The SMF #FridayFive: 4 December 2015

Their Tax Detox report has a number of interesting ideas, not least the abolition of inheritance tax (because it is too toxic). However, with my ex-Treasury tax official hat on, I wonder whether they will see themselves on the statute any time soon.

The first three of the #FridayFive consider other views on the Fabian’s recommendations, which give an interesting set of counter points:

• Chris Yiu, gives the ex-Treasury tax officials’ view on Inheritance Tax: http://yiu.co.uk/blog/ten-myths-about-the-dreaded-inheritance-tax/
• The IFS view on hypothecation of taxes: http://www.ifs.org.uk/publications/5622
• YouGov research on tax statements and what the public actually think: https://yougov.co.uk/news/2014/11/09/public-attitudes-tax-distribution/

However, while the recommendations in the Fabian’s report are open to debate, as with a number of other recent reports, the research does effectively highlight the need for a more effective tax system in the UK. So how should the tax system change? The final two #FridayFive provide an insight into the way I think tax policy should be made.

First, the “opacity rule” should often apply. That is that, for any given sum of revenue needed to fund public expenditure, rather than being transparent, behavioural economics suggests that taxation should be opaque. This is because evidence suggests that as well as being “risk averse” taxpayers are also “tax averse”.  This means that people respond differently to tax rises than they do to equivalent price rises, meaning that any particular good or service has both a price and a tax elasticity of demand.

An easy way to understand this is that someone might pay an accountant £100 to reduce their tax bill by £90, in financial terms they are worse off, but in utility (or welfare/ wellbeing) terms they are better off because they place a disutility on paying tax. While evidence of this extreme case is only anecdotal, a number of papers have begun to explore this in the context of investment decisions and how it can lead to the misallocation of capital.

• This paper is one of many beginning to emerge on the existence of “tax aversion”: https://ideas.repec.org/p/zbw/arqudp/133.html

An interesting extension of this is to consider whether this “opacity rule” always applies. I don’t think it does. For instance, if taxes are used to correct externalities and attempt to drive a change in behaviour (e.g. green or “sin” taxes), making them as transparent and upfront as possible would be more effective.

So what does this mean in practice?

• For taxes like Income Tax, which are mostly about raising the revenue needed to pay for public services, the less we know about it, the smaller the welfare loss will be. This has important implications for the ongoing debate about the merging of Income Tax and National Insurance Contributions (see a survey from the Office for Tax Simplification today). My view is that making Income Tax and NICs more transparent by bringing them together might have significant negative impacts on the labour market and the OTS and Treasury need to think very carefully before taking anything along these lines forward.
• Conversely, for taxes like tobacco duty or the proposed “fat tax”, the level of tax paid should be presented extremely clearly in order to put people off purchasing the products by both raising price and introducing tax aversion.

The second thought on how tax policy should be made will not be popular amongst Politicians. In short, things shouldn’t change unless they absolutely have to. With two fiscal events a year (Budget and Autumn Statement) the incentive for politicians to tinker with rates, allowance and regimes is far too high. Constant changes create a raft of costs for businesses and individuals alike, as they try to keep up to date with what they should be paying, what they can claim back and how tax allowances for investment and growth might actually work. For businesses looking to invest over a multi-year (and potentially multi-decade) period, the uncertainty that this creates can make the difference between choosing to invest in the UK and moving elsewhere. So the final #FridayFive is a blast from my back catalogue: policies to make the UK’s tax system more stable and investment-friendly.

• Recommendations 3-6 here outline a new system of tax policy making that would tie Government’s hands and give business certainty: http://www.policyexchange.org.uk/images/publications/looking%20to%20the%20future%20of%20growth%20-%20nov%2011.pdf

Probably not attractive to any government, but certainly attractive to businesses and those having to file self-assessments.