SOUND TAX POLICIES

The government of a totalitarian state doesn't have to worry about a

tax system because the nation's entire output is already in its hands

This is a mirror image of what happens in a democracy, where

government decides how much to take from its citizens; under a

totalitarian regime, by contrast, the state decides how much to give

them to enable them to live and, hopefully, keep them content

However, every state, whatever its political colour, should subject

itself to the discipline of keeping its spending plans within the limit of

its resources. If it spends more than it has raised in taxes, and what it

has in reserves, it must borrow the shortfall (assuming it can find a

lender) or resort to the monetary printing press.

Even that is not a viable solution because fake money loses its

purchasing power and, ultimately, becomes worthless. Current news

from Venezuela is that street beggars don't even bother to pick up

money that lies like litter in the streets, no matter how many zeroes

are denominated

Readers will know from my previous essay that most existing

methods of raising taxes are indiscriminate, politically

interventionist, and grossly inefficient. It's a huge compliment to this

country's productive capacity that it is able to survive the destructive

effects of its tax-raising regime.

Is there a better way?

Adam Smith's canons of tax policy have stood the test of time. They

tell us that a tax charge must fall within the capacity of the taxpayer

to bear it; its amount must be certain and not arbitrary; its cost of

collection should be the minimum required and involve no waste;

and its yield should be sufficient to meet the needs for which it was

levied - again, no waste.

We must also remember that low rates of tax will generally yield

more revenue than high rates. The so-called "Laffer Curve" is based

on the observation that tax rates of both 0% and 100% will yield zero

revenue. The skill of a judicious Chancellor is to identify the rate that

produces the greatest yield

Last week's essay demonstrated that "income tax" , levied through the

pay-as-you-earn system, is a corporate liability, effectively a payroll

tax or, unvarnished, a tax that penalizes businesses for employing

a

people

Almost 250 years ago Adam Smith illustrated the madness of such a

tax with the example of an employee earning £100. If the state

imposes a tax of 20%, the employee's pay must rise by 25% in order

to reinstate the employee's real income. The additional cost is borne

by the employer: the "gross pay" must now be £125 so that the

deduction of 20% tax leaves disposable earnings of £100. Indeed,

national statistics always show that, whatever the tax rate, the ratio

between real (net) pay and GDP tends toward a constant percentage.

It's the business that bears the tax!

The idea that the employer is a mere tax collector on behalf of

government is therefore sheer nonsense. The reality - that payroll

taxes are borne by the employer - takes no account of the fact that

marginal businesses have limited taxable capacity. As an example,

some years ago British Steel reported trading losses of £1 million per

day, an amount that was exactly balanced by the tax "deducted" from

its employees' "gross" earnings and paid to the revenue authorities.

British Steel, as an enterprise, clearly had no taxable capacity at that

point in time. Although its accounting losses shielded it from having

to pay corporation tax, it suffered a vast tax penalty for the sin of

being a major employer!

Several businesses I know took the brave step of paying employees

their full gross pay without deduction, and the result in each case was

a highly motivated workforce and a leap in productivity that

exceeded the additional tax. [I actually visited Nicholas Ridley at the

Treasury and persuaded him to provide them with "grossing up" tables

to help them work out the tax! Interested readers can find two of such

examples on my website.]

But wait for it! The most ludicrous charade of all is enacted whenever

the earnings of those paid out of taxes are "taxed". Applying the PAYE

rigmarole to the earnings of civil servants, council employees, NHS

employees, Inland Revenue staff, and the thousands of other central

and local government employees, all paid out oftaxes, takes on an

especially farcical twist!

Almost anything would be better than what we have now. What the

Treasury is able to raise in direct taxation is clearly insufficient, so it

taxes everything else, seen and unseen - property transactions, cars,

fuel, energy, insurance premiums, travel, everything you buy,

professional services, marriage, death, you name it - they are all

taxed, one way or another!

But to avoid the traps into which our tax regime has descended, it is

essential that we, as humans, exercise our powers of reason!

Next week I shall post my recommendations.

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ECONOMIC PERSPECTIVES -38

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Foreign Aid – setting the record straight