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Lord McKenzie of Luton: My Lords, I start by thanking the noble Lord, Lord Patten, for securing the debate. I greatly enjoyed his contribution, although I agreed with very little of it. I also thank other noble Lords who participated in the debate.
The issue of flat taxes is undoubtedly topical. While Jersey, Guernsey and Hong Kong have long had a flat personal income tax structure, elements of flat personal income tax have more recently been introduced in several central European countries. The issue has also received attention in the media here, as it has in the US and Germany. It is proper to keep abreast of such developments and understand the advantages and disadvantages of various tax initiatives. The Treasury's recent assessment of the long-term global economic challenges and opportunities for the UK, published at the time of the pre-Budget Report in December last year, noted that the UK needed to embrace fair tax competition while ensuring that flexibility was accompanied by fairness. The Government welcome this evening's debate as a contribution to ensuring that the UK continues to succeed in striking that balance. However, we recognise always, of course, that responsibility for taxation matters rests with the other place.
It is a pleasure to stand back and review the merits of flat taxes in an atmosphere of constructive exchange, enhanced by the fact that, as I understand it, none of the elected parties in the UK yet advocates a flat tax as party policy. I was interested to hear the noble Lord, Lord Newby, mention the commission that has been set up. I imagine that one of the issues that he will have to ponder is whether there is consistency between a flat tax arrangement and a local income tax.
My job now is to summarise the ground that we have covered, answer the points that have been raised and set out the Government's views. The Question tabled by the noble Lord, Lord Patten, asks Her Majesty's Government what they consider to be the benefits and disadvantages of a flat rate of income tax. As this evening's debate has illustrated, it is crucial to define carefully what is meant by a "flat income tax". The phrase can mean different things to different people. The noble Lord, Lord Newby, recognised that.
The fundamental principle, as suggested by proponents of a flat tax, is that income should be taxed at a single rate of tax for all taxpayers. Additional features that flow from that basic principle and are common to most flat tax proposals are a low rate of tax; removal of all extra tax allowances and deductions, which is the driver of the simplicity; and an increased personal allowance. I think that the noble Lord, Lord Patten, enumerated those. Some economists would exempt savings and dividend income to achieve the effect of a consumption tax—a so-called Hall-Rabushka model.
A concrete example of a basic proposal in current circulation is that put forward in a recent publication by the Adam Smith Institute and referred to by the noble Lord, Lord Roberts—the Richard Teather proposal. It suggests that a UK flat tax could consist
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of a single flat rate of 22 per cent—equal to the current basic rate of tax in the UK—a personal allowance of £12,000 and the abolition of further tax allowances and deductions—not dissimilar to the figures advanced by the noble Lord, Lord Patten. The author calculates on that basis that it would cost £50 billion a year in revenues, arguing that it is affordable and that the benefits in the long term are worth the cost. The concept of a flat-rate tax that is revenue-neutral has some real problems.
Several potential advantages of flat taxes were advanced, and we should examine each in turn. It is asserted that the simple nature of a flat tax is inherently attractive, as it can reduce compliance costs for individuals and business; reduce the administrative burden on the government; and make it easier for individuals to understand their tax affairs. Those are indeed attractive points, but they need a little more probing. There are interactions with the rest of the tax system that have not been convincingly worked through. For example, proponents of a flat tax must explain how they plan to treat savings and dividend income. They also need to explain how they would deal with the international component of company income and individual income.
When asked if that simplicity can really be achieved in practice, proponents of flat-rate tax often cite other countries—as has been done this evening—that have introduced such a tax. However, greater scrutiny often reveals that the actual tax system is more complex than the headlines suggest. For example, a far higher proportion of revenues is often raised from other sources such as social security or property taxes. The example of Estonia was quoted. The system there is certainly not as simple as the headline suggests. A lot of their revenue comes from social security contributions at a much higher rate than the UK.
More fundamentally, important though it is, simplicity is not the only aim of the UK tax system; I will return to that when I set out the Government's position. The keenest supporters of a flat tax concede that there is a significant cost at least in the short term, and that cost must come about if you are to deal with the aspiration of stopping poor people having a higher tax burden. They argue that the cost would be outweighed by reduced avoidance and evasion and through increased yield from improved economic performance.
Those arguments are ambitious claims. A reduced yield of the order of £50 billion equates to over 10 per cent of all tax revenues. That cannot be glossed over in any responsible debate. It is the equivalent to more than the effect of abolishing corporation tax. Evidence is cited from other countries, but, as noble Lords will appreciate, those comparisons are far from simple. There is little evidence in practice that the flat tax would generate extra revenue through increasing economic activity or reducing avoidance and evasion. Just take a trip to Hong Kong and see the scale of the tax avoidance industry still existing there. I bet that, if you looked at the revenues that the major legal and accounting firms are generating in those transitional
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economies in eastern Europe, you would see that they have increased revenues from tax services, not reduced tax revenues.
Some of the countries that have adopted a flat tax have indeed seen economic improvements, but the question is how many of those improvements are due to the changed tax structure. Only one country's introduction of a flat tax has been subject to robust evaluation by the IMF, and that has concluded that the reason for improved yields,
It is most probably due to the improved enforcement carried out by the Russian authorities. One must also be careful about the transferability of lessons to the UK, with its mature tax system and its established culture of compliance. In any case, the size of response required to recoup the cost of an Adam Smith-type proposal approaching an increase of 50 per cent of income tax revenue is a key issue that proponents of a flat tax must address.
There is a connection between the cost of introducing a flat tax system and the distributional impact. If the cost of a proposal were scaled down, those on lowest incomes would be hit. A lower personal allowance would mean in the UK that a proportion of 3 million people currently paying tax at only 10 per cent would start to pay tax at 22 per cent on the Adam Smith model. An increase in the rate of tax above 22 per cent would mean an increase in tax for the majority of the current 26 million starting and basic rate tax payers. That is why the proposals are costly. The tension is that it costs a great deal to try to make a flat tax system fairer.
Let us move from examining the arguments made in favour of flat taxes to asking what the UK requires of its tax system, and consider whether those needs will be delivered by a flat tax. As in most economies, the UK's tax system has multiple aims. While recognising the appeal of simplicity and efficiency, a third important aim is fairness. Any tax system also has the fundamental job of bringing in sufficient revenues while ensuring that the UK remains an attractive place to live and invest. There are key trade-offs to be made between those aims, and the UK has to find a balance between them that is most appropriate to individual circumstances.
We have seen that the cost of a flat tax with a generous personal allowance is, in the most generous interpretation, undeniably unaffordable in the short term. A realistic scheme would therefore have to comprise either a low personal allowance or a flat rate of tax above the current basic rate.
Let us consider what that would mean for those at the lower end of the income distribution. Because of the need for simplicity all allowances, reliefs, deductions and credits would have to be removed. That is what a flat tax system is about—it is a non-negotiable part of a flat tax. It is the source of the greatest simplicity gains.
Successive governments have not given those reliefs for no reason. Pensioners currently benefit from enhanced age-related allowances. The benefits reduce their tax bills all the way up to an income of £19,500.
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Under an affordable flat tax regime, they would start to pay full tax, possibly at a rate higher than the basic rate, at an income far lower than this figure. Perhaps it is simple, but is it fair?
Another aspect of fairness is where the burden of taxation should lie, which is often referred to as the progressivity of the system. To raise today's level of revenues, a flat tax would reduce the tax rate for those on higher incomes and increase it for those on lower incomes. Reference was made by, I think, the noble Lord, Lord Patten, to the tax wedge. The data for 2004 shows that the UK compares very favourably with other G7 countries, the tax wedge being: 31.2 per cent for a single employed person without children on average earnings, which is slightly in excess of 29.6 per cent in the US, but significantly below that for Germany at 50.7 per cent; France at 47.4 per cent; and Italy at 45.7 per cent.
Some argue that the long-term benefits to the economy would in turn improve revenues, and that through greater compliance in economic activity, the wealthy would increase the amount they pay. Even if one were sure of that, would it be fair in the short term to increase the burden of tax on the poorest?
The UK, like most developed economies, has made some trade-offs on simplicity to achieve other objectives efficiently and to target help for those most in need. Over the past seven years, there has been new thinking, and the Government have reformed Britain's tax and benefit system to achieve three overarching objectives: to improve financial incentives to work; to reduce child poverty and increase financial support for all families; and to tackle poverty among the current generation of pensioners and support people in providing for their retirement.
The Government's key focus for reform has been improving work incentives at the lower end of the income distribution through tax credits as opposed to a flat tax, which tends to disproportionately benefit those in the upper end of the income distribution. I do not have time to go through how one can quantify the benefits of that system, but they are significant for those at the poorer end of the income scale.
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The Government have introduced a system of tax credits focused on two critical issues: supporting families and tackling poverty through the child tax credit; and making work pay through the working tax credit. Increasing the personal allowance can only reduce a household's tax bill to zero, whereas tax credits can make payments to the household, providing help to those who need it most.
The Government have also cut rates for individuals and businesses. Today the UK has the lowest basic rate of income tax for 70 years, the lowest starting rate of income tax for 30 years and the lowest corporation tax since that tax was first introduced. We heard again about 66 tax rises. The IFS in its green budget report identified on the same basis as the Conservative calculations that there had been in excess of 200 tax reductions. That debate was settled by the electorate just a few weeks ago.
The Government's reforms have also included ensuring that everyone pays their fair share. Tax avoidance and tax or tax credit fraud undermine the ability of the tax system to deliver its objectives, imposing significant costs on society. Avoiders seek an unfair economic advantage over compliant taxpayers by using artificial arrangements to avoid their tax obligations. HMRC is expected to bring in an extra £2 billion within three years, after improved compliance efforts following the Finance Act 2004.
Although the Government are not complacent and are aware of the challenges at a time of radical transformation in the global economy, the strong performance of the UK economy suggests that we are striking an appropriate balance between simplicity, efficiency and fairness. As the Chancellor noted at the time of the Budget, Britain has today experienced the longest period of sustained economic growth since records began in 1701. Inflation has been at its lowest for 30 years, with interest rates at their lowest for 35 years and employment at its highest ever.
We are not complacent. We are aware of tax reforms taking place in other parts of the world. We certainly welcome noble Lords' contribution to the debate, but we remain confident in the current system.
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