Tax reduction priorities

Mark Wadsworth (whose blog is one we recommend in our blogroll) managed to get a long (by their standards) letter published in yesterday's FT, criticizing John Redwood's focus on reducing corporation tax, when in Mark's opinion greater emphasis should be placed on reducing VAT and National Insurance (NI). Well done for getting published, Mark. You are half right.

You are right that some taxes need reducing more urgently than corporation tax, and that NI is one of them. On the other hand, Redwood is nevertheless right that we need to cut corporation tax (if not as a priority above other cuts), and you are wrong about VAT as a priority.

I say this with some confidence, because I happened, the day before, to be browsing the latest version of Taxation trends in the European Union - Data for the EU Member States and Norway, from Eurostat, the EU's statistics office (yes, I am that sad). The figures in there do not support Mark's argument in its entirety.

Corporation tax needs cutting because, although our biggest competitors have higher rates, we are not only in competition with them, but with the 20 other European countries that have lower rates than us. Not to mention the BRICS countries, and other developing nations. Your principal competitors change according to who is competing most aggressively. The best way to lose your competitive position is to focus complacently only on your old competitors.

(Having said, that, one does need to be careful about what one means by "competitiveness", as Samuel Brittan, pointed out in yesterday's FT. But the conditions that influence where businesses choose to invest and to book more or less of their profits does seem a legitimate area for international tax competition.)

It also needs cutting because high rates of corporation tax distort investment decisions, as companies structure deals and decide their levels of borrowing and saving in order to minimize their tax bills rather than because of the fundamentals. And because experience in countries (particularly in Eastern Europe) in recent years suggests that high rates are at an inefficient point on the Laffer Curve, and that cutting rates to below our current level can increase (or at least, not significantly reduce) revenues.

Although the comparisons for consumption taxes indicate that the UK's rates are already pretty competitive, it would be misleading for me to suggest that we are in competition over rates of VAT in the same way that we are in competition on corporate tax. Most of us do not have much option to go to another country to consume our goods. The costs of doing so are likely to be very much greater than the tax benefit. Nevertheless, it does raise doubts as to whether further reductions in VAT should be an urgent priority.

VAT does not have much impact on costs of production, thanks to the offsetting of VAT on purchases against VAT on sales. It is effectively a tax on final consumption. Apart from the case of one-to-one transactions involving personal services (e.g. paying in cash for your gardener or cleaner), it is relatively unavoidable. Nor is it so high (at 17.5% nominal, 11% implicit, i.e. taking into account lower rates and exemptions) that it will be deterring significant levels of economic activity, relative to other taxes whose rates are significantly higher. Consequently, a reduction in VAT is likely to have a near-proportionate impact on tax revenues - there is unlikely to be a significant Laffer-Curve benefit.

Mark argues that -"VAT does not just increase the price paid by the consumer; it also reduces the net price received by the producer. Thus low-margin producers are forced out of business and output is reduced quite significantly."- Well, yes, it will be a bit of both, though the combined effect will remain 17.5% (or whatever rate of VAT applies to the good). The balance between one and the other will depend on commercial decisions, which will be heavily influenced by price-elasticity of demand. If demand is inelastic, producers should be able to pass on most of the cost to consumers without dramatically affecting volume, and therefore profits. If demand is elastic, producers will have to choose between passing on the costs to consumers and accepting a lower level of demand, or absorbing the cost to maintain volume, but reducing margins/profits. Their balance of fixed vs variable costs will play a significant part in that decision.

The net effect, as Mark says, is that some marginal products are not brought to market, the volumes of some other products are reduced, and the prices of goods that are essential or at least strongly desired, are higher than would otherwise be the case. But this is not different in effect to other taxes. Corporation tax also affects either the level of profits or the price at which the company's goods must be sold in order to deliver the return on investment necessary to persuade people to invest (or retain their investment). At the margins, it will also cause businesses not to be setup or to divert their funds into more profitable activities, which reduces the range of products available and the volume of transactions, and increases the price of goods for which demand is inelastic. And income tax and NI increase the cost of producing goods with a significant labour input, causing fewer of those sorts of goods to be produced and increasing the cost to consumers of essential, high-labour goods. All taxes have this sort of effect - it is a question of striking a balance between their impact on the economy and the need to raise revenue. In that regard, 17.5% (or 11% on average) on consumption could be expected to have a less significant impact than 28% on profits or 40-50+% on employment.

It is that latter figure that seems a particularly strong disincentive to something particularly desirable. NI, of course, is part of the tax on employment, and the most regressive part at that. I am in agreement with Mark on this, and yet the European figures once again do not appear to support us. The only countries in Europe with lower implicit (i.e. weighted average) tax rates on labour, including income tax and employer/employee social security contributions (SSCs, i.e. NI in the UK) are the tiddlers of Greek Cyprus and Malta. It seems that the UK government is taxing labour relatively lightly. Moreover, our SSCs are a relatively low proportion of the whole (less than half the average) compared to most of our neighbours, whereas our income-tax rates are higher than average, which might suggest that NI isn't even the place to start if one were reforming UK taxes on labour.

And yet, it is still true that our employment taxes are too high. Eurostat knows it too:

"Despite the presence of a number of low taxing countries, taxation on labour is, on average, much higher in the EU than in the main other industrialised economies. The effective tax rate on labour in the United States was estimated at just 23.9 % in 1999, compared with an EU-25 ITR of 36.3 % for that same year. Carey and Rabesona (2002) estimated a 24.9 % average effective tax rate on labour for the United States in 1999, i.e. 12 percentage points less than the estimate for the EU-15; the difference with Korea (13.9 %) was even more than 20 percentage points. Values for Japan (23.0 %), New Zealand (23.0 %), Australia (25.3 %), Canada (30.3 %), and Switzerland (31.1 %) were far below the EU-15 average, too. Martinez-Mongay (2000) found broadly similar differences between the EU and the United States and Japan. Indirectly this is confirmed by OECD data on the tax wedge."

And that's just the industrialised countries. The comparison with the developing nations will be even less favourable.

In this case, like corporation tax and unlike VAT, there is an element of international competition, as labour can move, if not as easily as capital. We see the effect in the inflow of Eastern Europeans to the UK at the moment (they could equally have gone to Sweden rather than Britain or Ireland, but the numbers were proportionately lower to the high-tax country that opened its doors) or the numbers of French already here, and the outflow of Brits to countries like Australia and the USA. The only country with higher taxes (and then not much, and not in terms of the proportion paid by the employee) to which there are major flows of Brits is Spain, and most of those are going there to retire.

The universal impact of taxes - of preventing some goods being produced, of reducing the volumes of other goods, and of pushing up the price of goods for which demand is least elastic - applies to taxes on employment as much as any other. But it manifests itself in specific and particularly harmful ways. The goods that are not being produced or are produced in lower numbers or are being made more expensive (without the producer benefitting) are jobs. The only way that high employment can be balanced with high taxes on employment is if people are prepared to accept a lower level of take-home pay. But as take-home pay has a significant impact on the sustainable level of demand in the economy, even that would not prevent high employment taxes from having a deleterious impact on the economy and people's wellbeing. And in practice in Europe, there is strong resistance to rebalancing levels of pay to take account of the cheaper labour and lower taxes that can be found elsewhere. The result is predictable and borne out by experience - high unemployment and low growth.

We may look smugly at the relative, official levels of unemployment and growth in Germany, France and the UK and believe that we are doing better than them. But while we undoubtedly have been doing better on average than those of our neighbours who have been slowly strangling themselves for the past decade or more, we are not so much better as the official figures might suggest. Our (un)employment figures are massaged by moving an incredible number on to disability benefit, and our employment figures are entirely dependent on the vast number of additional public-sector jobs (for which demand is unaffected by employment taxes because their "customers" - taxpayers - have no option until election-time but to pay the extra) that have been created since 1999. Worse still are our effective, marginal rates of tax (taking account of means-tested withdrawal of benefits), which provide a strong disincentive for those on benefits to seek work, unless they can jump straight into a high-paying job. We may only be mutilating rather than strangling our economy, and hiding our self-inflicted wounds better than our competitors, but it does not diminish the long-term impact, which is that competitors from outside Europe are catching us up or leaving us behind.

The first priority is clear, and I don't think would be in dispute between Mark, John Redwood and myself (though it would appear that Redwood's party, like the others, would dispute this). We must reduce the size and cost of government as much as possible, so that we are able to reduce the burden of taxation in general. But it will not be possible to reduce taxation to a level which has little impact. Priorities have to be chosen with regard to where the burden of the state should fall. As that burden is effectively a disincentive, it is, in significant part, a question of what one is least reluctant to disincentivize: jobs, profits or consumption (to limit ourselves to the three options considered by Mark). Though it is not ideal to discourage any of these, it seems to me that the least harmful of the three to deter is consumption, then profits, with employment being the least desirable thing to penalize. As things stand, the priorities are in exactly the reverse order. Redwood would rebalance it in favour of profits. Mark would rebalance it in favour of employment and consumption. I would rebalance it in favour of employment and, to a lesser extent, profits.

It seems that Mark and I agree on one other thing, though - perhaps more important than the levels of taxation, to complement the emphasis on reducing the level of tax on employment. Nominal rates are all very well and a worthy target for reduction, but what really matters are effective and marginal rates. This brings into play other factors, such as personal allowances and benefits. In comments on Mark's post, Vindico (a fellow individualist whose blog is now added to our blogroll) suggested that a flat tax be combined with a Basic Income (BI) to achieve a more efficient balance of effective and marginal rates of taxation. Mark agreed enthusiastically, and so do I.

I have been trying to promote BI as an efficient, liberal, compassionate alternative to welfare, and not necessarily a left-wing policy as many seem to assume, for some time. All reforms of the tax system, fiddling with the calculations for means-testing benefits, and sounding tough about forcing people back to work, will have little effect on the draconian levels of effective, marginal rates of taxation on low-earners that keep many of them out of work. Only a Basic Income can solve this. It is a -sine qua non- of genuine tax and benefit reform. If UKIP were to make it part of their programme, as Mark says they are considering, they would gain at least one more supporter.