Edward Leigh MP: A flat tax would revitalise the British economy

This essay from Edward Leigh MP appears in the new book published this week by ConservativeHome, entitled The Future of Conservatism. Find out more about the book.

The UK has a labyrinthine tax system. Much of the responsibility for this lies with the last Labour government, which burdened British citizens and businesses with over 5,000 pages of new tax rules and regulations. The result; our Tax Code has more than doubled in size since 1997, recently surpassing India’s to become the largest in the world.

This has allowed the growth of an entire industry to discover tax loopholes. The TUC claims tax avoidance costs the Treasury £13 billion per year in lost tax from individuals, and £12 billion per year in unpaid tax from businesses. This dwarfs the estimated £1 billion a year lost as a result of benefit fraud.

With the Coalition Government forced to make tough choices about public spending in order to reduce the deficit, we need to consider not just what the government spends money on, but also how the government raises taxes in the first place. If we really want a simpler tax system, we should implement a flat tax for both individuals and businesses.

This is how it would work. A flat tax policy involves setting a single rate of income and corporation tax, usually lower than most existing income tax rates. The exemption for those on lower incomes would stay. Logically this should reduce the government’s tax take, but in practice it increases it.

But how can lower tax rates lead to higher government revenue?

First, the flat tax would cut tax avoidance. Deductions, loopholes and allowances would be abolished, and with the lower rates businesses and wealthier individuals would find it cheaper to pay the tax than their financial advisers. Therefore more income would become taxable income.

If we implemented a flat tax rate of 22% with a £15,000 personal allowance, it would result in a one year reduction of tax revenue of £63 billion. However, the Taxpayers Alliance identified £81 billion in potential savings from closing loopholes and the elimination of deductions and allowances, an estimated £18bn increase in Treasury revenues.

Second, a low rate flat tax system would stimulate growth and productivity. Since businesses would no longer find themselves paying higher tax rates simply for becoming more profitable, there would be a real incentive to expand. This would generate wealth, create jobs, and boost economic growth. Already overburdened with regulation and red tape, the complexity of our tax system further discourages small businesses and potential entrepreneurs, who can find it intimidating, expensive and oppressive to manage.

Third, a flat tax would be cheaper to administer. With exemptions, deductions, and allowances abolished, the authorities would no longer need extensive and detailed financial information about individuals and businesses to calculate their tax liabilities, only their annual income. This would end the requirement for lengthy and complex tax returns and reduce the number of civil servants needed to make the system work. Back in 2008 the House of Commons Public Accounts Committee found that, every year, HMRC spends £55 million answering more than 12 million enquires from taxpayers dumbfounded by their tax forms. A flat tax system would go a long way to resolving this.

So what’s the catch?

Critics of the flat tax rate wrongly say it is unfair because the lowest paid in society would pay the same tax rate as the wealthiest. Gordon Brown refused to consider a flat tax for exactly this reason. But, as with so many fiscal issues, Brown had completely missed the point. A new flat tax system would include an exemption (similar to the personal allowance that exists now) to ensure those on lower incomes paid either very little tax or none at all.

Some critics also say the benefits of a flat tax system are more theoretical than real, but The Economist claimed in 2005 that the flat tax “seems to be working as well in practice as it does on the blackboard”.

In Europe alone nine countries have already introduced flat rates of personal income tax alongside similar rates of corporate tax. Slovakia is one of these countries. The simplicity of Slovakia’s tax system has, The Economist says, “helped to spur foreign investment and economic growth, actually leading to a slight increase in tax revenues.”

But the flat tax is not just for small, emerging markets. The hyper capitalist state of Hong Kong has employed the flat tax for decades. There are growing calls for a flat tax system in the US too. Although the USA’s Federal income tax is currently a ‘progressive’ one, seven states, ranging from traditionally Democratic Massachusetts to staunchly Republican Utah, have adopted a flat State income tax.

Russia, the biggest country on the face of the planet, adopted the flat tax in 2001. The effect was instant and remarkable. Russian income tax revenues rose by a quarter in the first year after the flat tax rate was introduced, and by another quarter in the second year. The reason; the flat tax made it easier for the Russian government to administer tax, eliminated loopholes, and made it easier for citizens to comply with their tax obligations.

The government’s planned clampdown on tax avoidance hopes to raise £4 billion by 2015, while the Treasury estimates the spending cuts as a whole will amass to £6.2 billion.

The government is right to tackle tax avoidance, but it is a task that would be made far easier, and bring in more revenue, if Britain had a simpler, less avoidable and more easily administered flat tax system.

The Institute for Fiscal Studies estimates the average household will lose £750 this year as a result of higher taxes. What is more, our current, so-called ‘progressive’, income-based tax system is actually structurally biased against those on lower incomes, who do not have access, as some wealthy individuals do, to a team of accountants, financial advisers, asset managers and private client lawyers who can instruct them in the complex methods of tax avoidance and offshore tax evasion.

But if we went further and introduced a flat tax, around 10 million of the lowest paid current taxpayers would see their entire income tax bill disappear. This would help some of the lowest earners in society and provide strong incentives for those on welfare to try and find work. Labour created a flawed welfare system which left thousands of individuals and families with little incentive to get off benefits and go out to work. “The best long-term help and security for the poor,” the Adam Smith Institute suggests, “is for them to get well-paid jobs in a growing economy. Keeping millions on benefits only really helps those politicians who want to keep their voters dependent.”A flat tax system structured so that the lowest earners paid no tax at all would make work pay. That would be a truly progressive tax system.

A country’s tax system has a huge impact on its citizens, businesses and economic prospects. Britain needs an efficient, modern tax system and competitive tax rates that maximise our potential as our economy recovers from the worst recession in 60 years.

The Government is rightly focused on tackling the enormous deficit left to it by the previous Labour administration. However, in doing so it should not ignore the opportunities presented by reform of the tax system. When addressing Britain’s economic problems, we in the Conservative Party should view tax reform not as a side issue but as part of the solution. The government should urgently consider introducing a flat rate of taxation to stimulate foreign direct investment, increase domestic productivity, raise the Treasury’s tax revenues, and allow businesses to expand, create jobs and provide the economic growth that is central to Britain’s economic recovery.