David Alexander: Increasing the tax on insurance would be a tax on prudent behaviour and send the wrong signal to responsible people

David Alexander was a senior adviser to John Howard's government in Australia and is a former economics editor of the Canberra Times who is now resident in the United Kingdom.

A little snippet of news in The Times £ a week ago should set alarm bells ringing – a suggestion that taxes on general insurance are set to double or more in the next Budget.

Hopefully this will turn out to be ill-informed speculation, because it would be a very inferior method of helping to address the budget deficit.

Economists are often pretty divided about most things but it is considered a no-brainer that insurance taxes are one of the most inefficient taxes in the revenue-raising spectrum. Taxes on insurance are taxes on prudent behaviour. They are a penalty on responsible people taking precautions against possible future adversity.

It would be hard to think of another revenue source that more proportionally impacted on responsible and prudent small “c” conservative people and businesses. Shifting the tax burden onto responsible behaviour sends all the wrong signals to the population and undermines the critical role that readily available insurance plays in risk management in the economy.

David Alexander was a senior adviser to John Howard's government in Australia and is a former economics editor of the Canberra Times who is now resident in the United Kingdom.

One of the worst effects of insurance taxes is that they lead to non-insurance or under-insurance. The higher costs will simply see many people give up insurance altogether or under-insuring as premiums rise beyond their reach.

What happens when people stop insuring?

Many that face unfortunate disasters will have insufficient resources to pull through and end up relying on the state or charity for assistance. The higher state spending that flows from under-insurance comes from, yes, higher taxes.

The people and businesses that show responsibility and prudence by purchasing insurance will be in effect double-taxed – first through the extra tax on premiums to pay for the deficit, and secondly through higher taxes to pay for increased welfare spending for the imprudent and those that can’t afford insurance.

The second thing that happens when insurance becomes too expensive is that economic activity tends to wind down.

Purchasing insurance is essential for consumers and businesses in allaying their financial concerns about catastrophic low probability events, providing them with a peace of mind that allows them to go about conducting their affairs. Restricting the availability of insurance will lead to lower levels of confidence amongst consumers and businesses which will translate into a diminution of activity.

Of course the government will raise extra revenue if such a measure is introduced, as many people will reluctantly pay the extra tax. But for those that do fork out the extra money, that is money that will likely be drawn away from its previous destination on the high street or investing in business activity.

An increase in insurance tax will also have a second-round impact on those insuring: as the pool of those taking out insurance shrinks due to the higher tax, the premiums of those remaining will of necessity rise to cover the same level of risk-reduction.

Britain has an alarming deficit problem that needs to be addressed urgently, that is not in question, but the budget deficit is an overspending issue, not an under-taxing problem. It is perfectly reasonable to reform taxes to produce a more efficient tax system, and this will often require higher taxes in particular areas, but increasing taxes on insurance would be an inferior solution to the problem.

A major tax review conducted recently by the Secretary of the Treasury in Australia recommended the abolition of all insurance taxes for their pernicious economic and social effects.

It would seem highly unwise for the British government to move in the opposite direction, even with a budget deficit to address.