The ‘flat tax’ revolution: Opinion piece

Academic Nigel Knight puts the case for the ‘flat tax’. Perhaps we shall all have a less taxing old age? Currently a peripheral argument so far as the main parties are concerned, it is something that tax professionals might well need to become acquainted with.

Gordon Brown has helped to develop one of the most complex tax systems in the world. Whereas previous Chancellors, particularly the Conservative ones, have tried to keep things simpler, we now have a tax system that is incredibly difficult to understand. The problem is not simply one of comprehension, but complex tax systems are expensive to administer, they encourage avoidance schemes and give the public difficulty in filling in tax returns. They also tend to stifle initiative and enterprise in the economy – though not among tax accountants and lawyers trying to develop avoidance schemes!

Currently, we have three rates of income tax: 10 per cent, 22 per cent and 40 per cent, starting at different income thresholds. We also have national insurance (NI) contributions currently at 11 per cent, which contrary to popular belief, are in fact an additional tranche of income tax. NI contributions are not hypothecated so as to be spent on pensions etc.(except for one percentage point of the current 11 per cent, which is supposed to be used for health spending), but rather they are just added to the general tax pool and are spent by government on all forms of expenditure.

The flat tax

By contrast to the present system, a ‘flat tax’ is a very simple one to understand and for government to implement. It requires a single marginal rate of tax to which all income is subject, above a given tax allowance. It eliminates the current three tiers, and if national insurance were to be included, flat tax would eliminate that tier as well.

Most flat-tax schemes envisage a low marginal rate of income tax, a high personal allowance and the elimination of most of the existing tax allowances. The system leads to reduced administrative costs for government and for employers, as well as those employees who are subject to self assessment. It also reduces economic distortions, as under the current system, investments are often made to reduce tax liability, rather than for maximising economic returns in the economy and thus maximising economic efficiency. If the marginal rate of tax can be set at a modest level, it will stimulate growth in economic activity.

By almost eliminating the complex array of allowances and exemptions, it significantly reduces the incentive to adopt avoidance schemes – a real disincentive for tax accountants and lawyers.

The flat tax is more than simply a matter of discussion (on both sides of the Atlantic), it is a reality in a number of states around the world, and in some places very close to home. Jersey introduced such a system in1940, Guernsey did in 1960 and, further afield, Hong Kong did in 1947. Also, a whole raft of Eastern European states have recently introduced such a system, including Russia, further encouraging foreign direct investment to Eastern Europe.

Does a flat tax create unfairness?

People will naturally say, well isn’t this system unfair as all people (subject to income tax) whether rich or poor pay the same rate? Well, yes, but of course the richer you are the more you pay, so the system is still progressive; it is only the marginal rate that is constant, not the amount of tax you pay.

What about the relationship between the flat tax and capital gains and inheritance tax?

Capital gains is particularly complicated: there are some 39 different tax rates and a considerable number of allowances and exemptions. Regarding inheritance tax, as I have recently found with the death of my father, a system of transfers can be necessary for tax efficiency, though if the government doesn’t get you with inheritance tax, they will with capital gains! The flat-tax proposals that have been put forward recently, mainly relate to income tax only, but there is no reason why capital gains and inheritance tax could not be treated in precisely the same way. The current 39 capital gains tax rates could be simplified to one, and the allowances and exemptions simplified as well. Inheritance tax is already simpler in respect of the marginal-rates issue (although this rate is quite high), but spouses are exempt, and children and others are not. When one spouse dies, it is not tax efficient for the children if the surviving spouse inherits all of the property (if that property exceeds £275,000 in total value). Thus, here is another job for the tax accountants and lawyers: to devise tax-efficient schemes. Again, it is the exemptions issue, the high rate and low threshold that constitute the problems. Addressing the exemptions issue, having a high threshold and a more modest rate of tax is the way a flat-tax approach would deal with these problems.

Drawbacks of a flat tax?

Well, what are the drawbacks with a flat tax? Principally this only concerns the purpose for which the fiscal system is there to perform. This may seem an odd thing to say, but for most governments since World War 2, the tax system has not existed just to collect revenue for public services and to encourage economic growth, but to redistribute income and wealth from rich to poor. The flat tax clearly does less of this than the current system, viz. it is less progressive.

However, this progressive aspect of the system has been substantially reduced over the years. In the 1970s, there was a top rate of tax of 98 per cent! The Thatcher and Major governments reduced this to 40 per cent, though they did increase expenditure taxes quite sharply. This was interpreted as a very regressive change in the tax system, as expenditure taxes are paid by rich and poor equally. But the Thatcher change represented a philosophical shift from ‘collectivism’ to ‘individualism’. If taxation is levied principally on income, it is the state that allocates resources on behalf of everyone, as we are left with only a modest amount of disposable income to spend as individuals. If taxation is levied principally on expenditure, we as individuals make choices as to the amount of tax we pay, by our decisions regarding the goods we buy, or do not buy. It also encourages saving, which in turn encourages investment. But what about the need to redistribute income? There are other mechanisms in the system that do this – the benefits system does, as do public services.

The current government has kept Thatcher’s change from direct to indirect taxation largely intact, and has even extended it to pay for its vast increases in expenditure. It has done this, not, however, for ideological reasons, but simply because income tax is the one we most notice. If the chancellor raises income tax, we all blame him. But if the chancellor raises taxes, which fall on expenditure, we all blame the shops that sell us the goods. These are the so called ‘stealth’ taxes.

Why has the flat tax not been introduced in the UK?

So the flat tax, a single tier of tax, set at a modest marginal rate is broadly consistent with the recent trend to reduce the incidence of direct tax. So why has it not been introduced? In the case of the past eight years, as we have seen, Gordon Brown has evolved one of the most complex tax systems to be found anywhere, he has a lot of political capital invested in such a system and is not going to reverse eight years of toil. If Brown replaces Blair as prime minister, he clearly will not appoint a chancellor who will reverse his work.

A UK flat tax: The details

Richard Teather recently wrote a paper proposing a flat tax for the Adam Smith Institute, which has aroused a lot of interest. His proposal has a marginal rate of 22 per cent combined with a massive personal allowance of £12,000. By eliminating the top rate of income tax, high earners obviously gain, but low-income earners gain much more because of that high personal allowance. With people earning £12,000 before they pay income tax at all, the very low paid simply will not be paying income tax. This reduces the problem of ‘churning’, which exists under the current system; this is where the low paid are both taxed as well as provided with benefits, so the state is giving them money with one hand and taking it away with the other. Even for those on modest incomes, the income-tax liability will be small. For middle-income earners, similarly, it is that tax allowance that would reduce their income-tax liability noticeably.

Now, people are naturally going to say, well if all income earners are potentially gainers, how can the figures add up? Surely there must be losers somewhere? The answer is quite simple. In Richard Teather’s proposal, the government would lose some £38bn in revenue per annum. So, where would this lost revenue come from? A reduction in government expenditure or a further rise in expenditure taxes are the only sources. Can government expenditure be reduced without seriously affecting public services? The government claims it can’t, yet even the chancellor has admitted that there are many billions of pounds of waste in the current system, and the Conservative party claims that the waste is billions more. Given the truly massive increase in government expenditure over the last few years, and with the creation of many public-sector jobs, which cannot be called ‘front line’ in any sense of that term, it seems that most commentators agree that reductions in expenditure are possible, without cutting the quality of health, education and other front-line services. So making our public-service provision more efficient could release the very £38bn needed to make the proposal work.

I remarked earlier that the lower incidence of income tax will make the economy grow. Well exactly how does this work? It works in two ways. First, via the ‘supply-side’: If people are taxed at 98 per cent, they usually leave the country. The tax yield to the treasury then becomes 98 per cent of nothing. Even if the top tax rate is rather less punitive it usually sends people to the golf course rather than to the office. Why apply extra effort when the government is taking most of your income in tax? There is no incentive. It is this notion of incentives that underlies the supply-side effect. If people can keep a larger amount of their own money when they work, they will work harder and so produce more and the economy grows. The American economist Arthur Laffer also showed that as the economy grows, the tax yield to the government also grows: a win-win situation. But is this really true? Well, empirical studies have shown that it is so for the higher paid, so the elimination of the upper tax rate in the flat-tax proposal should have this beneficial effect.

But there is another argument that applies, particularly to the low paid; the existing income-tax system can make it expensive to employ people, and this destroys jobs because in many cases, the gross-income that employers are obliged to pay will far exceed the value of the work undertaken by the employees. The flat-tax proposal, by reducing this ‘tax wedge’, would increase the creation of employment by employers.

The other way in which the economy grows with reduced taxation is via the ‘demand-side’: A reduction in income tax increases disposable income, the increased disposable income is used largely for increased consumption and so the consumer drives economic growth. We already have a situation where our economic success is predicated upon consumer expenditure.

However, a reduction in income tax financed through savings by government means a reduction in growth stimulated by government expenditure. This is true, but private markets allocate expenditure more efficiently than governments, and we have already said that it is wasteful government expenditure that would be cut to finance the flat-tax proposal.

In conclusion, the flat-tax proposal seems a compelling notion: it reduces the administrative costs of the tax system; it reduces the incentive to avoid paying tax; it reduces market distortions because it reduces inefficient government intervention in the economy; and it creates incentives to work and so encourages economic growth. Everyone gains, except the tax accountants and lawyers involved in tax-efficiency schemes!

Nigel Knight is a spokesperson for the ‘new party’ and has taught economics at both Oxford and Cambridge Universities. He can be contacted at nvk@cam.ac.uk