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Dr Madsen Pirie: Tax simplification should follow simple rules

Madsen Pirie Dr Madsen Pirie is the President of the Adam Smith Institute.

The UK tax code could certainly use simplification.  Since Labour won power in 1997 the code has doubled to over 11,000 pages just for the legislation.  The move to set up an Office for Tax Simplification is commendable, and the Adam Smith Institute will certainly be submitting evidence to it.

Tax simplification is best achieved by following rules. Adam Smith himself set out four canons which he thought taxation should follow.  Firstly, for any tax, the collection costs must be low compared to its yield.  Secondly, the amount to be paid must be known and certain, and not depend on the discretion of tax officers. 

Thirdly, the timing of payment should be convenient to the payers, preferably when they have received some money.  Smith's fourth canon was that taxes should be levied according to ability to pay.  They should be paid by those who can afford to do so.

There is a fifth one that can be added to Smith's list.  No tax should damage or limit the economy out of all proportion to any revenue it raises.  The point is that nearly all taxation changes behaviour and distorts the economy.  Taxes on goods make them more expensive.  Taxes on wages mean people have less to spend.  Nearly all of them result in less economic activity than would have happened in their absence. 

The trick is to have taxes sufficiently light in their impact that the economy continues to grow and generate wealth.  In practice this is probably best achieved by low tax rates that apply uniformly.  This means a relatively light burden spread evenly without sending people off onto tax-avoidance behaviour.  The problem is that politicians have preferred lots of exemptions and allowances, winning them favour with special interest groups, but committing them to higher rates to raise the same revenue.

It is those exemptions and allowances, legitimized by Parliament, that make the tax code complicated.  Trying to encourage what it regards as worthwhile activity, the Treasury has made concessions to firms that invest in expansion, that allocate funds to research and development, or that spend their profits in other ways considered to be worthwhile.

To simplify out of the maze that has resulted requires a different mindset.  Instead of giving people bolt-holes out of onerous tax rates, it needs them to think in terms of low rates with hardly any exemptions.  The aim should be to make rates sufficiently low that people will not need the exemptions and allowances.

Whether the low rates will raise sufficient revenue is the big question.  The dynamic modellers say yes, because economic growth will broaden the tax base, but more cautious Treasury analysts have equated lower rates with lower revenues.

Several countries, notably in Eastern Europe, have followed the dynamic route successfully, with lower rates and simplicity yielding more revenue than high rates with exemptions.  The ultimate simpler tax system is of a flat tax, long advocated by the Adam Smith Institute.  Our idea of simplicity is no income tax at all below £12,500, and 20 percent on everything above that.

Of course the special interests will squeal if their privileges are threatened, but if the result is a cleaner, simpler tax regime which imposes lower rates, everyone will benefit from the economic growth that results.


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