After the tax cuts of the 1980s, the tax debate in the 1990s has become more subtle. The uproar over VAT on fuel has challenged the view that indirect tax is less politically sensitive than direct tax. Meanwhile, the left has made its peace with indirect taxation, while all parties and countries are embracing green taxes. Stephen Tindale reportsby Stephen Tindale / November 20, 1995 / Leave a comment
Franklin Roosevelt called taxes “the dues that we pay for the privileges of membership in an organised society.” Paddy Ashdown made the same point-in almost the same words-at the last Liberal Democrat conference. Having endured a decade and a half of “tax revolt”-a gift to the world from the pampered citizens of California-the rehabilitation of taxation as a civic duty is, perhaps, overdue. The Labour party, seeking to escape its tax-and-spend reputation, could not afford to begin the campaign. So all credit to Citizen Ashdown.
The tax revolt has not led to lower levels of taxation. In the last financial year the UK government took 37.75 per cent of GDP in tax, compared to 34.1 per cent in 1980. The Nigel Lawson tax cuts of the late 1980s proved unsustainable as recession reduced revenues and increased the social security budget. Attempts to reduce public spending, particularly on welfare, have failed in the face of public hostility. A change of government will do little to alter the situation: Labour is committed to maintaining expenditure on welfare, health, education, defence and law and order. It will seek to cut the cost of unemployment by creating jobs, but it is unlikely that the net effect on public spending will be downward. The UK tax burden is already lower than other European welfare states such as Germany, 40 per cent in 1993, and France, 44 per cent in 1993, (though higher than Japan and the US-29 per cent in 1993). So whatever the short term debate about tax cuts, the prospect is one of a broadly stable or increasing level of taxation. Nor is the picture different in other industrialised nations: all but three OECD countries saw increases in the total tax burden over the 1980s.
But if we cannot significantly alter how much we raise, we can certainly refine how we we raise it; witness the shift from direct to indirect tax over recent years. Modern tax systems are haphazard affairs, complex mixes of necessity, opportunity and political will. Before this century taxes were levied solely to raise money, usually to finance wars. With the rise of mass politics and the influence of the new liberalism and socialism, taxation began to be used also as a means of redistributing income. With the Keynesian revolution, taxes took on a new role as macroeconomic stabilisers, and more recently still they have been used as a means of influencing behaviour: tax credits as inducements, special excise duties to discourage consumption of certain goods such as cigarettes. Environmental taxation, which remains in its infancy, is probably the most substantial attempt to use taxes to change outcomes, rather than simply raise revenue.
Sadly for policy-makers, however, these objectives are not always consistent. The “tobacco tax problem” illustrates the competing effects taxes may have–governments will have little incentive to reduce smoking because this would reduce their revenue. A more serious problem may be that tobacco taxes, though desirable in that they discourage smoking, are also highly regressive, because the poor smoke more. Taxing domestic energy might encourage energy efficiency (though not by much), but it is also highly regressive and-as Norman Lamont found-highly unpopular.
These conflicts are old and familiar. In the later 20th century, however, the taxation equation has been made even more complex by globalisation: the deregulation of international capital markets and the liberalisation of world trade. Countries are now in global competition to attract investment, so the scope to tax mobile resources-capital and labour-is reduced. Corporate taxes are on a downward trend in most developed economies: in France from 50 per cent in 1980 to 34 per cent in 1992, in the US from 49 per cent to 38 per cent, in the UK from 52 per cent to 33 per cent. The danger of competitive downbidding of tax rates has led some to call for taxes to be co-ordinated internationally, or even to be set supranationally. There is clearly an argument for taxation of highly mobile production factors, capital and professional labour, to be set at European Union level, for example.
But the impact of globalisation on corporate taxes should not be exaggerated. Not all countries have lowered their rates significantly: Germany had a combined central/local corporate tax rate of 62 per cent in 1980 and 59 per cent in 1992. The Japanese rate went from 52 per cent to 50 per cent. The differences have narrowed, but remain substantial. There are numerous other cultural, political and economic factors which influence investment decisions. Moreover, the decline in rates of corporate tax has not led to a reduction in the revenue raised from this source. The OECD average for revenue from corporate taxes as a percentage of GDP was 2.5 per cent in 1970, 2.6 per cent in 1980 and 2.9 per cent in 1990. By this measure, revenues from corporate taxes rose sharply over these two decades in Japan, Italy and the UK, while remaining broadly stable in France and Germany. Only in the US did the total fall-from 3.7 per cent in 1970 to 2.2 per cent in 1990.
More significant than liberalisation of capital may be the continuing liberalisation of international trade, which leaves national governments unable to protect their firms from any adverse effects of domestic tax changes. This is a serious constraint on fiscal policy. European industry successfully lobbied against the proposed EU carbon/energy tax on the grounds that it would damage competitivess. In the past it would have been possible to impose countervailing duties at the border to ensure that imported goods paid a similar tax on energy content. This is no longer an option within the EU. Countervailing duties might also fall foul of Gatt rules.
Tax reform in the 1980s
Such external constraints did not prevent- indeed may have helped promote-radical reform of personal taxation in many countries in the 1980s. During that time there was a global trend away from direct taxation in general and income tax in particular. In the US in 1986 the second Reagan administration, for example, simplified the income tax structure, reduced the top rate to 28 per cent (though state income taxes are levied on top of this), cut shelters and increased corporate tax. In New Zealand, the income tax structure was simplified and the top rate reduced to 33 per cent. A new VAT was introduced covering all goods-including essentials-and services.
In the UK, too, there has been a steady move away from direct taxes. Despite pledges in the 1979 manifesto not to increase VAT sharply, Geoffrey Howe, the then chancellor, almost doubled the rate, from 8 per cent to 15 per cent, in the 1979 Budget. At the same time he cut the standard rate of income tax from 33 pence to 30 pence, and the top rate to 60 per cent. Income tax went down in stages under Nigel Lawson, culminating in 1988 in a simplified system with a standard rate of 25 pence and an upper rate of 40 pence. In 1991 Norman Lamont increased the VAT rate by a further 2.5 per cent. In 1992 he cut income tax in a progressive way by introducing a 20 per cent band for the first ?2,000 of taxable income. In 1993, needing to recoup money after the election, he introduced a rare Tory increase in direct taxation-a 1 per cent rise in the rate of employees’ national insurance contribution. But he also announced the most substantial broadening of the VAT base since its introduction in 1973-its extension to domestic fuel and power. The fact that VAT on fuel caused uproar while the NIC increase passed almost unnoticed called into question the conventional wisdom that indirect taxes are politically more acceptable.
The Conservatives defend the switch to indirect taxes on both ideological and practical grounds. Indirect taxes are seen as voluntary: individuals need only pay if they choose to purchase particular goods and services. The reduction of income tax allows people to keep a greater proportion of their earnings, thus promoting hard work and enterprise. A continuation of Conservative government would almost certainly mean further increases in the proportion of revenues raised by indirect taxes- higher excise duties, an increase in VAT on fuel to 17.5 per cent, extension of VAT to books or children’s clothes (thereby undermining the argument that the tax is voluntary).
The left has traditionally opposed indirect taxation on the grounds that it is regressive, taking no account of ability to pay. The tax changes of the last decade have meant that the poor pay proportionately more, the rich less. The poorest 10 per cent of households have lost ?156 a year; they now pay 43 per cent of their income in tax. The richest 10 per cent have gained ?1,612 a year, and pay just 38 per cent of their income in tax (they pay proportionately more in income tax but less in indirect tax). The biggest winners have been the top 1 per cent of earners-those with incomes of over ?120,000 a year. They have benefited from cumulative tax cuts since 1979 worth tens of billions of pounds. This casts some doubt over the claim that little revenue can be raised from top earners. On the other hand, thanks to closing loopholes and simplification of the tax system many high earners actually pay more in tax now than they did in the 1970s. Indeed, the top 1 per cent of earners pay 15 per cent of all income tax in the UK.
Like cuts in corporate tax rates, tax cuts for top earners are part of a global trend. The highest marginal rates were reduced in the US from 70 per cent to 28 per cent (though they have since risen), Japan from 75 per cent to 50 per cent. In the UK, taking into account local and regional income taxes as well as national ones, the super-rich now pay a lower marginal rate than their counterparts in any other developed economy except New Zealand and Portugal. Britain’s top rate starts at a lower level, around ?30,000, than many-but not all-other countries. A rich New Yorker pays combined income taxes of about 38 per cent on income above $22,750 (?15,000), with three bands above that culminating in a marginal rate of 51 per cent for incomes above $250,000.
The Conservatives remain committed to reducing the burden of income tax-eventually to a standard rate of 20p. Despite an unpromising fiscal situation which makes tax cuts hard to justify, the chancellor may bow to political pressures and move in this direction in the Budget. John Major has also pledged himself to reduce capital gains tax and inheritance tax. These are fiscally insignificant but symbolically important, particularly given the prime minister’s desire to see “wealth cascading down the generations.”
Labour and the Liberal Democrats, in contrast, argue that the priority is for a return to a more progressive tax system. But Gordon Brown’s pledge at the Labour party conference to reduce VAT on domestic fuel from 8 per cent to 5 per cent-his “fair” tax cut-has obscured one of the most important changes in political attitudes to tax in recent years: a reappraisal on the left of the role of indirect taxes. This is not just another example of Labour moving to the right, but is based on a more sophisticated analysis of how indirect taxes work. After years of opposing VAT as a regressive tax, Labour in the late 1980s woke up to the fact that the exemption of essentials such as fuel, food and children’s clothes, which form a high proportion of poor households’ spending, made it substantially less regressive. More important, it is increasingly accepted on the left that tax changes should not be judged in isolation from spending decisions. A package regressive in its initial impact becomes progressive if the revenue is used, for example, to finance public goods such as the NHS or free education, from which the poor benefit disproportionately.
The decline of local taxation
The second significant change in the UK tax system, almost as contentious as the move away from the progressive principle, has been centralisation. During the 1980s approximately half local authority expenditure was raised locally, through domestic and non-domestic rates. In 1990 non-domestic rates were transferred to national control, reducing the local contribution to 25 per cent. The following year the poll tax subsidy of ?140 per head reduced it further still, to 17 per cent.
Most people assume that fiscal centralisation has been part of a desire to reduce the power of local government. Yet there were good practical reasons for the abolition of local business rates: local variations required complex grant arrangements to ensure uniform levels of service provision, and these meant that for every extra pound of revenue raised through business rates a pound was lost in central government grant. It is also not clear that the old clich? “he who pays the piper calls the tune” is necessarily true. The German L?nder, recognised as the most powerful sub-central governments in Europe, raise little of their own revenue; they are powerful because their role is constitutionally guaranteed and because they receive a predetermined share of national taxation.
Nevertheless, it is now widely believed that a greater proportion of local government revenues should be raised locally. Both Labour and the Liberal Democrats promise to return business rates to local control and to remove capping of the local authority council tax. The Liberal Democrats also support a local income tax, but the administrative difficulties and costs would be substantial. A regional income tax would be more practicable; Labour’s proposal to allow a Scottish parliament to increase or decrease the rate of income tax by up to 3 pence is a move in this direction. But like other proposals on local taxation, this runs into problems of equity. If the aim is to increase the proportion of the budget raised locally, rather than increasing the overall size of the local budget, then increases in local taxation will mean reductions in central government grant. We have to ask why parties committed to redistribution want to see this. To allow Liverpool Council, say, to raise a greater proportion of its budget locally means taking more from citizens on Merseyside and less from those in the home counties. There is a trade-off between local autonomy and social equity.
Taxing energy, not jobs
Both the OECD and the European Commission have recently highlighted labour taxes as a cause of unemployment. Roughly 50 per cent of the tax burden in the EU falls on labour (through income taxes and social security contributions), up from 30 per cent in 1960. The British government raises 17 per cent of its revenues from social security contributions and 25 per cent from income tax. The taxes which have the most significant impact on employment, in practice if not in economic theory, are those which directly increase employers’ costs. Employer social security contributions in the UK are lower than in other European countries, but nevertheless there are constant calls, particularly from the CBI, for further reductions, and most left and right strategies for cutting unemployment involve national insurance “holidays” for employers who take on the long-term unemployed. To have a significant effect on employment, however, labour taxes would have to be reduced substantially. If public spending cannot be cut, revenue would have to be found from elsewhere. Among the most popular candidates are environmental taxes.
Modern economies, in the words of the Delors white paper on Growth, Competitiveness and Employment, “over-consume nature and under-consume people.” We are profligate in our use of lightly taxed energy and resources, while screwing ever greater productivity out of a heavily taxed workforce. The result is too much pollution and too little employment.
Economic models have delivered impressive results for some kinds of eco-taxes, and there is now plenty of practical experience to draw on, too. The policy discussion in the UK, Europe and the US is far advanced, and Sweden and Norway actually introduced substantial environmental tax reforms in 1991. In Sweden the main concern was to reduce the very high rates of personal income tax. In 1991 the standard rate was cut to 30 per cent, and the top rate to 50 per cent. Excise taxes on some luxuries were abolished, new excise duties on carbon and sulphur emissions were introduced, and at the same time VAT was extended to energy. The tax reform in Norway took place over a two-year period. Again, a range of environmental taxes were introduced, including sulphur and carbon taxes, and the rates of personal and company taxation were lowered. In both countries the changes appear to have been well received although they had to be modified to take account of the fact that the EU did not, as some expected, introduce an energy tax.
The failure of the EU carbon/energy tax proposal indicates just how many political and social difficulties lie ahead for eco-taxes. The EU tax failed partly because of political opposition-notably from the UK-to Brussels’ involvement in taxation. There was also strong opposition from some industries, which argued that it would damage competitiveness. Whether this is true or not, it is one of the iron laws of tax reform that the potential losers make more noise than the potential winners, and in this case the energy-intensive industries led the lobbying against the proposal, while sectors such as financial services, information technology, retail and tourism stayed silent.
Another worry is the reliability of the new revenue streams: if the tax increase changes behaviour, the revenue will diminish. But the greatest concern is that eco-taxes hurt the poor. A recent study in the UK found that households with incomes in the top 20 per cent spend 4.2 per cent of their budget on fuel, while those in the lowest 20 per cent spend 12.1 per cent. Low income households are less able to cut back on fuel use by changing equipment or installing energy efficiency measures, which can have a high capital cost. Increasing the cost of motoring is less problematic and socially divisive-although it hurts some people in rural areas.
A more radical option for overcoming the regressive impact of eco-taxes is to use some of the revenue to give a lump sum payment to each individual, or possibly to each household. This “eco-bonus” has been the subject of extensive discussion in a number of countries. It is possible to see the eco-bonus as a forerunner to, or component of, a broader citizens’ income. (The Treasury would almost certainly oppose any form of eco-bonus on the grounds that it was a form of hypothecation-earmarking specific tax revenues for a specific purpose).
Environmental taxation is in no sense a panacea. It raises all the issues which have dogged tax reformers over the decades: the need to secure the revenue base; the need to protect international competitiveness; the need to redistribute income. Environmental tax reform will not happen quickly or without controversy-nor should it. Taxation is about reconciling conflicting objectives, making hard choices. It is the very stuff of politics.