In Part 1 we introduced the 16 considerations controlling taxation, and detailed the first 5 of them. Now, in Part 2 we move on with the next 5.

6. Taxation in a command economy

In an unashamed command economy such as that of the Soviet Union, the line between taxation and income is seemingly notional, because what each person officially earns is determined by the state. However, tax in its broad sense is there in the amount which the state takes from the individual in terms of labour and product. Simply put, the individual works and the state takes whatever it chooses to take and leaves the individual with what it chooses to leave.

Unsurprisingly, true command economies have only existed where democratic forms are absent.  But, very healthy black markets have always existed in such economies. The old Russian joke during the latter years of the Soviet Union – “We pretend to work and they pretend to pay us” – was not that far from the truth.

7. Taxation in a market economy

This is a somewhat problematical concept because all advanced market economies have elements of the command economy within them, not least because of necessity to have large bureaucracies and because in practice no government can resist the pressure or temptation to interfere with the market, like passing safety regulations and anti-monopoly laws. However, most modern democratic states are spoken of as being market economies, although it is important to understand that market economy does not equal free trade economy – a domestic market may be subject to either free international trade or protected from it.

Taxation in a market economy has two masters – ideology and practicality. Ideology divides between the simple need to finance government and the desire to use taxation as a means of social and economic engineering.

The practical principles of tax collecting in a market economy are three. Is a tax easy to collect? Is it cheap to collect? Does it produce sufficient money?

An example of a practical tax is the domestic rate on property, as demonstrated by the unpopularity of Margaret Thatcher’s Poll Tax, which had to be scrapped. The Poll Tax is a dire warning to politicians of any colour. It tells them two things: do not introduce a tax without understanding the administrative details and never allow ideology to override practicality. However, politicians being politicians, they rarely if ever learn this lesson.

8. Social and economic engineering

Taxing for the purposes of social or economic engineering rarely if ever works. If you try to tax the rich severely (or for the very rich, at all) because you disapprove of wide differences in wealth, they will simply put their money out of reach of the government of where they are resident. Put up the tax on tobacco and alcohol to reduce their consumption to “improve” the nation’s health and you tax the poor disproportionately because demand for these products is inelastic. Increase tax on petrol because you wish to restrain the use of private cars and you increase the costs of commercial transport and make your commerce and industry uncompetitive. The law of unintended consequences operates ferociously in the world of taxation.

Economic engineering through taxation has an equally woeful record. My favourite failed attempt in this category is the Selective Employment Tax introduced by the first Wilson government in the 1960s. This tax was designed to encourage employment in manufacturing at the expense of service industries. The service industries paid a levy on each of their employees which manufacturers did not pay. The result was to depress employment in the service sector without increasing it in the manufacturing sector.

There was an excellent and entirely foreseeable reason for this: it did not change the general economic circumstances of manufacturers. Their costs were not reduced. They still had to compete with foreign competition on the same basis as before. All that happened was that service sector employers had an additional cost. They not unnaturally cut jobs and did not create new ones. The tax was quietly dropped after a few years.

9. Fairness in taxation

It is difficult to say exactly what fairness in taxation is. Is it everyone paying the same or people paying according to their ability to pay? Should the manner in which people make their money be taken into account? Is inherited wealth more worthy of taxation than earned wealth? There are no certain answers to such questions, although most in Britain would probably choose “ability to pay” if asked where justice lay.

In fact, taxation in a modern Western state is always a balance between what seems fair and what can achieved. In Britain we have ostensibly ability-to-pay taxes such as income tax and ostensibly pay-the-same taxes such as VAT. In fact the dividing line is nothing like so clear because of both the inherent qualities of taxes and their practical operation.

British indirect taxes with one exception (the TV licence Poll Tax) are all related directly or indirectly to either wealth or income. A rich man pays more than a poor man in VAT and excise duty because he spends more. Those items deemed necessities such as food are either taxed more lightly than non-necessities or not at all, which benefits the poor most because they spend proportionately more of their income on necessities than the rich.

Nonetheless, most British people would say that direct taxes such as Death Duties, national insurance (NI) and income tax are in principle fairer than indirect taxes. In practice this is dubious.

Death duties in theory apply to all, but in practice can be avoided by the rich either through the use of trusts or the movement of their assets off-shore..

NI has elements of a poll tax. For most people it is comprised of two elements, the employers’ and the employees’ contribution – the self-employed just pay a single contribution. The employers’ contribution applies these days to the entire pay, but the employees’ contribution until 2002 was capped at a relatively low level, somewhere around the full-time average wage. Those earning more than the ceiling did not pay the employees’ contribution on their earnings above the ceiling. Thus, the richer you were the more beneficial the NI rules.

Income tax may seem to be the fairest tax yet in fact it is anything but. Generally, it is only honestly paid by those under the Pay-as-You-Earn scheme (PAYE). Even if they deign to make a tax return, the self-employed can, at worst, reduce their liability very substantially or make it vanish altogether by setting cost against their gross income.

Because income tax is only paid in full by those under PAYE, it is far from being a means of redistributing wealth according to income. Rather, it is simply a means of shearing the least mobile taxable sheep. If it could be enforced, a wealth tax would be a much more equitable means of taxation than income tax.

10. Which taxes raise the money?

It is all very well saying that this or that tax is unfair and should not be levied. In the end the first concern of a government must be to raise funds to meet its standing obligations and pay for any new policies it wishes to introduce. Governments however radical they are when they come to power, soon find that they have to worry about bringing in the money before making any attempt at social or economic engineering.

Which taxes bring in the money? In the UK, the proportion of total tax revenue raised from the most productive taxes are :

Income Tax 28.7%

National Insurance 17.9%

VAT 15.1%

No other tax exceeds 10% of the total and only one exceeds 5% (Corporation Tax at 8.2.%).

Institute for Fiscal Studies Table 1. Sources of government revenue, 2008–09 forecasts

Income tax, national insurance and VAT made up 61.7 % of the total tax revenues of the UK. In 2008/9. Consequently, anyone feeling that the taxes are unfair or retrogressive has a real problem even if they only wish to substantially reduce the taxes in those categories, virtually impossible to do in a country which provides a comprehensive welfare state.

Part 3

In Part 3 we start by imagining that a government decided to abolish income tax…

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