How can taxes make a fairer and more efficient economy?
Tax systems can play a central role in creating fairer and more efficient economies. Economic growth increasingly depends on the quality of public goods that only governments can provide, such as education, healthcare, and childcare. Taxing high incomes too lightly will increase inequality, which can damage social and political cohesion and weaken economic growth, as acknowledged by the IMF.
Many economists agree as to what constitutes a fair and efficient tax system. They believe the tax base, the activities and entities on which taxes are levied, should be as broad as possible, with few ad hoc deductions and exemptions. It could be made more progressive, with taxes levied according to taxpayers’ ability to pay. Some propose that tax systems could penalise activities that do harm, such as pollution or financial speculation.
The UK’s top rates of income tax were cut sharply in the 1980s. The Conservative government believed that this would encourage the wealthy to work harder and save more. It was hoped this would boost investment and economic growth enough to offset the loss of tax revenue. Investment and growth actually weakened.
Cuts to top rates of income tax have reduced the gap between the tax rates levied on high and low incomes. This has boosted inequality and has no significant effect on economic growth or unemployment. Proposals for reform of income taxes tend to focus on raising tax rates on higher incomes to make the system more progressive. Reformers in the UK have proposed "smoothing" the uneven marginal rates which currently characterise the income tax schedule.
A person earning £40k a year from their job pays more tax than someone living off £40k a year in capital income from their accumulated or inherited wealth.
Tax rates on capital income have been cut by more than those on income from work, despite property and financial wealth rising more rapidly. UK tax rates levied on dividend payments and capital gains are now lower than the equivalent labour taxes.
The rationale governments give for taxing capital so lightly is that it encourages entrepreneurship and therefore improves economic performance. Research from the Institute for Fiscal Studies shows lower UK rates of capital gains tax have not boosted investment.
The proportion of total UK tax revenues raised from taxes on property, wealth and inheritance are low, with only property taxes raising significant sums.
Parents and property are the best predictors of life chances, but the best policy tools for correcting this – wealth and inheritance taxes – are highly unpopular, even with those who would not have to pay them.
Wealth inequality reduces economic dynamism. Households with no wealth or savings lack the security to take new risks, such as entering education or starting a business.
Higher taxes on capital income, property and inheritance, or net wealth could help to tackle wealth inequality. Property taxes could focus on ownership rather than residency, as is the case with the UK’s Council Tax. Unpopular inheritance taxes might be replaced by taxes on lifetime wealth transfers or recurrent taxes on net wealth.
The UK has the lowest rate of corporate taxation in the G7 group of wealthy countries, at just 19%. Despite this, business investment in Britain is easily the lowest in these economies.
Tax rates are not the key factor in determining the profitability and the attractiveness of investments; more important factors are the availability of skilled labour and efficient infrastructure, and the overall demand in the economy. These require government spending and investment.
Corporate taxation can be highly progressive because it is primarily paid by shareholders, and share ownership is concentrated among the wealthiest groups in society. In recent years a number of multinational corporations have paid very low taxes in some countries, because they have managed to shift their declared sales and profits to countries with lower tax rates.
Governments fear losing investment and tax revenues to other countries. This has led them to cut corporate tax rates. This combination of tax avoidance and “tax competition” is eroding overall tax revenues and allowing many of the largest firms to pay very little tax.
Burning fossil fuels can have economic, environmental and social costs. It is widely considered fair and efficient to require energy users to bear these costs.
Carbon and other environmental taxes also encourage more efficient use of energy and resources, reducing environmental impact. Under the EU’s Emissions Trading Scheme, carbon emissions from the power and industrial sectors are effectively taxed, though not at a very high rate.
Petrol and diesel are taxed more highly, but these taxes have been frozen in the UK in recent years. Aircraft fuel is not taxed at all. So there is a strong case for a more comprehensive system of carbon taxation.
Taxes on consumption are regressive, with poorer consumers tending to pay more as a proportion of their income. Carbon and environmental taxes need to be carefully designed to ensure that they are perceived as fair.