Economics: Time to be direct about higher tax

BARRING the unforeseen, it is now odds on that the Chancellor will raise taxes on 30 November. Providing there is an offsetting cut in interest rates around the time of the Budget, the recovery is unlikely to stall. But the success of that strategy - fiscal tightening combined with monetary easing - depends on the type of taxes Kenneth Clarke puts up.

The big decision is between taxes on spending or taxes on income. There are several good reasons why the Chancellor should not raise taxes on spending (beyond the normal uprating of excises to take account of inflation). The first objection is that such 'indirect' taxes are regressive: they hit the poor because spending is a higher proportion of the income of the poor than of the rich.

This point would have less force if the Chancellor were to raise the rate of VAT, because so many basic commodities (such as food and clothing, although no longer fuel) do not carry VAT. But almost any base-broadening exercise that extends VAT to new areas is likely to be regressive. This certainly applies to any acceleration of the two-step imposition of VAT on fuel and power, which is to have an 8 per cent rate in April and go to the standard 17.5 per cent in April 1995. It also applies to food, clothing and transport, since the poorest third of households have no car.

The well-off have prospered mightily since 1979, so there should be a natural presumption against increases in the tax burden which let them off lightly. They have gained from the widening in the gap between skilled and unskilled incomes, and from the long period of high real interest rates and booming stock market returns. These market phenomena have been reinforced by the cut in top income tax rates to 40 per cent.

By contrast, the bottom fifth of the population have enjoyed negligible or negative real increases in income, a factor that is surely contributing to the strains that are increasingly apparent in British society. There is also a sound economic argument for suggesting that an extra pounds 1 is more valuable to someone who is poor than to a millionaire. The law of diminishing returns applies to money.

Nor is the famous 'incentives' argument - that a switch from direct to indirect taxes would help motivate people - entirely persuasive. I am glad to see the Institute for Fiscal Studies now taking the Economist to task on this point, which I first saw argued by that doughty free marketeer Enoch Powell. Mr Powell rightly pointed out that people work for the goods and services that they can buy with their money, not for some idealised and nebulous concept of the money itself. Therefore switching tax from income to spending may have less effect on incentives than supposed.

The properly calculated tax rate on extra income for standard rate taxpayers is made up as follows: out of the extra pounds 1, they will pay 25p in income tax and a further 9p in employees' National Insurance Contributions (10p after April). They will be left with 66p to spend. The standard rate of VAT on that spending (assuming that there is no spending on goods subject to excises) is 17.5 per cent, which takes 9.8p out of 66p. So the rate of tax on the extra pound - the marginal rate - is 43.8p.

In short, the switch in 1979 that cut the income tax rate from 33p to 30p in the pound by raising the VAT rate from 8 to 15 per cent was a trick of the light. The switch in fact raised the marginal rate of tax from 44 per cent to 44.8 per cent. This point completely cuts across the separate argument about whether people work harder if you reduce their marginal tax rate, a debate which will keep economists busy for a long time yet. (Do the work-inducing effects of a cut in the marginal rate outweigh the soporific effects of gaining more post-tax income without any additional work?) This question does not arise, because the marginal rate has not fallen.

It is possible, of course, to increase taxes without affecting most people's incentives by broadening the base of the tax rather than increasing tax rates, but this point applies to either direct or indirect taxes.

The base of income tax can be broadened by reducing reliefs just as easily as VAT can be extended. And it is possible to reduce income tax reliefs without making the poor pay a disproportionate amount. However, it is impossible to widen the VAT base in any substantial way without hurting the poor.

True, the best taxes from the point of view of maximising incentives are lump sum taxes, whereby everyone pays exactly the same amount regardless of their income and there is then a zero tax rate on extra earnings. This is a well- known finding of tax economics. But Lady Thatcher's experience with the poll tax, which was a lump sum tax, suggests that this point is best left in the theory textbooks. Economics is not just about some abstract concept of efficiency. It must also be about equity.

Another reason for avoiding a rise in indirect taxes is that it would stoke up the measured rate of inflation. I say the measured rate, because in theory a rise in indirect taxes gives only a once-off boost to the price level. After a year, it should drop out of the inflation rate (which is the annual comparison between this month's price level and the price level a year ago). The inflation rate will then subside to its former pace. But that complacent view does not take account of human nature.

As the Bank of England points out in last week's quarterly bulletin, there is a danger that wage bargainers will react to a rise in the headline inflation rate by settling for 'excessively high nominal wages, followed by increases in producer prices unwarranted by the stance of monetary policy'. Translated from central bankspeak, a blip in the retail price index could push up wage claims and prices. This would either ratchet up inflation or cause a jobs shake- out.

The Bank was referring to the rise in the headline rate that is already in prospect in the first half of next year, as the cuts in mortgage interest rates earlier this year drop out of the annual comparison. But the Bank's point applies with equal force to new rises in indirect taxes.

History is on its side. The 1979- 81 recession was made far more severe as a result of the near- doubling of VAT in 1979 and a speed-up in wage claims. Even a modest extension of VAT to newspapers and books would add 0.3 per cent to the inflation rate when the Bank believes that there is a significant possibility of the underlying inflation rate (excluding mortgage rate) exceeding the Government's ceiling of 4 per cent.

By contrast, cuts in income tax reliefs have no effect on the measured inflation rate. It is possible, of course, that wage bargainers will nevertheless notice the erosion in their real post-tax incomes, and will try to compensate by pushing up pay claims. But the evidence for this effect is disputed. If taxes do have to go up, it is better to opt for a method that may not boost inflation rather than one that certainly has boosted inflation in the past.

The Chancellor could, for example, abolish mortgage tax relief, raising about pounds 4bn of revenue next year. For a basic rate taxpayer, the maximum value of the relief next year is pounds 480 a year, and this loss would be more than halved by a 1 percentage point reduction in mortgage rates. Despite the grogginess of house prices, there will never be a better time to get rid of this misdirected subsidy.

There are, though, any number of other options. The most equitable involve making the value of personal allowances or reliefs worth the same to each taxpayer, whether they pay income tax at 20, 25 or 40 per cent. The personal allowance of pounds 3,515 is worth pounds 1,406 to a 40 per cent taxpayer but only half the amount to a 20 per cent taxpayer. It could be turned into a tax credit - an amount deducted from each tax bill - worth the lower amount for each taxpayer.

The Chancellor could also limit the relief available on occupational pension contributions to the basic rate. The IFS argues that if individuals choose to defer income by making pension contributions, then it is reasonable to tax them only when the income is received as pension. But the effect for the 1.6 million top rate payers may be to postpone income to a period when they enjoy a lower tax rate. There is a case for restricting the relief to the basic rate.