The sperm lottery

Our tax system is inequitable, but it seems neither main party is capable of change – Labour is obse

How do I loathe thee? Let me count the ways. Here's what we have.

A regressive tax system that became more regressive when the 10 per cent bracket was eliminated, and will become even more regressive when VAT is raised.

A growth-destroying tax system that already forces an exodus of entrepreneurs and will become even more deadly when the 50 per cent bracket is introduced.

A job-killing tax system that will kill still more jobs when National Insurance contributions (NICs) are raised.

An inequitable tax system that will become still more inequitable when inheritance taxes are lowered, to the benefit of winners of the sperm lottery, at the cost of productive workers and investors whose taxes must be higher in order to make up for the revenue shortfall.

A tax system so complex that, as Tevye from Fiddler on the Roof said, "it would cross a rabbi's eyes", and due to become more complex as poli­ticians react to the recession by introducing clauses to favour one constituency or another.

During periods of boom, these imperfections get drowned in a torrent of profits, higher wages, rising house prices and a lifting of all, or most, boats. That was then, before Labour squandered its Thatcherite inheritance and gave new meaning to the words "boom and bust" - of which, it turns out, there is a lot more of the latter in store. This is now, when the economy is in trouble, the fiscal deficit is ballooning and the Bank of England is printing money with which to buy the Treasury's IOUs, in such amounts that the rating agencies are casting a wary eye over Britain's credit rating. And all of these problems are exacerbated by the unhealthy combination of huge bonuses for bailed-out bankers and rising levels of unemployment.

So, as Lenin asked in a different connection, "What is to be done?" Not very much, unless we recognise the socio-economic environment in which tax policy will be made in the foreseeable future. In the good old days, markets more or less determined the pre-tax distribution of income: those who created the greatest market value received the greatest rewards. A hi-tech worker earned more than a toiler in an industry producing unwanted or low-value goods. Both might be good men, equally deserving of a place in heaven, but in the here and now one received greater rewards than the other. And the system that doled out those rewards had broad acceptance, especially since progressive taxation dampened some of the inequalities of pre-tax incomes, and the economies of mass production made goods available to the non-rich that were every bit as service­able as those purchased by those with very high incomes - a great ameliorator of that old devil, envy.

No longer. High earners in the finance sector are benefiting from taxpayer bailouts, implicit guarantees against failure, and the central banks' policy of cheap money, which increases the margin between what they pay for money and the rate they charge for lending it out (when, indeed, they do make credit available rather than increasing bonuses and dividends, or strengthening balance sheets). At the other end of the income spectrum, meanwhile, are an increasing number of people whose low incomes are in part a consequence of the actions of the very folks whose incomes are inflated by government policy and taxpayer support. Not exactly a situation that engenders support for market capitalism as it is now structured.

Towards the tipping point

I exaggerate. Many high earners are being rewarded for hard work, skill and daring, many low earners properly punished for a lack of skills or sloth. Still, it is fair to say that the relationship between talent and hard work, on the one side, and pecuniary reward, on the other, is more attenuated than it has been in the past. This change should affect the contours of tax policy, requiring that considerations of equity - not to be confused with equality, an entirely different thing - be given a bit more weight than was justified in the past. I would be more uncomfortable with this conclusion - equity, after all, is often in the eye of the beholder - were it not that the changes required to produce a fairer, more equitable system are also likely to produce a more efficient, growth-oriented economy.

So here are some suggestions for what is to be done - proposals designed to stimulate serious discussion to replace the political posturing to which we are too often treated. Consider this, then, a thought experiment.

Restore the 10 per cent tax bracket and, even more important, eliminate the benefit cuts that produce a de facto marginal tax rate in excess of 90 per cent for low earners who would otherwise decide to work a bit of overtime, or risk changing jobs in pursuit of modest increases in pay. As David Cameron has pointed out, this obscene system of withdrawing benefits from low earners who improve their incomes, combined with the income tax they must pay, reduces any incentive to find work, or work harder. It is therefore inefficient, depriving the economy of their effort, as well as wildly unfair.

Yet we must be careful not to relieve large numbers of people of all taxes on their income. It is not healthy for a democratic society to have masses of voters who pay no share of their income to support their government, lest they become inattentive to how tax receipts are spent.

Next, abandon plans to lower the tax on inherited wealth. That tax falls not on the person who earned the money in the first place - he or she, being dead, is in no condition to write a cheque to HM Treasury - but on the lucky winner of the sperm lottery. Studies show that inheritances tend to discourage many recipients from working, just as a win in any lottery often does. Worse still, the funds most often come from the sale of the dear departed's house, which has increased in value through no effort of his own, but because of the location of a new Tube station, or house-price inflation. And if the threat of a tax causes the ageing benefactor to spend his wealth, or donate it to a charity of his choice, so much the better. There is no reason to believe that the purchase of a set of golf clubs by the person who earned the money to pay for them produces less happiness than the potential inheritors' acquisition of the latest flat-screen TV. And there is every reason to believe that the charity designated as beneficiary by the person who earned the money is likely to put it to better use than the politicians who disburse the Treasury's tax receipts.

It is at the high end that making tax policy becomes more difficult. Unlike lower earners, high earners are geographically mobile. Pluck too many of their feathers, and they will do more than hiss: they will decamp. For example, about half of the 40,000 people employed in Europe's hedge-fund industry work in London, where they manage about 80 per cent of the industry's assets. They and other financial-sector workers have made London a credible rival to New York as the world's financial capital. Sneering at these people and the work they do - creating financial value - has become fashionable.

“The mood music has gone very bad here," says Julian Adams, chief executive of London-based Adelante Asset Management. Perhaps these people deserve to hear such dissonant music, but blindly translating any anger we might feel into tax policy risks triggering an exodus that would harm the butchers, bakers and candlestick-makers, not to mention tailors, who rely on spending by these financial-sector workers for their livelihoods.

Unfortunately, we just don't know where the tipping point is - the level of tax on marginal income that will induce these people to work less, risk less or, in extreme cases, flee to more benign tax jurisdictions. We do know that we are close to that point: witness the exodus of many financial firms to Switzerland. The solution might be an increase in the marginal tax rate on those earning more than, say, £150,000, as both main parties now favour, but subject to repeal when the Budget deficit falls to, say, 3 per cent of GDP, combined with a robust programme to encourage new enterprises. No nibbling around the edges with consulting advice or tiny bits of tax relief. Instead, forgive entrepreneurial start-ups all taxes for a period of five years - not only some NICs, as the Tories propose - and exempt them from all regulations during the start-up period. The result would be that bankers and others benefiting from taxpayer bailouts, central bank policy and irrational bonus schemes would be caught by the new higher rate, but job-creating entrepreneurs would not.

This is not as discriminatory as it might sound at first blush. It meets equity criteria by taxing earnings that at least in part are windfalls - income due not to the efforts of the banker, but to the desperate fiscal and monetary policies for which their behaviour is at least in part responsible. Besides, anyone caught in the net who feels he can do better as an entrepreneur is welcome to do so. And it meets the efficiency standard by establishing a tax that, in focusing on windfalls, has no, or at least few, negative supply-side consequences.

Tax pollution, not jobs

Finally, any programme of tax reform must involve a switch from taxing good things to taxing bad things. No, not a new round of regressive sin taxes, with upper-class bureaucrats deciding just what sin is. Instead, let's eliminate NICs, which tax jobs, and make up the lost revenue with pollution taxes.

We have to be careful here, given the recent disclosures of the, er, unscientific behaviour of some scientists who insist that the globe is warming, but feel dissenters should be silenced, and that contradictory evidence should be erased from computers and climate models kept beyond the reach of reviewers. Yet jobs are good, and pollution is not, and it is worth swallowing our doubts about climate change - well founded though they may be - to ride the popular anti-emissions wave and shift the burden of taxation from jobs to emissions. A bit of pandering to popular conceptions might just be useful in this instance.

If I had a solution for complexity, I would offer it. None is available. All parties see the tax system as a tool for social engineering: Labour uses it to create depositories for infants so that their mums can work, the Tories to support the "nuclear family" - to mention only two of the many items that the parties deem important. We can be certain of only one thing: that any reforms that are adopted, even the most sensible, will provide hours of work for accountants and lawyers, as they sift through new rules in search of benefits for their clients. Not a bad thing: after all, tax avoidance, as opposed to evasion, is legal. Unless we believe that the income and wealth produced in the country belongs to the government, which then decides how much to dole out to those who have earned it, we must believe that every taxpayer has a right, indeed an obligation, to retain as much of the fruits of his labour as the law allows. The accountants and lawyers, therefore, perform a useful function. Only a flat tax on gross incomes would set them looking for other employment, and that is a reform so unlikely to be adopted in a complex industrial society as not to be worth spending time on.

There you have it: something to offend and, I hope, to appeal to both left and right. Conservatives should view this set of suggestions as a programme for economic growth; it is also the tough love that is necessary if market capitalism is to survive in anything like its present form. It will not survive if the current inequities are allowed to poison public attitudes towards markets, giving politicians a further excuse to take over larger and larger segments of the economy.

Labour, or at least the Mandelsonian contingent that is intensely relaxed about people getting filthy rich, should view these suggestions as consistent with its goals of a more equitable ­society: one that taxes windfalls such as inheritances and some bonuses, reduces taxes on those least able to pay, and allows people to work their way off benefit by removing incentive-stifling taxation.

The combined effect of such policies (refined in the course of discussion) will be to stimulate economic growth and, therefore, the flow of funds to the Treasury. But they will not be enough, and certainly will not yield results soon enough, to obviate the need for deep cuts in public spending. These are a necessity, not only because the current deficit is unsustainable in the medium term, but also because that spending is transferring resources from the private sector to a less productive public sector, creating a serious drag on long-term growth. However, given that public-sector employees are now more highly remunerated than their private-sector counterparts (when the value of sick days and pensions is taken into account), such cuts should appeal to a Labour Party eager to see a more equal distribution of income!

Don't listen to the mandarins

Treasury mandarins will undoubtedly tell us that all of this would be impossible to implement and enforce. The rich will time their incomes so as to avoid a temporary surcharge; if allowed to keep more of their marginal income, the poor will somehow fiddle the system; unscrupulous entrepreneurs will find ways to make old companies seem like new ones. Yes, there will be fiddles. But that is no different from the current situation. Despite what Adam Smith called "the frequent visits and the odious examination of the tax gatherers . . . [exposing taxpayers] to much unnecessary trouble, vexation and oppression", some people escape paying what is legally due from them. It will be ever thus. Better to wrestle with enforcement problems created by a fairer and more efficient system of taxation, than the unfair, inefficient system with which Britain is now saddled.

Irwin Stelzer is US correspondent for the Sunday Times and director of economic policy studies at the Hudson Institute, Washington DC

 

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