Sorting out the public finances Part 1 : Changing the debate

This is the first of a 5 part approach to sorting out public spending. The later parts include: A fiscal turnaround plan for the UK regions whose deficits are much worse than Greece; Sorting out which generation should be paying for what.

Part 1 – Two ideas to change the debate about public spending?

It is no wonder that Western governments have got into such a fiscal mess – it’s almost impossible at the moment to have a meaningful public debate about the right overall levels of taxation and spending. There tends to be lots of fragmented debate about individual taxes (e.g. fuel duty, inheritance tax, personal allowances for income tax, bingo taxes, etc). There is an equally fragmented debate about individual areas of public spending (e.g. new roads, the police, social care, unemployment benefits, etc). But there is little meaningful debate about the right overall levels of taxation and spending – beyond the ideological preferences of the left and the right for more, or less, of it all. Nor is there any relationship in most people’s minds between what happens to particular taxes and what gets spent on particular services. This means that most people want to see taxes come down (especially the ones they notice the most) and public spending go up (especially on the services or benefits they most appreciate). In the absence of a proper joined-up debate, we drifted into the absurdity of 2009 where the Government was spending like a Scandinavian (almost half of our national income) and taxing like an American (little more than a third of our income). The result was the highest annual deficit of any developed country. Since 2010, at least, most people in the UK now agree that Government’s expenditure should not exceed its income. By 2018, after 7 years of painful austerity, we should achieve a balanced budget. It will be the first time in 20 years. But it won’t be job over. The pressures on public spending (e.g. from the ageing population) could easily overwhelm a less than robust tax base (e.g. falling revenues from fuel efficient, low carbon cars).

We need a better way to debate what we want Government to spend and what we’re willing to be pay in tax. It can be meaningless to debate how much in aggregate a Government should tax and spend. Whether it should take 20% of our income (as in Mexico) or nearly 60% (as in France) depends on the roles and ambition we give Government. There are some fixed elements of the current UK political consensus ( a universally free and high quality health service; free schools; a universal and meaningful state pension; redistribution of money to poorer areas; etc) which mean that public spending, and hence UK tax, will always be fairly high. Conversely, UK private spending in these areas will be relatively low (e.g. on private health). Sometimes the headline numbers for Government spending are so striking that they spark the debate – e.g. 20 years ago, the Swedish Government was spending two-thirds of national income, prompting a tough fiscal regime to get down to today’s half of national income; in healthcare, the US Government spends far more per capita on healthcare than the UK, in spite of our having the NHS and US government spend on health being less than half of the total public and private spend. In these extreme cases, it becomes clear that something must be done, but, as Obama has learnt, far from clear what solutions the public will wear. But with the UK’s extreme deficit now falling, there is a danger that public and political attention drifts away from the major fiscal challenges we still face.

Is there a fresh way to engage the public in this fiscal debate? I have two suggestions:

(1) Every public body (be that a Government department or a local public body) which spends money should raise its own income, by setting a tax which is clearly and exclusively linked to that public body. So rather than the Treasury raising all of Government’s taxes and pooling the funds, the Secretary of State for Health, for example, would set an NHS Tax to fund his proposed level of spending on the NHS.

(2) The level of spend for each service or benefit should be explicitly set, by each Government, as a percentage of our national income. This would allow a public debate about the priority accorded to the particular service or benefit, and how it compared to other countries. For example, this was how Tony Blair publicly set the ambition in the early 2000s that the NHS should receive 8% of GDP, to be in line with other rich Western countries. .

How could this type of hypothecation work? Let’s look at each proposal in a bit more detail.

(1) All the spenders have to raise their own taxes

This is a radical idea that would spell the end of the Treasury’s fiscal role as we know it. Under this principle any department or public body which spends money should be directly responsible for raising the money to pay for its spending. They would have their own specific and exclusive tax. The relevant politician would determine the level of the tax to meet their own spending needs. For example, the Secretary of State for Health would determine the NHS tax and be accountable for it, as well as the spending which it funds. Clearly, in central government each Minister would need to get Cabinet support for their proposal (as they do for all policy decisions), but it would be their decision on tax and spending.  Moving to this system may not be as hard as it sounds. It’s possible to align existing taxes with existing spenders, rename the tax to show its hypothecated purpose and give the relevant politician the power to take this forwards. 

– National Insurance could be renamed “NHS Insurance (NHSI)”. The current NI tax and NHS spend roughly balance. The nature of the NI tax ( a percentage of wages, paid through a mix of employer and employee payments) is very similar to health insurance payments in other countries. The Secretary of State for Health would determine taxation policy for the new NHSI – the amount to be raised, the balance of contributions between employers and employees and the progressive burden of the tax on different payers. 

–  Income Tax could be renamed “Pensions and Disability Tax”. This would include all payments to pensioners (State Pensions, Pension Credits, etc). It would also include DWP’s disability benefits (DLA, AA) and Local Government’s social care budgets. This spending would consume all of the income tax receipts. If the public recognises this, it should lead to a more grown up discussion about the affordability of our entitlements and the trade-offs between tax and spending. For example, if people understand that raising the retirement age by 1 year avoids adding 2p in the pound to the basic rate of income tax, we will have a better informed political debate. 

– Corporation Tax could be renamed “Income Guarantee Tax”. This would fund the cost of all employment-related benefits – tax credits, housing benefit for working age people, unemployment benefits, childcare support. This spending roughly balances with Corporation Tax receipts. Linking the two would illustrate the cost to taxpayers of having a minimum income guarantee. It would also make the point to employers that their taxes could be lower if they provided more and better paid jobs. 

– VAT could be renamed “Education Tax”. VAT receipts would be enough to cover pre-school, schools, further education, higher education, apprenticeships and adult skills. The level of VAT and, critically, the exemptions from it would be determined by the Education Secretary. This might assist a more grown up debate about some of the exemptions – e.g. the tax-free status of clothes for well-off children – versus the need to spend on children’s education. 

– Wealth Taxes and Business Rates could be renamed “National Security Tax”. The wealth taxes include capital gains tax, inheritance tax, stamp duty and share duty. Together with business rates, this would provide enough revenue to fund the budget for National Security spend, including defence, intelligence and the national crime agency. There might be two taxes – the property taxes (business rates and stamp duty, for example) set by the Defence Secretary and the wider wealth taxes (e.g. CGT) set by the Home Secretary – in order to get the funding split right.

Excise duties could be renamed “Investment Tax”. These revenues comes from duty on fuel, tobacco, alcohol and gambling. They would pay for future public assets, e.g. in transport, science, flood defences, business investment or social housing.This would tie a consumption tax on “bads” to investment in our future prosperity. This would give a new moral high ground to this tax base. 

– Smaller departments could, similarly, get their own taxes. For example, Airline Passenger Duty could be the tax base for the Department of Culture Media and Sport, as it would cover their costs and is linked to tourism, both in-bound and out-bound. Similarly, DEFRA could be funded by environmental taxes like the landfill tax and aggregates tax, or DECC by the climate change levy. 

– Council Tax in this system would more closely match local authority and local Police spending – as large elements of spending (in adults and children services would be funded through the national tax system e.g. via the Pension and Disability Tax). There would be some complexity (as always) to make sure that individual areas had the right funding.  


Some people will struggle with the idea of spending ministers being tax-setters. But how is the idea of a Defence Secretary setting a tax on property any different to a County Council Leader setting a tax on property to pay for adult social care? It promises a new type of political debate – as spending ministers may aim to be known as tax-cutters, or charges could be introduced to reduce taxes, or entitlements expanded in exchange for a visible increase in the tax, etc.

2) Setting spending targets for each service or benefit by percentage of national income.

Clearly, it is important that whatever money is allocated to a service or benefit is spent well. Spending more is not necessarily a good thing – if money is wasted, or could be better spent elsewhere, or better spent by someone other than Government. Similary, spending less is not necessarily a bad thing – if the same or better can be achieved with less, or if there is something better to do with the money. However, it is also true that, assuming it is spent efficiently, the level of public spending on a particular service or benefit is an expression of our collective priorities and expresses our values. Firstly, it shows how much of our private income we’re willing to give to Government for a specific service or benefit. Secondly, it shows how much we value one thing over another. So, for example, we are spending about 2.5% of our national income on defence. This is roughly half the proportion of income spent by the US, but roughly double the proportion spent by the Germans and Scandanavians. By contrast, we spend just under a fifth of our income on social protection (pensions and welfare payments), compared to the Americans who spent less than a tenth, whilst the French and Danes spend a quarter of their income. David Cameron promised at the last Election to increase overseas aid spend to 0.7% of our national income, which has been achieved in spite of the austerity budgets and makes the UK the first western country to hit this international target. The UK has poor levels of private sector investment in R&D. This depresses our total spend (public and private) so that the proportion of our national income spent on R&D is roughly half that in Japan and some Scandanavian countries, as well as being a long way behind the US. This puts pressure on Government to compensate for low private levels of investment. So, for governments, these sort of decisions are partly a matter of keeping up with our competitors, partly an expression of political priority and partly a pragmatic means of controlling spending. There are 3 elements to this allocative decision:

(a) How much of the national income ought a country like ours to be spending on an issue, e.g. providing pensions;

(b) How much of that total spending should come through the tax system, e.g. balance of state versus private pensions;

(c ) How much can be afforded by the taxpayers at  a given time, e.g. the level of state pension that can be afforded. 

There are 6 big fiscal decisions which cover 90% of the debate :

(i) Collective funding of health services

(ii) Provision of State Pensions and Disability Benefits

(iii) Guaranteed incomes for working age individuals and families

(iv) Collective funding of education, from pre-school, through school to colleges and universities

(v) Scale of investment in national infrastructure

(v) Scale of economic investment, e.g. R&D, skills,  (including the cost of tax reliefs as well as spending)

(vi) Scale of our international commitments in defence, diplomacy, aid and national security.

Wouldn’t it be refreshing if the next Election was an explicit debate about the proportions of our national income we should devote to each of these areas and how much of that should be via the tax system? This would require an unprecedented engagement of the public in setting fiscal priorities – tax by tax, spend area by spend area. It would make explicit that getting more services or benefits requires taxes to go up, and vice versa. It would also force the ideologues (big spenders, little spenders) to argue specifically the rights and wrongs of taxing and spending for a particular service.

If we combine these two ideas together, then we will have individual politicians (central and local) accountable for raising enough tax to fund their individual services and benefits. And, hopefully, we will have reconnected the public with the fiscal choices they face – getting them to take more responsibility for either reducing spend or raising taxes to pay for what they want.

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.