Taxing the Economy to Death

Times were hard – there was political unrest in Europe, financial difficulty in the UK, British armed forces were stretched, the country was running up a considerable national debt and the Government needed to raise money. 

It all sounds very familiar, but the time I describe was the late 1700s when Britain was under threat from the French forces of Napoleon and the cost of supporting our armed forces was placing an intolerable strain on the Treasury.  In 1799, under the guidance of the then Prime Minister William Pitt the Younger, income tax was introduced as a temporary measure to help finance the war.

More than two centuries later I think it is safe to assume that the temporary measure has become permanent, but the strange thing is that despite more than 200 years of experience, we have still not learned the lesson that not all taxes raise money!

Back in 1799 the Government’s expectation was that the new income tax would raise £10m in its first year.  In actual fact it raised less than £6m.  In 1802 Pitt resigned as Prime Minister and was replaced by Henry Addington who, following a brief period in which income tax was abolished, reintroduced it at a rate of 5%, half that of the previous rate.  Interestingly, despite the lower rate the number of taxpayers doubled and the revenue collected rose by a half.

The lesson is that the ‘optimum’ tax rate, i.e. the one that raises the greatest amount of income and/or is best for the economy, is not necessarily the highest one.  Because people don’t like paying tax, if they perceive the tax rate as being unreasonable, they will find ways of avoiding it.  But to Government, money is power – the more money a government has, the more influential it is on the world stage, the more ‘benefits’ it can offer to voters and therefore the more successful it can be as a political force, yet on the other hand, the more it can be seen to be cutting taxes the more popular it will be with the public.  The taxation system is therefore the battle ground where the public and governments clash, which is why successive governments have resorted to populist measures, such as ‘green’ taxes, or covert taxation where the intention is to hide the impact, as in the failed attempt to impose VAT on freshly baked pasties.

The net effect has been to create so much confusion that it is almost impossible to tell whether a tax is benefiting the economy or damaging it.  Take the 50% rate of income tax introduced by Gordon Brown as an example.  In the tax year prior to its introduction 16,000 people declared an income in excess of £1m in the UK, but in the following year the number fell to just 6,000.  Although these numbers do not prove anything conclusively, economists seem to broadly agree that less money was raised at the 50% rate than had previously been the case, yet when the Coalition Government reduced the rate to 45%, they were roundly condemned by the opposition parties for helping the rich.

My own taxation hobbyhorse concerns two taxes that I believe are both unfair and damaging.  The first is inheritance tax and the second is stamp duty.

The argument in favour of inheritance tax is that it is a force for social equality; that by taxing a person on income that they inherit is to tax them on ‘unearned’ income, such that over time it will lead to a more even distribution of wealth.  The reality is that the argument is complete tosh.  If its objective was to lead to a more even distribution of wealth then the tax should be levied on the inheritors rather than on the estate of the bequestor as this would provide an incentive for wider distribution.  In reality, the tax is simply a cynical way of raising money from a deceased person who had already paid tax on the money when it was initially earned.

More seriously though, evidence from research conducted over the last 20 years shows a strong correlation linking bequests, gifts and other such windfalls to new business start-ups.  According to HMRC around 14,500 people pay inheritance tax each year with the total tax take coming to £2.9bn, a mere 0.18% of GDP.  Scrapping this unfair tax would therefore release a further £2.9bn into the economy at a time when encouraging entrepreneurship would be helpful to the recovery of the country’s finances.  Moreover, since inheritance tax is mostly avoided by those rich enough to afford the advice that enables them to shelter their wealth from its pernicious grasp, it is likely that vastly more money would remain within the UK rather than being shipped to economies that have either scrapped it (such as Sweden, Austria, Canada, New Zealand, Singapore, India etc.) or never had it in the first place (such as Guernsey or the Cayman Islands).

Stamp Duty is paid when people buy and sell either property or stocks and shares.  Why the government feels it is reasonable to take between 1% and 15% of the purchase price of a property worth over £125,000 just because a person chooses to move beats me.  But regardless of the outrageous unfairness of the tax, its impact is to reduce the mobility of labour.  For example, imagine you live with your family in a semi-detached house in a suburb of Greater London, you have just lost your job as your company has gone bankrupt in the recession but you have been offered a new job in Birmingham.  If you move your family to an equivalent home in the Midlands the chances are that you will be paying Stamp Duty of at least £15,000.  When income tax and national insurance is taken into consideration that means that you will need to earn at least £19-21k before you have earned back the stamp duty and before you start to make a contribution to your other relocation expenses.  It’s no wonder the roads are congested with people commuting for hours rather than running the risk that a move may be temporary.

The point is that if we are serious about getting the country back on its feet, about having a free and flexible employment market and about making Britain attractive for business, simplifying the tax system and removing unfair taxes should be a high priority.

About the Author
Alistair Schofield is Managing Director of Extensor Limited.