduction plan the biggest question is about the proportion of tax rises to spending cuts.  The Coalition government mainly accepted the Conservatives' fiscal plan, predicated on a 80%-20% spending cuts to tax rises proportion, in support of which the Conservatives cite international evidence about successful fiscal consolidations in other countries.  The Lib Dem's influence was semi-jokingly cited when the actual balance announced at the emergency budget was 77%-23%.  This was softened slight further at the Spending Review, with the dropping of £2 billion of capital spending cuts, to a ratio of 76%-24%.  As you may have guessed from these figures, most of the criticism of the plan has been arguing for a higher percentage of tax cuts and a lower proportion of spending cuts.  There has been some small criticism from the Tory and Libertarian Right about the CGT rise, the Bank Levy, and the acceptance of most of the NI rise and especially the 50p tax rate, on the grounds that these will dis-incentivise entrepreneurship and encourage highly-paid wealth creating individuals to go elsewhere.  But it has been a pretty minority criticism, and has little popular support among the great voting public.

No, most of the criticism has been in favour of more tax rises, specifically to reduce the sheer scale of spending cuts required to fulfill the government's plans.  These criticisms have ranged from the complex and costed through to popular slogans and cliches.  At the moment though these seem to be the main element of public criticism however, with an emphasis that has shifted from the election-time argument about the sheer scale of consolidation needed.  This may return, however, if the economy and recovery is seen to significantly falter.

One of the first things that must be said in any discussion about possible further tax rises is to question the popular cliche, along the lines, that the problem with the New Labour government's fiscal plan was not that it spent too much, but rather that it taxed too little.  That is, roughly, that the UK is at the moment a low tax economy, with the implication that there is therefore significant room for further tax rises.  This is not really true though.  It is a tautology that Labour did not raise taxes enough to cover its spending, that is the definition of a deficit, but that it is not to say it did not raise taxes.  NI was its favourite tax, but it also went in for a whole range of stealth tax rises, including their devastating raid on pensions, and massive council tax rises, in an effort to gain revenue without raising the totemic figures for Income Tax or VAT.  Their other trick was to leave the thresholds still, rather than raising them with earnings, thus bringing more and more people into higher tax bands.  In fact, over its decade in office up to the recession Labour raised an additional trillion pounds in taxation, above what would have been raised under the plans left them by the Conservatives.  It is on top of these previous rises that we have already seen the £21 billion of rises planned by Labour, including the 50% income tax rate (the 4th highest in Europe) and NI pushed up to 12%.  On top of which we also have the extra £8 billion of rises planned by the Coalition.  This gives us main bands of direct personal tax starting at £6 grand (well below the poverty line) of 32%, 42% and 52%.  Added to this we already have high local council tax, Inheritance tax at 40%, VAT planned to rise to 20%, CGT hiked, and duty on fuel, alcohol etc that has gone through the roof over the last decade.  There is not really much else to raise on conventional taxes without really further biting into people's incomes.  Even compared to the remarkably high tax Scandinavian countries are tax system has begun to look not too shabby.

The problem with Labour's initial tax plan for the deficit reduction was that, though inventive with finding ways to soak the very rich, it did nothing to incentivise the private sector, piling on taxes on jobs in the form of NI, and ignoring open goals like CGT reform and the Bank Levy.  Unfortunately there is a limit to how much you can soak the rich through inventive schemes, or risk raising corporate taxation in a weak economic climate, so their tax strategy also did not raise enough money to go a substantial way towards closing the deficit, even with their relative reliance on it within their over-all plan.  Since the election of Ed Milliband as Labour leader and the appointment of Alan Johnson as Shadow Chancellor Labour has come forward with a new, slightly revised plan however.  It is basically the same old plan but with the acceptance of CGT reform and the Banking Levy, bloody obvious really for a left-wing party, and the claim the bank levy should be increased and Alistair Darling's Bonus Super Tax should be retained, giving a £29 billion total, the same as the government, but with no VAT rise.  This approach has its bonuses, it avoids VAT, widely seen as a problematic tax, but it retains the faults of failing to incentivise private economic activity as the Coalition manages, and it aims to suck money from the financial sector in a manner that may be electorally popular, but is not necessarily economically wise, as I shall argue below.  It also does not include the government's hike in the base rate, thus leaving the lowest paid under income tax, hardly a progressive alternative. I will go into this a bit more later.

Let's take things back to the beginning.  The most basic tax complaint that one could take about the Coalition's plans is that Osbourne does not go far enough even with the tax rises he has introduced.  The original Lib Dem plan for CGT reform called for it to be raised to the same rate as income tax, either 40 or 50%.  The idea being to tax 'earned' and 'unearned' income at the same rate.  But the definition of capital gains as 'unearned' income, as though it were some kind of feudal unearned rents is just economically illiterate. Some Capital gains could be just the prices of assets rising through sheer luck, but it also covers the wealth creation through entrepreneurship founding new companies or developing existing ones, of people making wise investments in assets, in companies, in commodities that is essential to economic growth and development. One could argue that is far more deserving, requiring personal risk and investment, often of time and money, rather than just receiving a ludicrously high wage for a day's work. Not to mention the role of inflation is much so-called 'Capital gains'.  However, there is a good argument that 18%, Labour's rate, is ludicrously low when Corporation Tax is 28% and higher income tax 40% (or 50%).  Also this difference has led to significant tax avoidance, as company executives and other higher rate taxpayers attempt to avoid such tax by receiving their pay in a form such a share options, which will attract CGT rather than income tax and hence pay 18% rather than 40% tax. Raising the rate to 28% establishes a medium between the 18 and 40% rates, disincentivising tax avoidance, and reducing the profit from doing so, while recognising the importance of capital gains as establishing and creating wealth. The criticism with the Bank Levy is that it is not high enough.  The rate at 0.075% is a little more than half of that proposed by President Obama in the US, and the Coalition watered down its original plans slightly when it became apparent that the Levy would raise more than the £2.5 billion originally planned.  Originally the idea was the Levy would apply on all the liabilities of any Bank with more than £20 billion liabilities.  Now it will apply on all liabilities above a £20 billion threshold, which obviously raises less money.  The Labour criticism goes further arguing that there should be a higher bank levy (roughly double the rate) and a permanent super-tax on pay and bonuses.

This last point brings us onto one of the most popular suggestions for further tax rises: Bash the Banks. This has been popular  both amongst media commentary and also in popular cliche and slogan.  Demonstrations have been full of signs claiming that the poor are paying for a crisis the rich have made, or slightly more precise, why the poor/public services/students or whatever group is being made to pay for a crisis caused by the banks/financial institutions, and hence the correct response should be to wack massive taxes on "the banks" rather than cutting public spending.  This claim deserves unpacking slightly though.  The problem with populist appeals to bash the banks as the solution to our financial problems, whether in the form of the awfully named 'Robin Hood Tax', or a higher bank levy or a bonus supertax, is twofold.  Firstly, we need the financial sector.  The recession was caused by the credit crunch, that was caused by a crisis in the banking sector, effectively drying up the flow of money the rest of the economy needs.  What the economy needs to recover as much as anything is for that flow of credit to resume properly again.  Wacking massive taxes on the large, but not that large, financial sector will only serve to suck money out of those banks, reducing their attempts to rebuild their balance sheets and taking away capital that could have been supporting lending to businesses and consumers.  It is to remove capital from the economy and spend it on our current account deficit.  In the popular slogans we cannot demand that banks both pay massive taxes and 'lend more to small businesses and consumers', we can encourage one or the other.  The other reason swingeing taxes on 'Bankers' is a morally illiterate idea is that not all financial institutions or bankers are equally guilty for causing the crisis.  Only certain banks went to the wall, and only (a relatively small number of) certain bankers and financial institutions were responsible for taking stupidly dangerous risks that horribly backfired.  And, for obvious reasons, these are the very same banks in the worst financial shape now, and hence are in no condition to pay back massive taxes to the exchequer.  If we could close the deficit by confiscating 80% of the assets of idiots like Fred Goodwin, who drove their companies (and the rest of the economy) into the ground while reaping massive pay and bonuses, then I would be all for it.  But it is legally difficult to do so, and sadly would not raise nearly the kinds of revenue we're talking about needing.

The other piece of moral and economic illiteracy is to suggest outrage that a crisis caused in the banking sector should affect public sector spending at all.  Yes, the recession was not caused by the government, but the deficit does exist and now must be addressed.  Yes, spending on the poor is being cut due to a recession not caused by the poor.  But neither did the poor or the state cause the boom before the crash.  And I don't remember hearing any moral outrage over the state or the poor benefiting from the revenue from a boom they didn' cause.  Also, the reason services for the poor and middle classes are being cut is that is where the money goes.  British fiscal policy is highly progressive.  We take money from the rich and spend it on the poor.  There is a limit to how much money we can take from the rich, therefore when money is short we have to give slightly less to the poor.  The much maligned City contributes around £40 billion a year in taxes, before all these new ideas for taxes.  And I don't imagine they get much of that back in services.  The poorest 65% of the population are, on the other hand, net recipients from the state.  They receive more money than they put in, on average.  This is not to say that there is not an argument to be had about the fairness of certain cuts or tax rises or fiscal policies.  But if we are to have a conversation about a fair share of taxes, these basic facts deserve some airing.

The most high profile single Banking Tax outside the government and Labour's proposal has been the so-called 'Robin Hood Tax'.  This has got to be the historical winner for the best idea with the most annoying publicity campaign ever.  Even the name is horrendous.  You may be surprised to learn that a Robin Hood tax is not a tax on robin hoods, or a tax designed by Robin Hood, nor does the actual proposal have anything to do with the name.  It is a Financial Transactions Tax.  It is also a crime against history.  Robin Hood was an enemy of state oppression.  He stole from evil tax collectors to return to the poor peasants their earnings.  Naming a tax after Robin Hood is like naming a prison after Nelson Mandela, or a gun after Gandhi.  This is truly campaigning on tax justice designed by ignorant hollywood, advertising and PR executives.  How very 21st Century. They also had a particularly annoying, smug website, though they know seem to have changed it to be less smug, and to concentrate on changes in the UK rather than internationally.  (They also seem to have branched out from an FTT to calling any attempt to get revenue from the banking sector 'a Robin Hood Tax', which at least displays an admirable degree of pragmatism.)

The basic idea derives from what is called a Tobin Tax, after the man who came up with the idea (see, that name actually makes sense).  This was originally a tax on currency transactions, changing pounds into dollars or yen into shekels or whatever.  The idea was a tax on transactions (not profits) would act as a disincentive to random speculation on the price, stabilising exchange rates by throwing some "grit into the gears".  This idea makes some sense in theory.  The problem in practice is that it pretty much needs wide-spread international implementation to work rather than just implementing it in one country, otherwise it will do little to stabilise the markets on a global basis.  The other problem is that there is no evidence it works even in theory.  Quite a bit of evidence suggest reducing the number of transactions may actually increase instability in the market by meaning that instead of the price being effected by a steady flow of smaller transactions, only larger more speculative transactions are worthwhile, and hence effect the price, making it jump around more.  Just as a flow of sand is smoother than a tumble of boulders.  The 'Robin Hood' Tax proposed recently is essentially a broadening of this tax on currency speculation to include all financial transactions: currency trades, shares sales, futures, derivatives etc; A broad Financial Transactions Tax, levied at on average 0.05%.  There is another crucial difference though.  The Tobin tax was designed to disincentivise certain behaviour: currency speculation. Hence it was not designed to raise large revenue, and would arguably have been a failure on Tobin's terms if it had, as that would imply it had not reduced said behaviour.

The Robin Hood Tax proposals are, on the other hand, explicitly about raising revenue to combat Climate Change, World Poverty and local spending cuts.  The method is just a convenient way to try to squeeze this money from the financial sector without affecting everyone else.  The original campaign was knee deep in contradiction, positing that this tiny tax would raise huge revenue (see the problem there) and that it would globally raise $200 billion a year our of financial sector profits of $500 billion, but that this would have no impact on the activity of this sector.  The problems are legion.  First, such a tax, even more than a Tobin Tax, would need to be introduced internationally, though admittedly not worldwide.  Sweden tried bringing in a FTT on its own several years ago.  The volume of Financial transactions taxable fell by 85% in a year, as it just wiped out the profitability of such deals.  The tax was repealed a few years later as it was bringing almost no money and had basically wiped out the Swedish derivatives market. Second, unless one assumes total global compliance, which is extremely hard even in theory and basically impossible in practice, the projections for revenue are grossly over optimistic. Third, even assuming you could get most of the world signed up, assuming that an attempt to tax off, on top of Corporation Tax and other taxes, half of the profit of an entire industry, an industry that is particularly marginal and sensitive to price changes, without causing a dramatic fall in the quantity of trades, the efficiency of markets and increase in the costs passed onto the consumer, is laughable.  Now, this is not all to say that some kind of FTT could not work. It could, and to work reasonably well it would only require the co-operation of a number of key countries, like with the Coalition's Bank Levy, but still a sizable amount of international co-operation and agreement that would not come quickly. But the actual revenue would almost certainly be well below the campaign's grossly optimistic estimates.  What this proposal is certainly not is a magic wand or an endlessly squeezable cash cow to harmlessly solve all our financial problems.    

Some of the most extreme plans for cutting the deficit through a greater tax contribution came during the general election.  It was often said that everyone agreed on the need for spending cuts, the question was just how much, how soon.  This was not quite true though.  Both the Greens and the SNP and Plaid Cymru all went in with an official position that all deficit reduction (using Alistair Darling's 50% target) should come through tax rises, though none of them detailed how.  That is £70 billion of tax rises.  This is what would be needed, under Darling's half-assed plan, to avoid any spending cuts.  This is an astonishing figure.  It represents more than a 10% increase on total state tax revenue.  That is about all taxes going up by more than 10% (of what they are now).  That is 2% on basic income tax, 4% on higher income tax, 5% on very high income tax, 3% on Corporation tax, 2% on NI, 2% on VAT, big increases in duty, 4% on inheritance tax, Council tax up by £150 a house (on average) all at the same time.  This would leave us with personal tax rates of 35%, 46%, 57%; IHT at 44%, Corporation Tax at 31%, VAT at 20% etc, etc.  The result of all this on a diminished tax base, and weak personal and business confidence, would be devastating.  Considering how much disquiet there has been about a measly 2.5% VAT one could only imagine what the public response would be to such a program.  And all to entirely protect a public sector that after 13 years of Labour rule did have significant scope to save money, though admittedly nowhere near the sums needed to close the deficit.  And the hit would affect everyone across the income distribution, pushing those on low pay into poverty, strongly disincentivising wealth creation and pushing companies away just when we need them to boost the economy.  

In recent months the focus for the argument on taxation in this country has turned interestingly.  With the kind of high-tax route just mentioned not having received great publicity and Labour's more modest program knocked back at the election the discussion on particular tax rises has gone largely quiet, even the 'Robin Hood' campaign appears to have changed to a slightly more pragmatic tack.  The one topic that has come to the fore though is that of Tax Evasion and Avoidance, previously a subject of interest to tax accountants and lawyers and not many other people.  The left appears to be concentrating on this point, because, quite frankly, like welfare fraud, no-one is going to speak up to defend tax evasion, and because they have largely lost the argument, for now, about pushing up actual tax rates.  This is another twist from the traditional political battle of tax and spend.  The first twist was the change from tax and spend to borrow and spend.  Now we have tackle tax avoidance and spend.  Tackling tax evasion is also one of those things that is very popular with the public.  Popular slogans about clamping down on tax avoidance rather than cutting spending are appealing.  The thought that spending cuts could be avoided if we just get those fat-cats to pay their taxes appeals to people as it seems a pain-free way of solving the problem.  But the truth is somewhat more complicated, unsurprisingly.

The first thing under contention is the actual figures involved.  Some campaigners have been throwing around a figure of a £120 billion 'tax gap', which is the combined figure for tax evasion, tax avoidance, and just unpaid owed taxes.  In some popular confusion this figure itself has been quoted as the figure for tax evasion (illegal tax avoidance, as opposed to legal tax avoidance).  Unfortunately though this is an entirely speculative figure and not the one calculated by either the Treasury or the Office of National Statistics.  It is also a somewhat ridiculous figure.  £120 billion is some 8.5% of GDP and about 20% of all tax revenue.  The chances that 1 in 5 of all taxes are being dubiously avoided whether legally or illegally is somewhat ridiculous.  Especially when taking into account that evasion and avoidance is concentrated in a few areas of the economy.  Were this true the figures for taxes un-paid in these areas would be running at 50% or even higher.  The official figures calculated by the ONS and used by the government is £40 billion, which is still huge amount of money, but not quite as impressive as the first figure.  This figure is almost certainly more accurate. Of this only about £13 billion is actual illegal tax evasion.  Tax avoidance contributes another £15 billion and the rest comes from unpaid back-taxes.  This last element the government actually actively encouraged during the recession, allowing companies to delay paying their taxes to help make sure they had sufficient money to survive through the recession.  Then there is the difference between tax avoidance and evasion. Obviously, firstly, evasion is illegal and avoidance is not.  But also, whereas almost everyone would agree that evasion is immoral there is an argument to be had about what tax avoidance is wrong.  At one end of the scheme we have tax lawyers and accountants concocting complicated schemes for large companies that allow them to avoid paying anything like the proportion of their profits in taxes that the law suggests they should.  At the other end we have measures like ISA's, old folk giving money to their children to avoid it getting caught up in IHT, buying wine in France to avoid duty etc.  And in between a whole grey area of varying morality.  Unless one is willing to posit a moral duty to maximise the taxes one pays it is impossible to just lump all avoidance in the same circle of hell as tax evasion.  And this of course cuts down further on the amount of money there is even theoretically available to cut the deficit from this source.

One of the most annoying things about this debate has been the tone of some of the comments accusing the government of choosing to cut public services rather than cut tax avoidance. As though the government could just flick a switch to stop tax evasion and avoidance occurring.  The reality is that cutting avoidance and evasion are very difficult.  The government already spends significant amounts of money pursuing people over taxes.  What is left is a hard core of complex and well planned criminal (or otherwise) activity.  Any fiscal plan that relies on saving a certain stated amount by clamping down on tax avoidance or evasion (see Lib Dems pre-election) should be treated with massive caution, because this is just not a source of revenue that can be easily drawn from by definition.  Nor can one be sure what amount of evasion and avoidance are occurring each year or how much can be stopped, due to the ever changing nature of this activity.  It is possible to clamp down on evasion by spending more money on pursuing it, like any form of crime, and the Coalition has done this, but the returns on this investment are impossible to determine in advance and there is a limit to what this can achieve.  Like with any form of crime, especially such an unobvious one, it is almost certain that it is impossible to completely stamp it out, however hard the authorities tried.  One can only try to minimise it as much as one can.  Similarly, realistically the only way to significantly reduce tax avoidance is through diplomatic agreements with other countries that may be used as tax havens, and by simplifying and flattening the tax system so fewer loopholes exist, or chances for arbitrage like between income tax and CGT.  This is hard diplomatic work and takes significant time.  The problem with simplifying the tax system is that the reason the system is so complex is because it is designed to both squeeze as much revenue from those who can pay while simultaneously discouraging innovation and wealth creation as little as possible.  This leads to complexity.  If the system is simplified one or both of these things will almost inevitably suffer. Even if this is done, like with evasion, it is certain that it will be impossible to entirely stamp out evasion and avoidance.  People will constantly find new ways to try to evade/avoid taxes, even avoiding the subject that some avoidance is not necessarily immoral. As far as the deficit goes, this dramatically reduces the scope for this to act as an alternative to spending cuts or tax rises. Even if the government pursues these issues as strongly as possible, as well as more efficient payment of back-taxes, we are talking about perhaps £10-20 billion a year. Now this is still a significant sum, and definitely worth having.  But it can't be just got at the flick of a ministerial pen, and no exact figure at all is guaranteed, and any major improvement could only be won with years of hard work and focus of time and money.  For all these reasons a permanent deficit reduction plan cannot be based on this possible further revenue.

The last issue that is worth mentioning as far as taxation in the government's plans has been the VAT rise.  This rise has been a flagship element of the government's new tax policy.  It is the main increase on top of Labour's previously planned tax rises that has added an extra £8 billion onto the total for tax rises.  It has come under a lot of criticism, due to the supposed 'regressive' nature of VAT. This is because being a flat tax across all products, it is not clearly progressive in the way income tax is, with those on higher income paying a clearly larger proportion of their incomes. This is not to say that VAT is 'regressive' though. According to the IFS VAT is moderately progressive, because many 'essential' products, which form a higher proportion of expenditure of lower income families, are VAT free, hence VAT falls more heavily on the wealthier who purchase a higher proportion of non-essentials. What the data shows is that VAT is moderately progressive when ranking households by their expenditure, and roughly flat when ranking households by income. This is because a lot of very low 'income' families, under the technical definition, are not actually as poor as these figures suggest. Their expenditure is higher than their income, because they're living on savings, pensions etc, rather than income. This of course skews the figures for the impact of the VAT rise as a percentage of income. For example, I have been a post-graduate student for the last year. In that time my income was practically zero, but my expenditure was much higher. I lived a perfectly comfortable middle class life, and I certainly would not have classified myself as poor. But if you just looked at the percentage of my income was taken up by VAT you would get an absurd figure. It is widely agreed that looking at households by expenditure is a better measure of how well-off a family is, and under this measure VAT is moderately progressive. It is obviously not as progressive as Income Tax or NI though, so why pick VAT to raise.  The answer to that is simple.  Labour's £21 billion had already taken about every approach to squeezing the rich easily available.  To raise further significant money would require rises to VAT, NI or income tax.  Raising NI further, at a time of weak employment, would just push unemployment even higher.  NI is a direct tax on jobs, and the last thing that we want to do is to raise it further at a time like this.  And, raising the headline figures on income tax is about the only thing more unpopular than raising VAT.  Higher income tax rates at 40, 50% are already high, and to raise the basic rate hits everybody unavoidably, whereas VAT can be avoided to a degree, as it does not fall on essential products such as food (though the list of essential products does not make perfect sense to say the least).  To raise the large amount of money that the government's plans need VAT, NI and Income Tax are the only taxes that raise enough to do this, especially once committed to a plan of lowering Corporation Tax to incentivise companies and economic activity, and for the above reasons NI and Income Tax were not chosen.

This finishes my over-view of some of the questions surrounding the Coalition government's tax plans for the deficit reduction program over the next 4 years.  The basic conclusion is that there is no one magic answer to the problems we face.  Tax measures whether a FTT, further bank taxes on liabilities or bonuses, or tackling tax avoidance are all worth investigating and possibly implementing.  But they are all complex ideas that will together produce uncertain levels of revenue, and even all together will certainly not replace the need for serious spending cuts to get the deficit under control.  That is not to say they are not worth pursuing though, every little helps.  I think that we have reached the point where there is relatively little scope for raising significant further revenue within the current structure of the tax system.  This does not mean that nothing can be done, but rather that the situation requires more imagination and innovative thinking, combined with a real attention to the details, rather than simplistic solutions or slogans.  Real reform of the tax system could bring significantly more revenue, in a more progressive manner with less economic disruption.  Possibilities include a Land Tax, a Property Tax, Local Income Taxes, replacing Council Tax, a Wealth Tax, reform to VAT as well as the FTT, specific financial sector taxes and tackling avoidance and evasion.  All this deserves a deserves a good deal of attention and I hope to explore these ideas more fully in a subsequent article.      


Stephen Wigmore said...

One of the best analyses of the continuing risk to the economy from the banking sector. And the risks to the economy going into the year ahead. The comments are unusually interesting and good as well.

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