Economics: Think small and spare the taxpayer

This article could have been headlined 'Ashdown acclaims hypothecation', but do not be put off. The subject matter is not as dull as it sounds. It addresses one of the big issues of the 1990s, which is the legitimacy of taxation and of the state itself.

The Liberal Democrat leader's speech last week picked up various themes from the thought-provoking first publication of Demos*, the think-tank that faces in all directions, rather like the nuclear missile strategy of the French Communist party.

The main diagnosis of the authors, Geoff Mulgan and Robin Murray, is surely correct. It is that the developed countries face a crisis of rising expectations about what the state can deliver, combined with a declining willingness to pay. This latent tax revolt is compounded in Britain by the lack of sophistication of our political system.

As Demos says: 'The argument remains locked between parties favouring low taxes for low spending, and those favouring high taxes for high spending. The former have proved incapable of cutting taxes while the latter have proved incapable of winning elections.' Despite Margaret Thatcher's best efforts, Britain taxes a higher share of national income today than in 1980.

The authors identify part of the problem as increasing globalisation, which means that the footloose rich and mobile corporations can avoid national taxation, shrinking the tax base and imposing a greater burden on those that remain. Multinationals, for example, can surreptitiously transfer profits to lower tax areas: one subsidiary can charge artificially high prices for goods supplied to a higher-taxed subsidiary.

The authors have two interesting suggestions. The first is that governments in developed countries should tackle the tax-minimising tendencies of their international corporations by adopting a form of unitary taxation on worldwide corporate income, and then jointly agreeing on how to apportion the revenue. In effect, there would be a world - or at least European - corporation tax.

The second suggestion is that economic rents - that part of the money received by a person or by capital over the amount needed to attract them to whatever they are doing - should form a larger part of the tax base. The advantage of a tax on such rents - the high payments to rock stars or lucky land speculators - is that it does not affect behaviour. By contrast, other taxes discourage people from earning or spending.

This is a theme that goes back to the nineteenth century economist Henry George, who advocated a tax on land rents. He pointed out that the value of land often rises not because of the talents of a landowner but because of railways and roads, or simply because other people decide to build, too. Why should those gains not be captured by society as a whole?

The outstanding modern example of a society that raises revenue from land is Hong Kong. Because the colony owns so much land, it is able to levy low taxes on other things. As a result, it is a marvellous place to earn and save money.

A distinguished group of US economists recently urged a land tax on Boris Yeltsin, as the states of the former Soviet Union are one of the few areas of the world where vast amounts of revenue could be raised from land because of public ownership.

However, Mulgan and Murray suggest other ways of capturing economic rent. For example, there could be a progressive tax on the yield from patents. Instead of drug companies gaining all the revenue from a patent, however successful, they might give up a part.

A similar principle could apply to the taxation of the royalties of bestsellers or blockbuster films such as Jurassic Park. As knowledge and information-based activities grow, patents and copyrights could become a useful tax base.

Mulgan and Murray also put forward various ideas for reconnecting taxation - essentially, for increasing people's willingness to pay. The most attractive is decentralisation of decision-making. Local councils should take more responsibility for their taxes and services, but only if their decisions were more responsive to their electorates. Referenda are one possibility; directly elected mayors another. An electoral system that allowed voters to boot out more bad councils might also help.

Ironically, the worst idea in the Demos pamphlet is the one that has attracted most attention. Mulgan and Murray argue that taxes should be earmarked for particular purposes so that people could clearly see the connection between what they pay and what they get. For example, we might have a public transport agency funded by a fee, like the BBC. But the principle of hypothecation - the grand name for this linkage - is best left in the grave.

The Treasury's antagonism to hypothecation arises from the fear that it would be swamped with letters from people remitting 8 or 15 per cent less tax this year because they were conscientious objectors who disagreed with defence spending, or philistines who hated arts subsidies, or anybody else faced with an item of public expenditure that happened to excite their bile.

Given that stroppiness is one of our most cherished national characteristics, the result would not be a strengthening of the tax base but its collapse under the weight of angry letters signed 'Disgusted' of Royal Tunbridge Wells.

Hypothecation is also intellectually dubious, because it fails to recognise that money is fungible - money that is raised or borrowed for one purpose can easily be used for another. In the early 1980s, many people took out mortgages for 'home improvements' and promptly took winter holidays in Mauritius. Our bankers discovered the fungibility of money when Latin American governments borrowed money to support investment, and instead allowed their elites to buy apartment blocks in Miami.

Saying, as Paddy Ashdown did at the election, that he would add a penny to income tax to pay for schools, may be good presentation. But he might well have done so in any case, and would in fact have used the extra money to reduce the deficit. Money is slippery stuff.

In the long run, there is no substitute for trusting our politicians to spend our money wisely. Sometimes this will involve looking afresh at objectives, and sometimes at how we meet them. Defence falls into the first category. It still takes more of our national income than it does in any other Western European state, and it is still planned to do so even after all our cuts.

Why on earth are we pulling troops out of Germany less quickly than the Russians, who have now taken three quarters of their forces back? The real cost of Labour's dalliance with unilateralism is becoming apparent. Its reputation on defence is so tarnished that it fears making the case for deeper cuts.

But there is also far too little fundamental questioning about how we meet objectives. Mulgan and Murray are wrong to argue that targeting benefits on those who need them would undermine public support, any more than targeting bus or rural rail subsidies undermines public support. There are myriad examples of public spending that benefit minorities, but do not disappear.

It is a nonsense to run a system where the average taxpayer receives back at some point in life 62 per cent of all the tax payments he or she makes. Targeting is the only realistic way in which there will ever be a real attack on poverty, because universal benefits such as child benefit and the old age pension are too expensive a way of helping the poor.

There is also a debilitating lack of interest in good public sector management, yet efficiency is one key to public support.

If a majority of Americans believe that half their tax dollars are wasted, according to a poll cited by Mr Ashdown, no wonder there is a crisis of legitimacy. In Whitehall, there are far too many little units charged with management issues, and none that tackle the big questions.

Who is asking, for example, whether it really makes sense for central government to run four separate tax-raising agencies: the Inland Revenue, which employs 68,000 people; the Customs and Excise, which employs 26,000 people; the Contributions Agency, which employs 7,800 people; and the Driver and Vehicle Licensing Authority, which employs 5,000 people? The last serious shake-up in the revenue side of government was in 1909, when David Lloyd George merged Customs with Excise, until then independent departments.

The public sector needs to think the unthinkable, like the private sector. The truth is not so much that there is a crisis of the state or even of taxation but that there is a crisis of bigness. Both technology and the free spirits of educated people are militating against large, slow, cumbersome, unresponsive, hierarchical and bureaucratic organisations. Look at the problems of IBM and General Motors. The world is changing. The public sector must too.

*Reconnecting taxation, Demos, pounds 5.95.