A stealthy step towards abolishing income tax

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British chancellors may be known as Machiavellian creatures, but in this week’s Budget George Osborne drew his inspiration from Thomas Hobbes instead. It was Hobbes, after all, who – writing at the height of the English civil war – suggested that people should pay tax on what they spend instead of what they earn. The man who “laboureth much, and sparing the fruits of his labour, consumeth little” should not, Hobbes argued, pay more “than he that liveth idlely, getteth little, and spendeth all he gets”.

It was an idea that was ahead of its time. The income tax that Hobbes was railing against had yet to become so much as a glimmer in the eye of the English crown. Almost a century and a half would elapse – and the articles of union would be signed – before a levy on income was finally introduced in 1799, ostensibly as a temporary measure to pay for the Napoleonic wars. But Hobbes’s idea was a good one, and with this week’s Budget – “for the makers, the doers, and the savers”, as Mr Osborne said – its time has come.

To listen to the chancellor’s speech, it did not exactly sound like a step towards the abolition of income tax. His announcement came in the dull key of technocracy. Instead of being forced to buy annuities, retiring workers would now have far more latitude to do what they like with their pension pots. “No caps. No drawdown limits,” Mr Osborne said, with little thunder.

These measures were widely seen as a political ploy to woo voters of a certain age while escaping the notice of the rest of the electorate. Steve Webb, the Liberal Democrat pensions minister, was only a little more forthcoming about what the new financial freedoms meant when he added that “if people do get a Lamborghini . . . that is their choice”.

Be that as it may, Mr Osborne’s announcement accords with an important principle. People should be taxed on what they spend, for that is in effect what they take out of society. Income tax is a levy on what they put in. And taxing consumption – whatever the source of the money that finances it – is the least objectionable way of taxing inheritance.

True, consumption taxes have been widely criticised for penalising the poor. But that is because they usually take the form of indirect taxation – such as a levy on sales, or a value added tax. Such taxes generally claim a higher proportion of what poorer people earn and spend. In part, that is because low earners tend to spend a greater proportion of their income; saving is hard when you only have enough to get by. It is also because sales taxes and the like are paid by everybody at the same rate. Here, direct taxation has an advantage; it can be adjusted to people’s circumstances by the use of tax brackets.

But a consumption tax need not take this indirect form; it need not be collected at the till. Instead, taxpayers could hand over directly to the government a slice of their total spending. And bigger spenders could be made to hand over a bigger slice – just as high earners currently pay income tax at a higher rate.

The idea of a consumption tax has echoed down the ages. John Stuart Mill was an early advocate. More recently, but not very recently, I published a book called The British Tax System with another young economist, Mervyn King, the future governor of the Bank of England. Our central proposal was that income tax should be replaced by a scheme we called a lifetime expenditure tax, based on cumulative household expenditure.

Nicholas Kaldor, who advised Harold Wilson’s Labour government in the 1960s on taxation matters, had also written a book on the subject. He had even persuaded the Indian government to undertake a brief and unsuccessful experiment. But Kaldor’s mind was more fertile than practical – his name forever associated with the ill-fated Selective Employment Tax on service industries, an attempt to subsidise manufacturing and help exports. And India, tied up in bureaucratic red tape under the Licence Raj, was not the place to experiment with new frontiers of tax administration.

The most practical method of levying a direct tax on expenditure is to tax people on their cash receipts instead of their income. Earnings would be paid tax-free into a savings pot, where the money could be kept indefinitely. Tax would be imposed only when cash was taken out. The same system could be used for receipts of any kind – income, capital gains, bequests, lottery winnings. Most people would be likely to save when their income was high and withdraw cash when their income was low. Their overall tax bill would tend to reflect their average expenditure over their lifetime.

When Lord King and I wrote our book, a wise old policy maker damped our reforming zeal, if only a little. “You will get the tax reform you describe,” he told us, “but you will never get the name.” He was right.

This week, Mr Osborne announced the widest extension yet of tax relief on savings. From next year, individuals can receive tax relief on annual savings up to £40,000, can create a tax-sheltered pension fund of £1.25m, and can draw down this balance almost at will from the age of 55. Looking ahead, anyone with sufficient resources to put aside can reasonably expect to accumulate tax- free savings of £2m over their lifetime. A couple can jointly build up £4m. For all but the 1 per cent, the expenditure tax has arrived – even if the forms we fill in each January will still say “income tax” at the top of the page.

Reform is a winding road. Back in the 1980s, officials argued that a consumption tax – even if attractive in principle – would be unworkable in practice. Look at how complex the income tax has become, they used to say. Taxing expenditure would multiply that complexity, they said.

Actually, the complexities of income tax multiply themselves. Measuring and monitoring cash flows turns out to be easier. Indeed, Mr Osborne last week cited simplification of the tax system as one of the benefits of his reforms.

But it is an irony of the sweetest kind. Rarely does a chancellor take his seat on Budget day having made the tax system simpler, fairer and more efficient. Whether his motives were Machiavellian or Hobbesian, Mr Osborne has done all three.

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