Tax Reform

Introduction: where we are now

It is common ground between our main political parties that economic salvation lies in growth. Yet the debate on how to achieve it rapidly descends into a partisan dogfight between proponents of the alternative ideologies of austerity or monetary stimulus.

The austerity brigade offer cuts in government spending and increased taxation in order to reduce the deficit, while even the most avid advocates of printing fiat money recognise that this hare-brained activity has been tested to destruction and it doesn’t work anyway.

The need to reduce wasteful government spending is obvious. At current levels it is unsustainable compared with the resources of the Exchequer. Hence the pressure to raise taxes that are already far too high. Even at existing levels there is a risk of strangling the very industries capable of providing the growth needed to expand the tax base.

This circular logic is self-defeating. Its implicit assumption is that the existing system can be reformed by tinkering with the details while leaving its structure intact. Yet fiddling around with the web of unprincipled lunacy known as the UK tax code, enshrined in 12,000 pages of incomprehensible garbage, will achieve nothing. What is really needed is a large compost heap and a completely fresh and dispassionate examination of tax principles.

Merits of the “flat tax”

Countries such as Estonia, Lithuania, Latvia, Russia, Czech Republic, Slovakia, Ukraine and Georgia had to undertake such an examination following the collapse of that economic aberration known as the Soviet Union. They kick-started their economies into unprecedented levels of growth, at least in part by applying the principles of the low-rate “flat” tax system, in force in Hong Kong since 1947 with a track record of unparalleled success.

The template they followed installs a generous tax-free threshold above which all earnings, whether individual or business, are taxed at a low constant rate, generally in the 10% to 23% range, eliminating all the usual benefit traps (that keep people in poverty), distortions, gradations, deductions, allowances, credits and reliefs that clutter up most tax systems. Dealing with the needy and inevitable “special cases” is achieved by direct payment, not involving the tax system.

Those who remain circumspect about the merits of the flat tax dispute the link between the tax and the growth levels attained, claiming that these were attributable as much to the shedding of Communist shackles as to the tax system. Sceptics also point to instances where initial bursts of growth have been followed, sometimes after many years, by a decline in the rate of growth, as if this were evidence that the flat tax is not quite the panacea claimed.

A closer look at the metrics shows, however, that such growth reductions may well have resulted from wider recessionary forces and inflationary distortions that have little to do with the flat tax.  Indeed, in a number of cases the success of the tax has even enabled its rate to be brought down.

The flat tax has a classical pedigree

The low-rate flat tax is somehow perceived as a novelty, whereas only its name has been coined relatively recently. Its historical provenance goes right back to Adam Smith’s maxims, canons or principles against which the fairness and efficiency of any system of taxation may be tested. Other classical economists accepted their validity without question, notably David Ricardo and John Stuart Mill.

The first canon is the most relevant to the current debate. It states: “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.”

The underlying principle could hardly be clearer. Only a flat tax is truly levied “in proportion” to the income being taxed. The alternatives are taxes which are either “progressive” or “regressive” in their incidence.

Progressive” sounds good – but such taxes are pernicious

Any tax which bites “differentially” will be either progressive or regressive. Most industrialised nations have progressive tax regimes. Such systems impose tax rates that rise as earnings rise and therefore, by their very nature, discriminate against the achievement of higher earnings. Similarly, such a tax will, without doubt, impose a disincentive to achieving earnings above the marginal threshold. A tax system that has more than one such graduation threshold merely compounds the felony and loads the system against hard work,  industry and endeavour, while greatly encouraging tax-dodging in the murky realms of the unrecorded cash-economy.

Only a flat tax conforms with Adam Smith’s insistence that tax should be proportional to revenues. The very moment politicians tamper differentially with rates of tax, invariably in the interests of “fairness”, the cause of fiscal justice is as good as lost. Tax then becomes a populist bauble and the handmaiden of electoral ambition.

The political classes will always present ever-so-cogent arguments concerning the amount of tax which the “rich” should bear and the amount of tax from which the “labouring classes” should be shielded. But the truth is that all such hypotheses, clothed in notions of fairness, are arbitrary and unprincipled. These rule-makers don’t actually have a clue.

In this short piece I have focused on the most important principles, and have not covered key issues of simplicity, ease of administration and the low costs of collection; nor the knock-on effect of business success on employment and, ultimately, on forging the virtuous circle of a rising tax base and a falling tax rate. On such questions  the flat tax is an outright winner.