Andreas Whittam Smith: Making the rich pay the tax they owe is one way to achieve fairness

The millionaire, who when his fortune is made, moves to the Isle of Man, is a tax dodger

(James Benn)

What are people angry about? The deepening recession? Yes. The high level of youth unemployment? Yes. The excesses of the bankers? Yes. But more than anything, I believe, people are rattled by the widening gap between the "haves" and the "have-nots". The banners at demonstrations that proclaim, "We are the 99 per cent" speak eloquently to that. "We are getting nothing, while the other 1 per cent is getting everything." Many people think so.

So we need explanations why inequality began to grow again some 25 years ago after a long period of decline. And we need policy responses. I wish that governments, for instance, in dealing with the poor economic outlook, as the Chancellor of the Exchequer, Mr Osborne, will do in his Autumn Statement next Tuesday, would ask themselves an additional question: are our proposals likely to widen or to compress inequality? Raising the rate of VAT, for instance, exacerbates inequality because the additional tax burden weighs more heavily on the poor than on the rich.

There are two ways of recounting what has happened over the past 150 years. In 1955, Simon Kuznets, a Russian-American economist, produced an explanation that held the field for a long time. He argued that as industry began to supplant agriculture as the main source of employment, inequality started to rise. But then, as industrial revolutions gathered pace, said Mr Kuznets, governments intervened and began to play a redistributive role. They provided a range of services that were free at the point of use, chief among them education. And income tax rates on the rich were sharply raised. As a result, inequality started a long period of decline, which lasted for a substantial part of the 20th century.

The second explanation focuses on changing technology and employment. When the railway was invented, for instance, with the result that a large part of the system of transport by horse would be put out of business, the manufacture of locomotives turned out to require huge engineering plants in places like Derby and Swindon that employed many thousands. And that was quite apart from the enormous staffs needed to run the railways themselves. Huge fortunes were made, but many jobs were created. Lawrence Summers, the former White House economist, recently gave a good example. He noted that when George Eastman revolutionised photography, he did very well, and, because he needed a large number of Americans to carry out his vision, the city of Rochester was a thriving community for two generations.

The sudden resurgence in inequality 25 years ago seems to have coincided with the moment when the process of innovation, redundancy, retraining, moving to where the new jobs were being created, stopped working well. For the nature of innovation had changed. We were moving from an industrial economy to a knowledge economy.

The first point about digital technology is that, like the development of steam power and electricity before it, it changes everything. Digital technology is used in a very wide range of functions, unlike Mr Eastman's inventions, for example, which, marvellous as they were, focused solely on photography. It takes longer for employment patterns to adjust to sweeping changes.

Moreover, advances in digital technology come with breathtaking speed, each breakthrough pressing on the heels of its predecessor. As two economists at the Massachusetts Institute of Technology, Erik Brynjolfsson and Andrew McAfee, comment in their new book Race against the Machine, "in the 21st century, technological change is both faster and more pervasive. While the steam engine, electric motor, and internal combustion engine were each impressive technologies, they were not subject to an ongoing level of continuous improvement anywhere near the pace seen in digital technologies. Already, computers are thousands of times more powerful than they were 30 years ago, and all evidence suggests that this pace will continue for at least another decade, and probably more."

Labour markets simply cannot keep up with this. For the specialised skills of only a relatively small number of workers are required for the development of each innovation and, thanks to globalisation, the actual manufacturing processes can be done overseas where wage rates are lower.

In practice, then, the monetary rewards from the advances that are taking us into the new knowledge economy are narrowly shared. The "superstars" in the field make fortunes. Shareholders do well. So do investment managers who are quick to identify the next big thing. In effect, innovation has become a closed circle. Not many hands are needed even though the rewards can be enormous. This is a large part of the explanation for rising inequality, but it is not complete.

To see what is missing, we must turn to the work of the French economist Thomas Piketty. He makes the obviously common sense assertion that changes in personal taxation have a big influence on the gap between the haves and the have-nots. He began by studying the evolution of high incomes in France for the whole of the 20th century. He found the same reduction in inequality, particularly in the years after the Second World War, as noted by other analysts. But in Mr Piketty's view, this was entirely accounted for by the imposition of high rates of tax on the rich. And the sudden rise in inequality since the 1980s is likewise explained by reductions in the tax burden on high income and on large fortunes.

There is, however, an important distinction to be drawn between the two explanations even if, as I do, one accepts both of them as together explaining rising inequality. We can do very little about digital innovation except to encourage the creation of new businesses that can benefit. But governments can make changes in personal taxation. They can deal with the hidden truth about taxes on the very rich: that they are easily avoided.

The millionaire who, when his fortune is made, goes to live in the Isle of Man, is a tax dodger. The rich man who purchases a farm for its tax advantages, even though he has zero knowledge of and interest in agriculture, is a tax dodger. The employees of investment banks who benefited from trusts that gave them non-repayable loans so that they could avoid paying National Insurance (schemes that were subsequently closed down by HM Revenue & Customs) were tax dodgers. Making the rich pay all their taxes would be a good place to start in the enormous task of reducing inequality.

a.whittamsmith@independent.co.uk