Principles of tax policy - Treasury Contents

Written evidence submitted by the School of Economic Science


In simple terms, the attributes of "good" taxes are that they do not discourage growth, do not pervert economic behaviour, are easy to collect and difficult to avoid. On this basis taxes on both income and consumption are not good taxes since they discourage growth by artificially raising the price of goods and services. They also discourage employment. Taxes on profits discourage investment and are particularly difficult to levy on international corporations that are free to choice the location where they pay tax. Government revenues taken from surpluses which are not the cause of the price of goods but are determined by the price have the attributes of good taxes. A particular recent example of this more effective way of raising Government Revenues was the licensing of the electromagnetic spectrum. Other examples are the taxation of resource rents and the collection of the economic rent of land.


The School of Economic Science is a registered educational charity founded in 1937. It studies the fundamentals of economics and offers public courses in Economics with Justice.


1.    The Treasury Committee should be commended for launching an enquiry into the principles that should underpin tax policy. For several hundred years now the basis of taxation in the UK has been expediency rather than principle. In that time the proportion of the wealth of the nation that has been taken as public revenue has grown to almost half of the total. When such a large fraction of the wealth produced is taken in tax it has such a significant impact on the economy that it becomes one of the most influential factors in determining the decisions that businesses take in determining their strategy. In such circumstances if the system does not follow sound economic principle but is driven by expediency or is politically motivating it can become highly damaging to the economy.

2.    Most of the questions set by the Committee are succinctly answered by the set of four canons of taxation set out by Adam Smith in his Wealth of Nations: (1) "Tax should bear as lightly as possible upon production so as least to check the increase in the general fund from which taxes must be paid and the community maintained," (2) "that tax be easily and cheaply collected and fall as directly as may upon the ultimate payers - so as to take from the people as little as possible in addition to what it yields the Government," (3) "that taxes should be certain - so as to give the least opportunity for tyranny or corruption on the part of officials, and the least temptation to law-breaking and evasion on the part of tax payers," and (4) "that tax should bear equally on all so no-one gains an advantage."

3.    What these might mean in practice in the twenty first century will be considered below by first examining the unacceptable, negative, distorting effects of the main taxes at present levied in the UK, then by comparison exploring some examples of taxation that follow Smith's canons and finally eliciting the distinguishing feature these "good taxes" have in common.


4.     The Committee's fourth question supplies a good place to start a practical consideration of how tax impinges negatively on the economy. This last question: "Are there aspects of the current tax system which are particularly distorting?" implies a recognition that taxes do distort the economy and implied in the second question is a recognition that one of the most damaging ways they distort is that they restrict growth. Smith's canons suggest this applies when taxation is placed on production. This would include all the major taxes levied in the UK. Income tax and national insurance are effectively taxes on labour, corporation tax a tax on profits and VAT a tax on exchange which is also an aspect of the production process.

5.    Of the present taxes the one that best exemplifies the distorting effect of bad taxes is income tax, or to be realistic the combined effect of income tax and national insurance since, as the Mirrlees inquiry recently demonstrated, national insurance is effectively an additional tax on labour. Although the formal incidence of these two taxes is taken to be the individual, in economic terms there is a strong argument for considering them to fall on the employer, ie to regard them as a payroll tax. This view coincides with the simple fact that the tax is actually paid by the employer. It is supported by the fact that most business liquidations are instigated by the PAYE authorities. What obscures this view is the undue attention given to the "gross" wage or salary. In economic terms what is of significance is not the figures displayed in job advertisements but the real wage or salary, namely, the actual goods or services that can be exchanged for the work done. In monetary terms this corresponds to the net wage. It follows that any increase in taxation that reduces real wages is countered by wage demands that press to restore the previous situation in terms of the actual spending power of the amount received so it is the employer who is worse off. Conversely, in the situation where there is a significant amount of unemployment putting downward pressure on wages the medium to long term effect of decreasing income tax would not be to increase real wages but to keep them roughly constant as competition for employment would enable employers to offer reduced gross wages so that the wages received remained roughly the same. Thus it is employer who benefits.

6.    The way payroll taxes produce a deadweight loss can be shown on a simple supply and demand curve. Basic economic theory states that equilibrium price is determined by the intersection of the supply and demand curve (E1 in figure 1). The effect of income tax is to add to the cost of production. It raises the supply curve. This means it now intersects the demand curve at a higher price and therefore smaller quantity (E1 in figure 1). The shaded area in figure 1 represents the loss of production due to increased cost caused by tax on production. Reducing production across the economy increases unemployment. This requires additional social provision. This puts extra demands on taxation. A vicious circle ensues wherein the additional tax further adds to production costs leading to further loss of production and even more unemployment.

7.    Taxes on trade such as VAT have a similar effect on production but they work by lowering the demand curve since tax has to be subtracted from the price paid to the producer.

8.    The case of British steel provides a specific example of the destructive effect of taxing production through taxing labour. This company made the headlines in 1982 when the figures published by the accountants showed it to have made a loss of £385 million in the previous year, almost £1 million per day. Considering the enterprise from the viewpoint of economics rather than accountancy gives a very different picture. British steel had taken £2,300 million worth of raw materials and converted it into finished products which were sold for £3,400 million. This difference of £1,100 million represented the value added or wealth created by the 112,000 workforce. £700 million of this added value was distributed to the workforce as take home pay and pension contributions, £100 million was paid in interest and £250 million was ploughed back as investment. On the basis of these figures British Steel appeared to be a going concern. Where did the loss come from? In addition to the above BS contributed £64 million in local taxation and £480 million to the Treasury, a large proportion made of PAYE and NI payments. Thus BS could be regarded as a business that was a going concern being destroyed by a tax system that levies tax on production irrespective of the business's ability to pay. Much of the UK's manufacturing industry has suffered a similar fate, particularly in recent years in the face of strong international competition with low labour costs made up of not just low wages but also of low taxes on employment.

9.    The corporation tax, as a tax on profits, has a similar distorting effect since it renders businesses that are viable without the tax uneconomic with it because they provide insufficient return to investors. In these times of international corporations the taxing of profits meets an additional problem that renders its collection difficult. The underlying cause of the problem is that the levying of the tax on profit is disconnected from the location where the wealth is produced. Many strategies are available to corporations to reduce their corporation tax liabilities. They can relocate their head office to a jurisdiction with low tax rates. They can make internal transfers between subsidiaries and make use of offshore facilities. All these have a massive distorting effect on the way the company does business.


10.  In relation to the Committee's questions and Smith's canons of taxation the main taxes levied in the UK, viz. income tax, VAT and corporation tax, can be categorized as "bad taxes" in that they distort the economy, they detract from growth, they encourage employment, they are not easy to collect, and their incidence does not fall on the ultimate payers. Not all taxes are bad taxes. However, in order to include good taxes are it may be necessary to widen the remit from "taxation" to consider Government Revenue more widely. By definition tax is "an arbitrary levy" and so the word "tax" is associated with what has been defined here as "bad tax". "Good" forms of Government Revenue may not be associated with the word "tax".


11.  One of the most successful revenue raising exercises by the UK Government in recent years was the auctioning of the electromagnetic spectrum for 3G in April 2000. It raised £22.5 billion. This had many of the attributes of a "good tax". It stimulated rather than hindered production, it was easy to collect and was regarded as fair. What made this tax different from conventional ones was its incidence. The electromagnetic spectrum has no cost of production, it is a "free gift of nature". What the licenses were paying for was access to it. The Government could have simply allowed free access and foregone any revenue. In Adam Smith's terminology what was being paid was a "rent." Since rent is a surplus it enters into the price of a good in a different way to the costs of labour and capital. Whereas the latter are a cause of the price rent is an effect. What the licensees could afford to pay for their licenses was based on the excess of the market price they predicted they could obtain for their 3G services over their costs. If the Government had not charged for the license they would simply have kept the surplus as excess profit, the costs to customers would not have been any less.


A second example of a "good tax" is one based on resource rents. A resource rent is the difference between the cost of production of a particular raw material (including normal profits for the extractor) and the market price. As such, a key feature of resource rents is that they are site specific (figure 2). The price per unit of the resource is set by the market and is the same for all sites. On a prime site extraction is easy and the resource rent is high. On a marginal site the cost of production is so high it approaches the market price and so there is no rent. If the cost of production exceeds the market price production is not worthwhile. Resources have traditionally been taxed on profits or royalties. Both these fall on the marginal site and effectively tax it out of production in the same way that PAYE taxed British steel out of production. A resource rent tax falls highest on the most productive site, the one most able to bear tax, and leaves the margin alone. It encourages full use of the resource and does not deprive producers of a normal profit. As the rent is an effect of price rather than a cause it is none-distorting. Such a regime was put in place in spirit if not in name in the taxing of the North Sea oil in the 1980s by ring-fencing and giving concessions to the less productive sites. This enabled a much greater production to have been achieved than by simply taxing profits.

The same idea has been successfully applied in Australia to their offshore oil and recently extended to the extraction of other minerals.


12.  The examples given so far have only limited application. Can it be extended to a more general form of taxation/Government revenue? An example that illustrates in principle how this can be done is that of the former Crown Colony of Hong Kong. This territory's public finances are the envy of the world, they combine low taxes on income and profit with a Government surplus whilst at the same having funds to invest in world class infrastructure development. One reason for the success is the system of land tenure. When the New territories were acquired the land remained Government property and was leased out on short leases. In terms of Government Revenue these leases and the associated rents could be regarded as another example of an access charge to a free gift of nature. As the colony grew in prosperity these leases became more and more valuable providing a useful source of Government Revenue relieving the colony of the burden of conventional taxes. The leases have the characteristic of a good tax. They are easy to collect, fall on those who pay and do not hinder production but rather stimulate it since the buildings erected have to generate sufficient income to cover the costs of the leases.


13.  The principle of collecting access charge for land can still be applied when land is privately owned as in the UK. Instead of leasing land an annual levy could be collected on all owners in proportion to the rental value of the land they claim. This would have the characteristics of a "good tax." The principle is illustrated by a traditional story. Two kings ruled over neighbouring prosperous and fertile lands where dates grew abundantly. They were both in need of revenue. One of the rulers put a tax on the date trees. The effect was that his citizens chopped down their date trees and both the king and his citizens became poorer. The other taxed the land on which the dates grew. Because the citizens wished to stay they could not escape the tax so they put all their efforts into growing more dates. The king collected his revenue and the citizens were as well off as they had been before. The principle still applies in a developed economy. The where the most valuable sites are commercial, financial or residential.

14.  The quote from the recent OECD report on taxation given in the Committee's briefing notes contains a broadly similar conclusion to what has been presented here. They report that the tax system should distort economic incentives as little as possible and that "corporate taxes are the most harmful for economic growth, followed by personal income taxes and then consumption taxes, with recurrent taxes on immovable property being the least harmful tax." Chapter 16 of the recent Mirrlees review argues in a similar way but qualifies the last part of the OECD statement. They quote Nobel Laureate William Vickrey: "The property tax is economically speaking a combination of one of the worst taxes - the part that is assessed on real estate improvements … and one of the best taxes - the tax on land or site value." This is an important distinction. A tax on buildings is a tax on capital so it is a tax on production and has the negative effects of a "bad tax". The tax on the site is an access charge like the 3G license or resource rent and if not collected as public revenue goes to some individual or organization as an unearned windfall.

15.  A site value or land value tax is an annual payment, based on the rental value of a site discounting any buildings or other modification of the site. It is payable by the owner of the site, rather than the occupier. It has the merits of a "good tax" as defined earlier. It is another example of making an access charge but one that is of general application. It will not have a distorting effect or discourage production since land is not a produced input. Because good quality sites are inherently in short supply tenant occupiers are already paying as much as they are able to afford so the introduction of a tax would come out of a surplus that at present is a windfall to the owner.

16.  At present the effect of successful Government investment such as new transport, schools or hospitals is that the monetary benefits go to landowners through the uplift in surrounding land prices. If land rent were collected as Government Revenue it would enable the self-funding of public infrastructure since the cost of valid projects would be recouped by the increase revenue corresponding to the increase in land values they bring about.

17.  A tax on site rents is very transparent. Unlike a tax on profits the tax-base cannot be hidden or moved offshore. The location of the owner is immaterial. The obvious penalty for non-payment would simply be return of the site to public ownership. The principle of "ability to pay" has come to be associated with income streams, but it is as fundamental to associate it with ownership of inherently valuable or potentially productive locations.

January 2011

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