The popular ownership of taxation: must taxation be an imposition?

Written by Chris Huhne MEP and published in the Report of the 2001 Liberal Summer School on Wed 1st May 2002

How do we establish and maintain a consensus in favour of relatively high levels of public spending and therefore taxation? It can be done, but of course it depends on the nature of the tax as we can see in the United States. The states in the US are extremely sovereign. They make a lot of important political decisions, and there is no federal minimum/maximum for tax rates.

This leads to some quite big problems on occasion. Some years ago when New Jersey abolished the sales tax on clothing, six skiwear shops in neighbouring New York City promptly closed down because everyone decided to buy big-ticket clothing items across the state line. When there is no link between services and taxes paid, people will shop around. That is why in Europe we do have some minimum on sales (Value Added) taxes. Indeed, often it seems that it is British governments arguing that they should be higher, because of our losses on drink and tobacco.

With taxes that can be linked to services - through some check on entitlement - people are surprisingly willing to pay. An example is Vermont and New Hampshire in the United States. Vermont charges 7 cents in the dollar more income tax than next door New Hampshire (and 9.5 cents for higher rate taxpayers), but Vermont residents do not move because they think they get better public services. Value for money is the key. If people think they are getting value for money, they will happily pay the extra income tax.

The key, though, is surely the link to services. And we have to be very careful. During my five years in the City, when I visited a large number of developing countries, rating the likelihood of them repaying their debts to investors, I did a lot of comparative work on political and economic systems. I only saw one case of a political party winning power on the basis of promises of increased taxation. That was Sweden during the 1990s. In the main, those who want to tax more try to find stealthy ways of doing so. The Swedish preference for the open fiscal lash was in fact very dispiriting to our sister party, the Liberal opposition to the social democrats. They thought that tax and spend had reached such a high rate of national income in Sweden, and so many people were on the public sector payroll, that they would have a ratchet until the whole system ground to a halt. In fact that is very largely what happened.

Suddenly the consensus about tax and spend in Sweden changed rather dramatically. I mention the Sweden case, as it is a very interesting one. We can learn from those who have been where no other free market economy has ventured before. You might say that the Swedes are the 'trekkies' of the fiscal galaxy. Sweden's public spending as a share of GDP peaked at 67.5% of GDP in 1993, compared with our peak of 45.5% of GDP in the same year.

This was not willingly borne. Even in Sweden, the actual behaviour of the government shows that there was considerable resistance to extra taxation. Quite an important signal here is when governments begin to finance increases in public spending, not through taxation at all, but through borrowing. That can happen for cyclical reasons, but it is quite clear that politicians have a notorious habit of behaving like Mr. Micawber in the belief that 'something will turn up'. Finance ministers who fall prey to these delusions, usually find themselves ejected from office in fairly short order.

Thus the peak public spending levels in both Sweden and the UK actually coincided with peak public deficit levels. So you were not financing, in either country, public spending level through honest taxation. Politicians evidently did not think that they could get away with it. A very large and increasing part of the money for public spending was coming from government borrowing. And that of course is not ultimately sustainable. Just to remind you of the facts, given how different they are from the current situation, in Sweden in 1993 the deficit was 11.9 % of GDP. A lot of money to borrow in one year, if you bear in mind the Maastricht criteria of 3 % for deficits and 60% of GDP for debt. In the UK in the same year, it was 8% of GDP, quite a substantial deficit. In order to control those deficits, and indeed to respond to the public's desire for lower taxation, both governments cut back public spending sharply. In Sweden, the share of public spending in gdp has now fallen back to 51.6 per cent., or a reduction of 16 per centage points of gdp.

In general therefore, I am suspicious of the motion that people are ever likely to welcome taxes as anything but an imposition. They can evidently - see Vermont - be sold as a necessary evil. But we will be very cautious if we venture away from that. If Nelson Mandela, as the nearest thing to a political saint in our time, can't persuade the South Africans that a higher tax burden is a good thing, I think that we have to recognise the political constraints on those of us with less persuasive power than him.

This view of course is a fairly standard one amongst people who have studied this field. One of the world's more successful finance ministers was Jean-Baptiste Colbert, who was the finance minister of Louis XIV. Colbert famous dictum, based on a considerable felicity with the dark arts of the Treasury, was that the art of taxation consists in plucking the goose to obtain the largest number of feathers with the smallest amount of hissing. Colbert was the first finance minister to advocate stealth taxes. Given the Sun King's extravagance, Colbert certainly had large ambitions for revenue as well as a highly 'dirigiste' conception of the role of government.

This is not it seems to me a liberal view. In fact the old liberal position, as embodied by John Stuart Mill, was wholly opposed to a Colbertian view of the state. For Mill, public spending had a tendency to balloon, and was inheritantly suspicious. He would have been very bemused by the fuss surrounding our proceedings today, much of which has been how to sugar the pill. In Mill's 'The Principles of political economy', he argues that we should choose the most disagreeable taxes that we can possible find as liberals. Because there would be 'a security, which now there is not, for economy in public expenditure'.

Mill's position was pretty clear: pleasant taxes were bad and in general if we wanted to make sure that we have a reasonable limit on it, the idea of pleasant taxes was not one that appealed to him. In fact, pleasant taxes are perhaps as much of an oxymoron as numerate journalists and modest politicians. Mill would certainly have been wholly shocked by the growth of the modern state. In 1913, on the eve of the First World War, total government expenditure was 13.3% of GDP in the UK. Quite a lot lower than it was in Germany at that time, 18% in the Bismarkian Social Welfare State, however, that equalled only a third of our current level of our current public spending as % of GDP.

So it seems to me, thinking about the overall burden of taxation, that no liberal ought to be, should be or could be in favour of taxes for their own sake. And, I hope that is a message that we will shun. True, over the last few elections, as a party we have come to be rather fond of our policy of a penny on income tax. It is one of the very few policies that we have which has lodged itself in the public imagination. But I think that it is very important to remember that we have always argued for the penny on income tax, as a way of giving credibility to our commitments for higher and better provision in education and health in particular. It is not an end in itself. I come back to the incessant need to improve value for money in expenditure, and to be seen to be doing so, if the consensus for a high standard of public services (and high taxation) is to be maintained.

Inevitably taxes reduce personal choice because they limit personal income, and therefore we should aim to raise the minimum amount of taxation consistent with the objectives of the government in providing public goods, defence, law and order, health, education, transport, social cohesion via income transfers and so forth. And the proper argument is therefore about what those appropriate public goods and goals should be. The level of taxation will tend to flow from that judgement with the necessary trade off for the amount of hissing from the goose. This is what the business of politics is all about.

Although my view is that the overall tax burden is a necessary evil, and our fellow citizens are likely to go on seeing it as such, it does seem to me that there are some taxes that actively perform useful social functions. These include: sin taxes and taxes/charges on bad things. The first category includes taxes on drink and tobacco, the second on factors that are degrading to the environment.

Nethertheless, I think that we have to be very careful about making these arguments too enthusiastically. There is often a fine line between activities that are generally harmful to others; alcoholism and cancer clearly impose costs upon the rest of society as well as on the individuals involved. And global warming is clearly a threat to society as a whole. But we must distinguish between activities that are genuinely harmful to others and activities of which we merely disapprove. And, liberals it seems to me must instinctively be on the side of personal freedom, and to misquote Voltaire, 'I may disapprove of what you are doing, but I will defend to the death your right to do it'. And even when we have enthusiastically taxed bads and sins, we still have a large public sector to finance.

So what principles should guide us in trying to finance the public sector? Let me put forward a few thoughts and then turn to some statistics. First, clearly the principle of fairness. Sir William Petty many years ago said, 'that which angers men most is to be taxed above their neighbours'. And, clearly this is an important element of fairness and in this day and age we must also expect some measure of progressivity, so that those with the broader shoulders bare the heaviest burden. Secondly, taxation rates should distort peoples' choices as little as possible. Whether those choices are over their spending or how they spend their time. It follows from this principal that we should, other things equal, attempt to avoid high marginal tax rates that may discourage people from particular activities. Relatively high marginal tax rates, with all due respect to Bob the Builder and his payments in cash, have in fact created an entirely new industry in this country, of which we previously did not have, which is of course the do it yourself industry. DIY stores have come about in part because if you pay a builder to do something for you and you are not paying cash, then you actually have to pay him/her not only the cost but also the national insurance contributions, income tax and value added tax. If you do it yourself you avoid all of those taxes at a stroke, though if you are like me, then your conservatory may fall down as a result.

One unintended consequence of relatively high marginal tax rates is an erosion of the division of labour, of specialism, and of expertise. A third principle is that we should avoid inefficient taxes that cost a lot to administer. We must look at total compliance costs for different taxes. One of the wrong turnings that we made many years ago was value added tax, which has now become a by-word for modernity around the world. In fact, this is an extraordinary tax which requires a massive amount of compliance costs on people, which the old purchase tax did not, and yet it raises very little extra money. Of course for the government and customs and excise, particularly in countries where there is not a very well rooted tradition of paying taxes, then VAT does have the beneficial effect that you are checking the previous person in the chain of tax returns as you go along. Unfortunately, from a social point of view overall, it clearly has very high compliance costs indeed.

Fourthly, a related principle - keep it simple. If you can't explain it quickly to the person in the street then don't do it. Taxation must be transparent and the most extraordinary line of this government, since Gordon Brown became Chancellor, has been the increasingly baroque, if not rococo, nature of the British tax system. Special clauses and exemptions have proliferated. The tax guide has grown to hitherto unimaginable proportions. Tolley's is raking it in. Gordon Brown is indeed that patron saint of the accountancy profession.

Fifthly, taxation should be under the control, as closely as possible, of the same elected people who are spending the public money. This seems to me a basic democratic principal that we have ignored in this country for far too long. The longer the link between you as an elector and the person who is deciding how much of your money should be taken out of your pocket and spent on a public service, the less likely you are to be satisfied. You are unlikely to get good value for money and have a good public service. It is not an accident that Denmark has such high satisfaction ratings for its health service: Denmark's population is half that of the south east of England.

This principle of a taut link between taxing and spending is one that we have failed to respect. The recent work for the Organisation for Economic Cooperation and Development shows that we have an exceptionally centralised tax system. In fact, we have the most centralised tax system of all the big developed countries that the OECD studied. Some 78% of all the tax revenues raised in this country accrue to central government, compared to 29.4 % of all tax revenues accruing to central government in Germany and 30% in Switzerland. Even in France, in the country that has inherited that dirigiste legacy from Colbert, the proportion is in fact 43.6% compared with our 78%. We are extraordinarily centralised in terms of where the tax revenue actually goes.

I admit that some of the smaller developed countries are worse, in Ireland 86.8% of tax revenues accrue to central government, but we must make some allowance of the fact that the population of this country is 60 million and the population of Ireland is 3.7 million. Therefore if it was the case that half of London were responsible for 87% of total tax revenues, I would not feel that was excessively centralised. But, to centralise so much tax revenue over the whole of this country, when we are so big and the levers of control and public choice are so long, is appalling. Those levers run from you sitting fuming in the Accident & Emergency because you have not been seen adequately quickly, and being able to complain and get some response. That seems to me to be the central issue. It is the closeness of the decision making to you, as the electors and to us as the political activists. That is something, which we need to address with a good deal of urgency.

I would just like to dispel one particular myth that is associated with this. That is the myth that somehow it is necessary and more efficient to collect the taxes at a national level than local level. You can have a tax collection system at national level with very clear rules about how to divide it up. This is broadly the German system. But in Spain, for example, the autonomous communities in the Basque country are actually responsible for collecting the majority of the total taxes levied. They are the people that then pay on the amount, which is due to central government in Madrid. So there is nothing inevitable about doing it the way we do, and I do think that we need to bare in mind that fundamental principle of reducing the length and linkage between the elector and the people making those choices. In providing a framework for local choices, the key issue is not whether tax is raised locally but whether the spending allocation is reliably fixed.

Let me quickly run through some of the issues in applying these particular principles

and raise some new thoughts. It seems to me that there are some things that we must not lose sight of in the tax debate and one of those is a big choice. The real problem in the direct tax system is where you have very high effective marginal tax rates upon the low paid. These are caused by the problem of benefit withdrawal combined with a tax rate. I have spent a long time looking at these issues over a number of years, and I came to the conclusion that there are serious difficulties both about the basic income guarantee and the ideas for an expenditure tax (where the tax base would be income minus saving) that the Meade committee put forward. Both would solve the super-high marginal tax rates on a relatively small number of people moving from benefits by imposing a substantial increase in the marginal tax rates on most income tax payers. If you decide not to target your help in terms of benefits, if you give universal benefits across the board, then they are expensive in terms of raising the marginal tax rate for a large number of other people. And although I am sympathetic to the argument that this is unlikely to have any great economic effect, I am afraid that in seats like Guildford it might have some undesirable political effects. I think that we have to be aware of that political issue.

There is a straightforward trade off here between targeting help for people who need it,

which is relatively cheap, but when they get richer and you withdraw that targeted help they face relatively high marginal tax rates. That is relatively cheap if you don't have high tax rates for the rest of income tax payers and the alternative is that you give a big basic income allowance or big tax allowance, but at the cost of putting up marginal tax rates for everyone to raise the extra revenue. This is not an easily saleable political proposition. So, it is important to bare in mind that piece of trade off.

We need not be despondent, because there are a lot of interesting things that we could do with taxes, which, if not popular, at least fulfil the Colbert criterion of causing the minimum amount of hissing. One of the important areas for us to look at is the taxation of rents. I mean by that economic rents. Economic rents are what is paid a person, or piece of capital, beyond what is actually necessary to persuade them to do the job in hand. If you are an opera singer with a world renowned reputation you would probably be prepared to get out of bed and perform at La Scale for two thousand pounds. But if your fee is one hundred and seventy five thousand pounds, then the economic rent involved is one hundred and seventy three thousand pounds.

If we could actually think of a way of taxing that economic rent, it would not distort the world at all. Everybody and everything would continue to do what they were doing. Therefore there have been two traditional proposals from economist for having taxes that don't distort peoples' decisions. One is to try and tax rent in one form or another and the other is to have a flat rate tax, like the poll tax, because then you try to go on and make up your income, without distorting your decisions. There are of course other very substantial problems with flat rate poll taxes as Mrs. Thatcher found out to her political cost. So lets glide over that particular proposal as part of the economic canon that should be left in the chapter entitled 'theory'.

The taxation of rents, however, is a real policy prospect that we should look at more. I don't see that it has been very easy to operate in the case of rock stars, footballers and opera singers, however much that might on occasion to be desirable. It seems to be quite hard enough, judging from some well-known Italian opera stars, to get them to pay tax in the first place. Let alone to get them to pay a special sur-tax on the grounds of their economic rent. But, I do think that this principle bears re-examination by the party in the context of land rents.

I was always very struck by two particular modern phenomena, one is that we have a real problem in so many of our inner cities with the amount of vacant land. It is a genuinely an oddity that so much of that land stays vacant and undeveloped for so long. It is partly because there is no cost to the owner for holding on to it. The other thing that I noticed from visits to Hong Kong was how they managed to pull off this trick of having very low tax rates, but having rather more public services than you would expect considering the low rates. The answer was, as I discovered, that there is only one part of Hong Kong that is actually a freehold property, and that is the Anglican Cathedral on the Island. Every other part of Hong Kong was owned on a leasehold, in the old days from the crown, but today from the Special Administrative Region.

What happens as those leases come up and are resold at auction providing the Hong Kong government with anything between 25 and 30% of its total tax revenue? What it actually means is that if the government builds a new tube line or improves public services in some way that augments the value of property, the next time that lease is sold, it recaptures the value that it has put into the community in the form of a yield for the government. This provides a sensible economic basis of tax (because it is a tax on rents that do not distort decisions) and it means that the Government has an incentive to improve public services.

However, I do not believe that this is the future of property owning in this country. We cannot magically turn freeholds into leaseholds, so our starting conditions are very different to those in Hong Kong. The main difficulty is that we cannot turn a stock of wealth into an annual flow of income. Often non-economists fail to distinguish between what is your income each year and what is the stock of wealth. Someone may come along and suggests a tax on land values and fail to recognise that you can't afford to pay that land tax out of your income. Then the only way you can afford to pay the tax is by selling the land, a somewhat unfortunate position to be in. But if one can actually do this very gradually, and introduce some land value taxes as an experiment, perhaps on the increases in the value of land, then I think we could begin over time to gain the benefits of land value taxes.

The effects in old inner city areas where there is a vacancy problem and a lack of development is particularly great. We would see enormous benefit accruing to those communities as developers had an increased incentive to use less developed land. If they did so, they would not pay any increase in tax. But if they did not do so, they would continue to pay the same tax. So we would introduce an incentive to development that is not there at present, and which could help to improve organically and naturally the dynamism of inner city communities. But we must be very careful not to overstate the case for land value taxes. We should certainly not go down the route of the single taxes, attempting to raise all revenue from land values. But I do think that we need to dust off and look again at that good old liberal theme of land value taxation.

I am a little more sceptical about the whole issue of hypothecation of taxes. Clearly, there are advantages of linking tax with popular spending but the traditional Treasury argument then has always been 'well what about what's left'. What about the Cinderella items of public spending? You may find that people say that they don't want to pay for any defence spending as they have political or religious beliefs against it. Or they don't wish to contribute to education as they have no children, or do not wish to pay for health care as they have private insurance. The hypothecation argument is one that, if carried to an extreme, could undermine a sense of social solidarity.

These are not necessarily decisive objections, but I think that we have to be very careful. There are also practical problems. If, say, we convert National Insurance contributions into a health tax and clearly hypothecate that revenue to the National Health Service, what happens when we go into a serious recession? Health demands do not go up and down with the health of the economy. Who is going to be doing the topping up? Because we certainly can't have the NHS level of spending bobbing around according to whether the economy is booming or busting at the time. So there are serious problems, This does not rule out hypothecation entirely. It is one of the issues which clearly the Federal Policy Committee have asked the public services working group that I chair to look at, but I can see problems there both of a political/philosophical nature and also of a practical nature.

There is another area where it is interesting to see if we can explore new ways of doing things, In some ways, if we were to have a national health tax, you might regard that rather as compulsory social insurance as on the Continent (in France and Germany). Effectively compulsory social insurance is a tax, it does not go through the government, it goes through health organisations, but it is compulsory. But people don't apparently seem to resent it quite as much as the taxes, which are paid through their pay packet via PAYE.

A clear example of that is Chile. In Chile the government introduced a rather interesting reform. It said we need to have a pension scheme that ensures that we don't have pensioner poverty. We don't want to do this through the public sector, for many reasons, not least of which was that public sector tended to suffer periodic crises and then default on its obligations, making Chilean pensioners less willing to believe that they were going to get a public sector pension. So the Chileans proposed a compulsory pension contribution, but it stayed as your money, going into a privately managed pension fund that was regulated to prevent the costs from going to high. You continued to have control over the money, within the constraints of these schemes. You would pay in the compulsory contribution over time. After a period of years you might decide that you were fed up with the people who were managing your contribution, you could move to another organisation. You could follow the value of the scheme in the Chilean newspapers from day to day. One thing that the scheme has clearly done it to create a belief amongst Chileans that this is their money, even though it is compulsory contribution. This seems to me that is a rather good, liberal way of doing things, which avoids excessively statist solutions, and for good reasons in the case of Chile and a number of other countries.

As we are finding out on the Continent. You don't hear about it much in the British newspapers but most continental governments are in the process of airing down their public sector pension commitments very substantially. Understandably they don't shout this from the top of rooftops, so it does not feed back to the Euro-sceptics, but it has been going on. Private pensions that can be enforced through contracts are more reliable than public pensions that may be cut or ended.

Another area where we need to look afresh is the issue of charges and of regulation. Road user charges in inner city areas are a sensible response to congestion, which benefits no-one. Having spent too much of my life recently sitting in traffic jams on the M25, there does seem to be an increasingly strong argument in favour of tolls on motorways. The old argument was that you didn't want to have tolls on the grounds that you wanted as many people to use the roads as possible and they were never congested. I find it very hard to find any stretch of motorway that is not congested these days, and so that argument has collapsed. So we should be looking at putting tolls on motorways, and perhaps even at privatising motorways and getting them out of the public sector entirely. We need to look at alternative flows of revenue, sometimes connected with the service. There is room for us to be more imaginative.

If, though, I have to highlight one particular message, it would be the need to reconnect. We have to persuade people that they are getting value for money when they are paying taxes. I can see no better way than to embark in this country on a pretty major program of devolution: a revival of local democracy; revival of local decision-making; revival of local freedoms. We have to be very clear as a party that means that we are not going to have national standards all the way across the country. Devolution must mean responsibility and diversity. There will be people in some parts of the country that are making decisions which are different to those being made in other parts of the country. Some areas might have better education or health, but those services will be tailored for what people want locally. By definition, that is the way, to my mind, that you establish a consensus behind relatively high levels of service, expenditure and tax.

Chris Huhne MEP is chair of the party's public services commission and economic spokesman of the European Liberal Democratic and Reformist group in the European Parliament.