Taxation in a nutshell

Taxes affect behaviour, and in so doing reduce productive economic behaviour. Outside of impossible or improbable lump-sum taxation systems like taxes based on height, innate ability, or simply existence, and with the exception of a small range of Pigovian taxes on externalities, there are no taxes which do not cause deadweight losses. That is, there are no real world taxes which simply move money around, without reducing economic activity at the same time.

Once we’ve collected the revenue of well-designed congestion charges, fuel taxes, alcohol and smoking levies, and carbon taxes, we are always going to have to reduce economic welfare when we tax (even if we increase welfare overall by spending that money well). But that doesn’t mean that every way we raise our £700bn, or however much the government has decided it needs, is equivalent.

Some taxes are costlier than others. Imagine a consumption tax that falls on every good and service as a baseline. This reduces everyone’s buying power, and it distorts activity, since it makes every good more expensive with the exception of leisure, which is now cheaper (since every £1 you earn, and hence every hour of work, can buy less in goods).

What's more, it doesn't just shift people towards working less, but also working in lower productivity—but more pleasant and satisfying or less risky—careers. You get fewer oil riggers, actuaries, and IT admins, and more think tankers, charity workers, and florists. But other than that, it is neutral between different goods: everyone still spends their budget in the same proportion as they would do in the no-tax world. And everyone saves the same fraction of their budget as they would in the no-tax world.

Now consider a world with an income tax. In that world you pay tax not only on the fraction of your income you consume, but also on that fraction you save. Since this both reduces the principal upon which you earn interest, and the interest itself, directly, this makes future consumption more expensive, and saving (which provides the funds for investment) less attractive.

In this world, not only do people do fewer hours and produce less output because consumption is more expensive, work is less well paid, and leisure is cheaper, but people also invest less, reducing future living standards. According to plausible estimates from Nobelist economist Bob Lucas, the gains of scrapping all taxes on capital, those that encourage people to consume output, rather than investing it for the future, would be larger than eliminating the boom-bust cycle.

What should we do

The ASI has consistently advocated for a swathe of policies that would shift the UK's tax system in a rational direction. Number one is removing the bias against investment, but there are a huge range of practical reforms that can make British taxation simpler and less costly.

  1. Replace corporation tax with a cashflow tax. Corporation tax feels good because it seems like big "fat cat" corporates are paying the bill. But capital can move around: out of the more efficient corporate sector, out of the country, or it can be consumed and never invested in the first place. Capitalists need not themselves pay the bill: some will be passed on in higher prices, and most will eventually result in lower wages, because lower investment means less productive employees. What's more, the subjective system for judging where profit is generated more or less guarantees avoidance. All of this can be solved with a "border adjusted cashflow tax". The border adjusted means we remove any incentive, or ability, to shift the tax base abroad, by taxing based on the destination of sales, not a philosophical guess at where the profit was created. The cashflow means that all investments can be immediately expensed in full—when Estonia adopted this system investment surged compared to similar nearby countries.
  2. Merge income tax and national insurance contributions, rationalising the rates schedule. National insurance contributions used to be linked to welfare payments and pensions. Since then the consensus has shifted: most believe that the needy should get benefits whatever they've paid in, and the system has moved to accommodate this feeling. At this point the link between what you pay in and what you get out has been severed almost completely. The remaining system is an opaque stealth tax that begins at a threshold far below the personal allowance. Employee and employer NICs—which are already paid by the worker—should be rolled into income tax, with two clear rates, beginning from the same threshold, the current £12,500.
  3. Create an unlimited ISA to exempt all investment from tax. Economic theory is clear that we shouldn't bias the tax system against investing today and consuming tomorrow—rather than right now. We fret about our historically low savings rate and capital investment rates, but we tax the returns from those at exponentially increasing rates over time. The solution is an unlimited ISA, built on the current model, covering all normal investments. 
  4. Broaden the base of VAT by eliminating exemptions, zero-ratings and deductions. No tax is a "good tax", really, but VAT is as close as we come in the current system, notwithstanding a not insignificant collection cost and some avoidance and evasion among smaller firms. For the time being we should make the best of what we have, and iron out the currently illogical mess of handouts we give through VAT—instead of directly. VAT exemptions on things like food and clothing are very slightly progressive, but only very slightly, and at a large cost: the deduction on clothes means £1 off a £5 t-shirt and £40 off a £200 Armani baby gro. Broadening the VAT base would bring in over £50bn that could be used to reform other more damaging areas of the tax system in a progressive way, e.g. by raising the threshold before which low earners pay national insurance.
  5. Reform the property tax system. Britain's property tax system has three main prongs, all artefacts of past reform that no longer make sense. Council tax is charged on 1991 housing values, and banded, so that more expensive properties face little less than more modest ones. Stamp duty land tax discourages moving for jobs and down- or upsizing, as well as limiting the ability to have children by keeping bigger houses in the hands of those who don't really want or need them. Business rates is far more rational levied, but it is levied at too high a rate—49.7p in the pound on rental values—discouraging using valuable land for business. All three should be merged into a single tax on the owner of property, based on rental values as estimated from a sophisticated algorithmic database, like an improved version of Zoopla's or Rightmove's. A rate of around 20p in the pound—equivalent to extending VAT to property—may be enough to cover the abolition of all three systems.

The ASI's role

The Adam Smith Institute has been a loud and consistent voice for tax reform to boost investment, more efficiently allocate assets, raise pay, and eventually economic growth for years, with staff blogging, writing across the web, appearing on TV, commenting in newspapers, and hosting events to build a coalition and drive the message forward. We also calculate the UK's Tax Freedom Day every year, to provide a clear measure of just how much of Britain's income the government is spending.

Highlights include:

We have also created videos for the ASI hub, hosted on Youtube, Facebook and Twitter—our videos often receive thousands of views and large social media traffic.

And we have produced research outlining who bears the incidence of taxes like corporation tax, as well as the costs these taxes have to the economy and society at large. This research has tended to bounce around the internet and policy debate for years after it was first released, with citations in the least expected of places.

Her Majesty's likely new government under Theresa May does not seem radical—it may be, in its instincts, one of the least radical governments in decades. But when it comes to corporation tax it is carrying on the reforming instincts of the latest government, and aims to bring the headline rate down further, to 17%.

What's more, no one expected Margaret Thatcher to make radical changes; and nor did anyone expect Donald Trump to be associated with one of the most sensible business tax reforms in history. Reform can come from surprising sources. In the next year we will work as hard to continue building the case for an economically rational tax system, one that taxes us less and taxes us better.