A stealthy step towards abolishing income tax

‘For what reason is there, that he which laboureth much, and sparing the fruits of his labor, consumeth little, should be more charged, than he that liveth idly, getteth little, and spendeth all he gets:  seeing the one hath no more protection from the commonwealth than the other’.  

(Thomes Hobbes, Leviathan, Chapter 30).

Hobbes was arguing that we should tax spending not  income a century before income tax was introduced in Britain (in 1799, to pay for the war against Napoleon).

       More recently, but not very recently, I published a book on 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.  We did not have in mind a sales tax or an extension of value added tax. Our proposal was to create a new direct tax, based not on income but on cumulative household expenditure.

A tax on consumption was not a new idea. John Stuart Mill had followed Hobbes in advocating it.  Nicholas Kaldor, who advised Harold Wilson’s Labour government in the 1960’s on taxation matters, had written a book on the subject, and 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 –  and India never the place to experiment with new frontiers of tax administration.

The concept of a direct tax on expenditure was given a more realistic appraisal by the newly established Institute for Fiscal Studies in the 1970’s and featured in  the Meade Report which helped establish the Institute’s reputation. Mervyn King and I drew the material for The British Tax System from work we  had done for that report

At that time, a wise old policymaker dampened our reforming zeal, but only a little.  He said ‘you will get the tax reform you describe, but you will never get the name’.   Thirty-five years later, he has been proved right.  What we have today is a more or less the lifetime expenditure tax we envisaged, but the returns we fill in each January still have ‘income tax’ at the top of the page.

We never envisaged that  tax collectors would surreptitiously observe the bills people rang up at the supermarket till (although this approach, utterly fantastic in 1979, is almost conceivable in a modern world where electronic payment is taking over from cash and cheques).   The practical method of levying a direct tax on expenditure is to do so indirectly, by exempting savings from income  and taxing people on their net cash receipts.

In such a system, individuals and households could defer tax on anything they received by placing it in a savings pot. They could accumulate tax free within that pot, and would then face a tax charge on what they withdrew when they withdrew it.  Most people would be likely to save when their income (and marginal tax rate) was high and spend when their income (and marginal tax rate) was low.   As a result, their overall tax bill would tend to reflect their average expenditure over their lifetime. 

Such a scheme existed in 1979, but was limited in scope and restricted in scale.  It was called a retirement annuity. It was, however, an idea whose time had come. Today we describe it as a defined contribution pension scheme.

An alternative, less elegant, approach to taxing lifetime expenditure allowed people tax exempt roll up of savings between the time they were made and the time they were spent.  A mechanism of this kind was introduced by the then Chancellor of the Exchequer Nigel Lawson in 1986.    Personal Equity Plans were initially limited to an investment of £6000 in shares listed on the UK stock market. But not for long.

Over the following three decades, the scope of these two schemes was steadily extended and the numbers of savers using them steadily increased.  This week, George 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 £1.25 m, and can draw down this balance almost at will from the age of 55.  Under new Labour PEPs became cash and share  ISAs, and after the latest changes most financial assets will be eligible for inclusion, up to an annual total of £15,000.  

Looking ahead, anyone with sufficient resources to put aside can reasonably expect to accumulate tax free savings of £2m over their lifetime, and  a couple can jointly build up £4m.   For all but the 1%, the expenditure tax has arrived. (Maybe it is time to think more carefully about the taxation of the 1%, It was the wealth of the Maharajahs that had attracted Indian interest in expenditure taxation).

The arguments for direct taxation of expenditure today are much as they were  in 1979 – though one, the difficulty of adjusting the income tax base to reflect the impact of inflation, has become less important as the rate of inflation itself has fallen.  An expenditure basis is fairer, more reflective of ability to pay, reduces discouragement of  savings and investment, and encourages households to make adequate provision for retirement.

And, unexpectedly, taxing expenditure is simpler.  In the 1980s, we engaged in many arguments with officials and practitioners who pointed to the complexities of income tax and claimed that our ideas would multiply that complexity.  Actually, the complexities of income tax multiply themselves, and have continued to do so.  Measuring and monitoring  cash flows turns out to be easier than computing income.  It was no surprise to us that in making the most extensive move yet towards an expenditure basis for direct taxation in the UK, George Osborne cited simplification as a critical benefit.