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
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".
TAX - THE
3G ELECTROMAGNETIC SPECTRUM
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.
TAX - RESOURCE
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
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.
- TAXING LAND
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
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
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
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