Is abolishing income tax the best way to rebalance our economy?

The most striking thing about footballers’ salaries is that the headline figures we hear so much about are after tax. When a footballer hears that another club is offering £100,000 per week, he knows that he will get all the £100,000 in his own pocket. Imagine if that was true for everyone. Unfortunately, not even the Premier League can afford to pay us all £100,000 per week and pay our tax bill too. But let’s imagine that we keep all of our salary. And then made our own decisions about how much of it to spend, how much to save and how much to invest in our own futures. It’s probably beyond the political pale to even consider this policy unless the income tax is replaced with another tax. Otherwise, government spending would have to reduced by a third given the importance of income tax to the UK Treasury.

But other than the thrill of bigger of pay packets, why bother making this change? Well, I am always attracted to any change which gives people freedom of choice and invites them to take more responsibility for their own lives. But the real attraction in this idea is the potential to rebalance Western economies and make them more sustainable and competitive in the future.

Although the UK economy is growing again, we still need to fundamentally restructure the economy. If we don’t rebalance the economy, there is every risk that growth will only repeat the mistakes of the recent past. Good progress is being made on fixing the fiscal deficit. But there is so much more to do. There is a broad consensus about this “to do” list. We need to reduce our dependency on consumption and reduce debt. We need to export more and we need to increase levels of private economic investment. We need to get more people to work and those who do work to work more. Finally, we need a higher savings ratio to fund investment and to pay for our old age. But we don’t seem to be making enough progress on these structural changes. We are not alone. Most other mature rich countries want the same changes. But it isn’t clear what is going to turn things around. So, It must be a good time to think about some fresh options. And one area we haven’t explored enough in the UK is the abolition of income tax and its replacement with taxes on consumption instead.

This is not an argument about having higher or lower taxes. That’s a good argument to have. But let’s assume that the level of tax raised is constant, but raised in a different way. A simple proposition would be to simply abolish income tax – all the money you earn is yours. In the UK, we would need to find £160 billion from somewhere else to replace the lost revenues. Existing consumption taxes already raise about the same amount (£100bn from VAT, £27bn from fuel duty and £26bn from others such as alcohol and air passenger duty). So we’d need to raise about the same again. There are lots of ways to increase these taxes. But let’s keep it very simple. Firstly, let’s remove all the exemptions and special rates for VAT and simply charge a flat rate on all consumed goods and services. That would raise another £60bn. If we then increased VAT from 20% to 33%, that would raise another £100bn, giving us a total of £260bn from VAT, compared to the current £100bn. We would have replaced the money lost by our abolition of income tax. Combined with the existing £53bn of specific consumption taxes (eg alcohol), this would mean that just over half of our revenues came from consumption, compared to little more than a quarter at the moment. This is not unheard of in the world – e.g. Mexico has a similar reliance on consumption taxes.

What would be the effects? Too often this discussion is strangled at birth by hysterical claims that consumption taxes are regressive and only income taxes are fair. But this argument ignores the question of what government does with its spending. It looks at only side of the fairness equation – what do people pay in, rather than the balance between what they pay in and what they get out.  It’s entirely possible that progressive public spending can more than cancel out the regressive effects of a particular form of taxation. The majority of UK public spending comprises income transfers from the government to people in need. Already nearly half of the UK population gets more back from the government than it pays in. Within this level of income transfer, there is the scope in public spending to sort out any regressive impacts from a tax reform. This could be further tax credit payments or other benefits. It would also be possible to make other taxes more progressive to compensate for any regressive effects. For example, National Insurance (Social Security) charges could be more progressive to reflect ability to pay. So let’s suspend the regressive hysteria for a few minutes and think of the other effects.

Apart from the powerful psychological and philosophical benefits (you keep what you earn, you choose between consumption now and saving for later benefit, etc), there could be a number of positive structural effects on the economy. Firstly, people will save more. Saving would be encouraged by people having a greater choice between consuming now and not-consuming now and by the fact that the income from savings (interest, dividends, etc) would not be taxed so the returns are higher. Secondly, investment should increase, funded by the increased savings. Thirdly, people are likely to work more, as the marginal tax rate is zero, so all extra income is their own. Fourthly, the tax base would be widened as consumption taxes capture spending funded by people’s wealth (which is untaxed) as well as by their income. (This is increasingly important given the emerging inter-generational tensions about high income taxes levied on younger working age people to fund the entitlements of older people, who are increasingly wealthier than them). Finally, it could be a lot cheaper to collect than income tax. VAT works well and there are ways to improve its efficiency further with modern technology.

It would be possible to go one step further and remove income tax from business. That would mean abolishing corporation tax, which currently raises £40bn per year. If that was also to be replaced by a consumption tax, it would require the new VAT level (now covering all the currently exempt items) to be raised a further 5 percentage points – to 38% or so. Alternatively, some of the specific taxes (eg alcohol, fuel, tobacco, flights, etc) could be increased further and the VAT level restrained. There is no doubt that abolishing corporation tax would have a dramatic effect on UK competitiveness. If businesses had no tax to pay on earned profits, production costs would fall, as would the cost of capital. Most importantly, the incentive to export would be very strong, as the consumption tax is only paid on goods consumed in this country. A recent Princeton University study asked 500 European and Asian firms how they would respond to the replacement of income and corporation taxes with a consumption tax in the US. It found that 80% would put their next plant in the US and 20% would also move their global HQs there.

In simple terms, by this point we would have doubled the headline level of consumption tax (from 20% to nearly 40%), but abolished income tax for individuals and businesses. (At 40%, there would be substantial funds to compensate poorer households with additional benefits). If we reach the point where a majority of tax revenue comes from consumption, it also opens up lots of new policy options for governments wanting to influence demand for goods and services. The leverage effect of targeted increases or reductions in consumption tax on certain goods or services would be much higher. Consumption taxes could themselves be progressive. For example, stamp duty on house purchases in the UK is charged at different rates depending on the sale price of the house. This ranges from 0% for houses costing less than £125,000 to 7% on houses costing more than £2m. Policy choices could allow more tax on “bads” (e.g. unhealthy goods) and less tax on “goods” (e.g. lifelong training). It could also allow some radical policy shifts, such as a consumption tax on the carbon used to create domestic and imported goods to replace all sorts of existing bad policy on climate change.

In this scenario, we haven’t changed National Insurance (Social Security) payments from employees and employers. However, there would be an attractive option in the UK to rebrand this  “NHS Insurance”. It raises almost exactly the cost of the NHS (£100bn). So it could even be hypothecated as the nation’s health insurance fund. This bring a simple transparency into the tax system and replicate the type of health insurance deductions common to other countries. It would also be possible to make National Insurance more progressive, with higher rates paid by the better-off and big reductions for the poorer.

So, what about this shift from income taxes to consumption taxes? In the US, there is now a fair head of steam behind the Fair Tax movement which aims to do just this. Heavyweight economists are predicting that this sort of shift in the US would produce, within 5 years, a 10% growth in GDP, jobs, real wages and consumption, along with a doubling of investment. It definitely seems worth exploring further in the UK, and other Western countries. It would be critical to look at the combined effect of tax and spending on different income groups – and to find options to compensate for regressive tax effects with progressive spending effects. The Fair Tax movement has worked hard on this in the US, e.g with its “prebate model”. Inevitably, it’s hard to copy US solutions given the different government structures (federal, state, etc) and the very different welfare spending. Of course, the decision about this sort of shift is not binary. It would be possible to pursue lots of interesting variants. For example, perhaps we should only abolish income tax on incomes below a certain level (e.g. £50,000) which would mean that most households paid nothing. And there would need to be a transitional period to avoid extreme turbulence.

Before anyone else says it, I am totally aware that the UK does not control its own consumption taxes, given the impact of EU law and regulation. But given our need in the UK for the potential benefits of this shift in how we tax ourselves (less dependence on domestic consumption, increased saving, more investment, more exports, greater competitiveness, etc), shouldn’t we start a UK debate about it? And if it turns out to be good for us, then it’s probably good for the rest of Europe too.