Direct Taxes or Indirect Taxes?

Transcription

1 A consideration of the relative merits of the two approaches A discussion paper by David F Williams of in the UK May 2009 Abstract The paper draws attention to the current trend for governments to reduce rates of direct tax and place reliance on indirect taxes for a larger proportion of their total revenue. It goes on to consider the relative merits of direct and indirect taxes as regards: revenue raising by governments; the financial effect on companies and individuals; taxpayer perceptions; administrative convenience and cost; behavioural effects; and social and economic policy. It concludes that for governments indirect taxes have many advantages, while for taxpayers the choice is much less clear cut. The regressive impact of indirect taxes may, however, be a major disadvantage. An appendix considers how direct and indirect taxes should be defined for these purposes. It outlines some deficiencies in commonly used definitions based on the identity of the person bearing the tax, given the uncertainties that exist as to where the burden of particular taxes actually falls. It suggests instead that a more precise distinction between income-based ( direct ) and expenditure-based ( indirect ) taxes may be established by reference to the net or gross nature of the tax base. Broadly, its argument is that taxes on expenditure apply to an unreduced base, whereas income-based taxes apply to a reduced (or irreducible) amount. The thesis is tested by reference to a number of UK taxes.

2 Contents 1 Introduction 4 2 Trends in the use of direct and indirect taxes UK trends Global trends UK statistics 5 3 Revenue raising 5 4 Financial effects Corporate taxpayers Individual taxpayers 7 5 Taxpayer perceptions General Income-based taxes Indirect taxes Headline rates 9 6 Administration Agreeing the liability The number of taxpayers The nature of the taxpayers Ease of change The position of taxpayers 11 7 Behavioural effects Expenditure-based taxes Direct taxes Inward investment Carrot or stick? Environmental taxes Incentives to work Incentives to save 15 2

3 8 Social policy Progressive and regressive taxes Redistribution 16 9 Economic effects The UK s VAT system: a special case? Freedom : an ideological argument Conclusions 18 Appendix: Defining direct and indirect taxes A1 Introduction A2 A preliminary definition and some reservations A2.1 The preliminary definition 19 A2.2 The economic incidence of the taxes 19 A2.3 The example of stamp duty 20 A2.4 Differences between various indirect taxes 20 A2.5 A preliminary conclusion 20 A3 Profits-based and transaction-based taxes 21 A3.1 An alternative approach 21 A3.2 The tax base 21 A3.3 Objections to this approach 21 A3.4 Testing the definition 22 A3.5 A note on terminology 22 A3.6 Classification difficulties: examples 23 A4 The United States Constitution A5 Conclusions

4 1 Introduction This paper draws attention to a shift by governments away from the use of direct taxes in favour of indirect taxes, and goes on to explore the relative merits of these two approaches from the point of view of both governments and taxpayers. It considers their impact in terms of financial consequences, administrative convenience, behavioural effects, social policy, economic implications and political theory. The terms direct taxation and indirect taxation are not used consistently by commentators. There is, however, a broad consensus that direct taxes are those, such as income tax or corporation tax in the UK, that are levied directly on the taxpayer by means of some process of assessment. By contrast, indirect taxes, such as the UK s value added tax (VAT), are those that the taxpayer pays to the government indirectly; ie, the person who bears the tax (the customer) pays it to the retailer, who in turn passes it on to the government. An appendix draws attention to some deficiencies in this approach, and suggests instead a distinction between income-based ( direct ) and expenditure-based ( indirect ) taxes. The problem remains, however, that the same transaction will normally represent expenditure to one person and income to another, so it will not necessarily be entirely clear which category the related tax falls into. The appendix suggests that this difficulty may normally be solved by reference to the net or gross nature of the tax base, rather than by reference to the identity of the taxpayer whether that term is used in the sense of the person who bears the economic burden of the tax or the person who is legally obliged to account for it. Broadly, its argument is that taxes on expenditure apply to an unreduced base, whereas income-based taxes apply to a reduced (or irreducible) amount. The body of the paper leaves those difficulties on one side and proceeds on the assumption that, whatever the precise definition, the distinction between income-based and expenditure-based taxes is clear in general terms, even if the categorisation of particular taxes is problematic. In what follows, therefore, the terms income-based and expenditure-based are used interchangeably with the terms direct and indirect. 2 Trends in the use of direct and indirect taxes 2.1 UK trends A major shift from direct to indirect taxation in the UK began in the late 1980s. VAT was increased from 8 per cent to 15 per cent in 1987 (subsequently increased to 17.5 per cent in 1991); the top rate of income tax fell from 60 per cent to 40 per cent in 1988; the basic rate of income tax, which had been between 30 and 35 per cent over the previous ten years, fell in stages from 30 to 25 per cent between 1985/86 and 1988/89; and corporation tax fell from 40 per cent to 35 per cent in 1986, having been 52 per cent for most of the previous decade. (In the case of corporation tax the change was not as dramatic as first appears, because the fall in rate was compensated for by reductions in allowances for capital expenditure.) 4

5 2.2 Global trends This was part of a global trend that has continued to the present. Most recently, KPMG s Corporate and Indirect Tax Rates Survey indicated that average corporate tax rates over the 106 countries surveyed had continued to fall during the year under review, from 26.8 per cent in 2007 to 25.9 per cent in 2008, while average indirect tax rates (over 90 countries) had remained steady at 15.7 per cent. In addition, there had been a steady expansion of the indirect tax base, with the result that indirect taxes continued to represent an increasing proportion of the total tax yield. The survey also reported a steady expansion in the number of governments that have adopted a value added tax (VAT) or a Goods and Services Tax. Similarly, KPMG s Individual Income Tax Rate Survey 2008, 2 which examined data for the last six years, reported a general trend of falling income tax rates throughout the world, with very few exceptions. 2.3 UK statistics How important are direct and indirect taxes, respectively, as sources of Government funding in the UK? Any analysis would clearly require a working definition of the two terms, and Government figures are not reported in this way. Nevertheless, it may be noted that for 2007/08, the most recent year for which figures are available, taxes generally considered to be direct 3 accounted for billion of revenue (45 per cent of the total collected by HM Revenue and Customs (HMRC)); taxes generally regarded as indirect 4 accounted for billion (33 per cent of the total); and national insurance contributions accounted for billion (22 per cent of the total). 5 As will be seen at in the Appendix at A3.4, the writer considers that employers national insurance contributions should be classified as an expenditure-based or indirect tax, and employees contributions as an income-based or direct tax, but no split of the total figure between these two categories is available. 3 Revenue raising A government will have many factors to consider in relation to tax policy, such as the behavioural effects of its proposals, their effect on the economy as a whole, and political constraints. The principal purpose of taxation, however, is the raising of funds to finance public expenditure, and the revenue-raising capacity of any tax, whether direct or indirect, is likely to be the major consideration underlying any government decisions in this area Available at Available at pdf. Income tax, corporation tax, petroleum revenue tax, capital gains tax and (subject to the points made in the Appendix at A3.6) inheritance tax. VAT, fuel duties, stamp duties, tobacco duties, alcohol duties, betting duties, air passenger duty, insurance premium tax, landfill tax, climate change levy, aggregates levy and customs duties. HM Treasury, Pre-Budget Report: Facing Global Challenges Supporting People Through Difficult Times, Cmnd 7484, November 2008, page 203, see pbr08_completereport_1721.pdf. 5

6 From the point of view of governments wishing to raise revenue, it might be assumed that the best tax was that one which would have the highest yield. However, within reason any tax can be made to yield more revenue simply by increasing the rate at which it is charged. More important, therefore, is the question of how volatile, and thus how predictable, the yield is. A revenue yield that is less than expected may cause serious difficulties to governments, for obvious reasons. On the other hand, a higher yield than expected may not be as welcome as might be supposed. It will provide only limited benefits if there are no plans in place for how the additional revenue is to be spent; thus to some extent (and depending on one s view as to the appropriate size of the public sector) it may be seen as representing a wasted opportunity, even though it will have the advantage of reducing the public sector borrowing requirement. The yield for most taxes will vary according to the level of activity in the economy but incomebased taxes, particularly those charged on trading profits, will tend to be more volatile than turnover-based or expenditure-based taxes. For example, a company in the UK may buy goods for 1,000 and sell them for 2,000, incurring staff costs of 450 and making a profit of 550, on which it pays corporation tax of 154 (assuming that the full corporation tax rate of 28 per cent applies). It will also account for VAT of 150 (ie, output VAT of 300 less input VAT of 150, assuming a 15 per cent rate). If its sales fall by 50 per cent in an economic downturn (ie, sales of 1,000 and purchases of 500), the VAT it accounts for will similarly fall by 50 per cent. Its profit, however, will fall to 50, on which it will pay corporation tax of 14 a fall of 91 per cent. If sales and purchases fell by a further 5 percentage points, to 900 and 450 respectively, the VAT accounted for would fall in the same proportion, but the company would make no profit at all, and thus pay no corporation tax. Thus some VAT will continue to be due as long as there is any economic activity at all, whereas in a recession corporation tax receipts from trading income may fall dramatically. To the extent that a government relies on indirect taxes, therefore, it builds into its tax system a greater measure of protection against unpredicted swings in revenue. However, it also cuts itself off from the possibility of windfall gains, which could give it greatly increased revenue without the political cost of observable rate increases. Thus in the example above a doubling of sales and purchases (with the same staff costs) would give a 100 per cent increase in VAT revenue but a 180 per cent increase in corporation tax. For this reason (among others) few governments will wish to rely exclusively on one form of taxation or the other. They will wish to achieve an appropriate balance, taking into account their assessment of the risks involved and how seriously they regard the various possible outcomes. For instance, in the example just given a government relying exclusively on VAT would lose the benefit of the 180 per cent corporation tax increase if sales doubled but it might not regard this as very serious because, by definition, it would be taking place in an economic climate where the government was in any case enjoying a significant (though lesser) benefit from increased VAT. Within the category of indirect taxes, governments may also prefer to limit volatility by placing indirect taxes on goods or commodities for which there is relatively inelastic demand; so, for example, a tax on food will generate a more predictable revenue return than one on luxury goods. 6

7 4 Financial effects 4.1 Corporate taxpayers While a company may pay corporation tax on its profits, arguably it cannot bear the tax because companies are artificial constructs. On this view all taxes on companies are ultimately borne by individuals, whether by customers in the form of higher prices, by the workforce in terms of downward pressure on remuneration, or by shareholders in terms of reduced dividends or reduced shareholder value resulting from lower retained profits. From this it might appear to follows that companies (or, strictly, those individuals responsible for conducting their business) will have no preference as between direct and indirect taxes, from the point of view of their financial effect. Clearly this is not the case in practice; companies may frequently be found making representations as to the impact of the tax system on their business. The reason is that though the tax burden does not remain with the company, it does significantly affect its financial results. A massive excise duty newly imposed on a particular type of goods for which there is elastic demand may (if the company so chooses) be passed on in its entirety to customers, but there will be far fewer of those customers than previously, and thus less profit for the shareholders to whom the directors are answerable. If the company reduces its price to compensate for the effect of the duty, then again profit will be reduced. However, in principle, for the company there is little to choose between direct and indirect taxation. Either will form a cost component of any goods or services sold, and will affect the financial results accordingly. Preferences in particular cases are likely to relate to specific features of the particular business or of any particular taxes applicable to the goods or services in question, rather than to generally applicable principles. Particular concerns relate to competitiveness (ie, how the tax affects the company s position vis à vis other companies operating in the same or similar markets); to questions of transparency or visibility (ie, how easily the impact of the tax on the company s results can be assessed); and to administrative convenience. 4.2 Individual taxpayers For individual taxpayers preferences will vary very much according to their own patterns of income and expenditure (except to the extent that political or moral convictions lead them to favour a result which is not optimal for their own financial position). Those who are large consumers of specific commodities such as tobacco, alcohol or road fuel, for example, may wish to see the taxes on those goods lowered, in favour of higher income tax. Where they also have high incomes, the desired outcome may involve a careful balancing of advantage and disadvantage. Broadly, however, an emphasis by governments on indirect taxes rather than direct taxes works to the benefit of those who choose (and are able) to save a significant part of their income; they are in a position to avoid expenditure-based taxes by avoiding expenditure, while enjoying lower income-based taxes. In the same way an emphasis on direct taxes favours those who choose (or are obliged) to spend most of their income. These will tend to be individuals with smaller 7

8 incomes, who in a progressive tax system will bear tax at a relatively low rate. This will be a rate that to some degree takes account of their circumstances, in a way that an expenditure-based tax cannot do. 5 Taxpayer perceptions 5.1 General Taxpayer perceptions of different taxes are not only of interest from a sociological point of view, but may also have an influence on the choices a government makes in this area. This issue therefore brings together political, behavioural and revenue-raising factors. A government will not wish to make itself unpopular, for obvious reasons, but the effects of an unpopular tax go beyond the political. If the tax is unpopular enough that people change their behaviour in order to avoid incurring it, then its revenue-raising capacity is also impaired. 5.2 Income-based taxes Income-based taxes tend to be more visible, and thus less acceptable to taxpayers, than expenditure-based taxes. For example: six-monthly payments of income tax by an individual carrying on a trade may give the taxpayer significant cash flow concerns; similarly the difference between employees gross pay and their net pay may be a constant source of irritation to them when they open their payslips, particularly as regards overtime or bonus payments to which their marginal rate applies without the benefit of any personal allowance; or a corporation tax charge in company accounts may prompt shareholders to ponder the fact that the government s appropriation from the profits is larger than their own. An exception to this level of visibility arises where profits-based taxes are imposed early in the supply chain. The purchaser of road fuel, even if he or she is aware of the excise duty and VAT component of the price (as to which see 5.3) is unlikely to be conscious of the impact on the retail price of such taxes as petroleum revenue tax (PRT) charged on the profits of the producer. 5.3 Indirect taxes Indirect taxes, by contrast, are often significantly less visible to those who bear them. Traders are well aware of VAT because they have often onerous administrative obligations to account for the tax to the authorities. Nevertheless, in general it does not have a direct impact on their profit and loss account, except in the case of exempt or partly exempt traders. In effect traders receive VAT on sales, and pay it on purchases, as agents for (respectively) the government and the final consumer. That is not to say that it has no economic effect on their business; its incidence will affect their purchasing decisions and those of their customers, but not always in readily identifiable ways. They will also bear administrative costs. By contrast, in the case of the final consumer, who arguably bears the bulk of the burden of the tax, VAT has more direct impact, but is not necessarily all that visible. Some purchases will involve an invoice on which VAT is separately identified. However, many will not; and even in cases where the VAT is separately identified in this way, the advertised price, on which the consumer makes the decision to purchase, will usually be VAT-inclusive. Where advertisements 8

9 show a VAT-exclusive price, and the consumer only discovers on investigation that VAT must be added, this is perhaps more likely to result in irritation with the retailer who obscured the real cost of the transaction than with the government that imposed the tax. Many consumers are completely unaware of which goods and services bear VAT and which do not; and of those who are aware many will not understand the distinction between zero-rating and exemption (and will assume, normally erroneously, that the price of exempt goods includes no cost element that relates to VAT). Other indirect taxes may be even less visible than VAT. The ultimate purchaser of tobacco, alcohol or road fuel will have no idea of the amount of excise duty effectively included in the price, except from external sources unrelated to any documentation used in the transaction. Perhaps many would be surprised to know, for example, that excise duty and VAT together can account for some 70 per cent of the price of petrol. Even the determined enquirer may not find it entirely straightforward to establish how much excise duty has been paid on the product he or she purchases because the charge may be by reference to price, to quantity (sometimes using different units from those applying in retail sales) or to a combination of both. In the case of alcohol the charge may be by reference to the quantity of alcohol, the quantity of the product or a combination of both. 6 The quantity of alcohol in a drink may not be readily apparent to the casual purchaser, particularly when it arrives in a glass rather than a labelled bottle, and in any case detailed calculations may be necessary before meaningful figures are available in relation to particular purchases. An exception to this lack of visibility arises immediately following the making of changes to rates of duty, usually in the annual Budget. Official announcements will normally indicate what the effect of the change is on the retail price of a bottle of wine, a pint of beer, or a packet of cigarettes, and a regular purchaser will be well aware of the price increases even if the announcements themselves do not come to his or her attention. Media reports may draw attention to the total duty cost at such times, in the course of reporting the increase, but in general this information will then retreat from the consciousness of the public. 5.4 Headline rates The tax base of a turnover-based tax will be a larger figure than that of a profits-based tax relating to the same goods or services. This means that a lower tax rate is necessary to raise the same amount of revenue (and to impose the same burden on taxpayers as a body). In theory perhaps this should be of no consequence in the presentation of tax policy the relevant political questions should relate to the size of the total tax burden and the way it is distributed among the population. Nevertheless, the uninformed observer may perceive a VAT rate of 8 per cent (which applied in the UK from 29 July 1974 to 17 June 1979) as a comparatively trifling matter when compared to a basic rate of income tax of 35 per cent (and a top rate of 98 per cent), which applied for part of that period. Aided by the loose terminology of the media, such an observer may also fail to appreciate the difference between an increase of 1 per cent and an increase of one percentage point. He or she may thus perceive a one percentage point increase in the tax rate as negligible, or at least be indifferent as to whether it is imposed on income tax or VAT, being 6 Details of current rates are given in HMRC, Alcohol Duty: Rates, Budget Note 86, 22 April 2009, see 9

10 unaware that it represents an increase of 12.5 per cent on an 8 per cent rate but only a 2.8 per cent increase on a 35 per cent rate. 6 Administration 6.1 Agreeing the liability As regards administrative convenience, indirect taxes are likely to present fewer problems than direct taxes in agreeing the amount of the liability, because turnover figures (whether general or relating to specific goods) are normally easier to ascertain than profits figures, which require detailed calculations to be made. This advantage applies equally to tax authorities and taxpayers. 6.2 The number of taxpayers Significant administrative advantages arise for tax authorities in circumstances where large amounts of revenue are raised from small numbers of taxpayers. This may be the case with those indirect taxes where the nature of the charge limits the number of taxpayers affected. Thus the collection of excise duty on fuel from a small number of producers, or of air passenger duty from a small number of airline operators is relatively straightforward. The same advantages may arise with specialised direct taxes, such as PRT, which are paid by very few taxpayers. In this case the agreement of the liability may be more time consuming, because it relates to a net profits figure, but the reward for the effort is significant. Statistics for the last seven years show total receipts of 11 billion, from a maximum of 38 PRT-paying fields in any one six-monthly period. 7 (A field may involve more than one taxpaying company.) With corporation tax, by contrast, although the top 40 taxpayers in the year 2006/07, each with liabilities in excess of 100 million, accounted for 8 billion of tax or 18 per cent of the total, the price that the system imposes for that yield is that computations must also be agreed for 880,000 other companies, 94 per cent of which have liabilities under 50,000, plus others with no liability at all The nature of the taxpayers Where the tax liability must be diffused between a large number of taxpayers with a relatively small liability, the preference of tax authorities from the administrative perspective is likely to be for a turnover tax such as VAT that enables them to deal exclusively with businesses. In part this is because businesses have the facilities and experience to process figures to a much higher degree of accuracy than is likely to be the case for individual taxpayers. It may also reflect the fact that it is easier to shift the administrative burden from the authorities to the taxpayer where the taxpayer is a business. 7 8 Statistics on HMRC s website at Based on statistics from HMRC s website at corporate_tax/table11 6.pdf. 10

11 However, VAT is arguably an inefficient tax from the administrative point of view in that it is imposed on retail transactions; ie, it arises at that point in the supply chain where the number of transactions is greatest. In addition, most VAT incurred by businesses is claimed back by offset of input tax against output tax, so that the total amount of tax charged by businesses on transactions is vastly in excess of the amount actually remitted to HMRC. The cost of this administration is borne by businesses rather than by the authorities. Arguably the allocation of the cost in this way (as distinct from the fact that it arises at all) is of no consequence, because all administration costs are eventually borne by taxpayers, either directly or by paying the taxes that finance the operations of the tax authorities. However, the problem with VAT is that the system of administration by businesses makes it very difficult to determine what the administration costs are, and what burden of unproductive effort this is placing in total on the economy. 6.4 Ease of change In the UK, it is generally easier for governments to change indirect taxes than direct taxes, and this is clearly an advantage when it comes to using such taxes as a means of managing the economy in the relatively short term as, for example, in the fiscal stimulus 9 provided by the Pre-Budget Report of 24 November To some extent this is simply a reflection of how Parliament has chosen to write the relevant legislation. For example, section 2(2) & (3) Value Added Tax Act 1994 empowers the Treasury, by Statutory Instrument, to vary the rate of VAT that has been set by Parliament by up to 25 per cent (eg, in the case of a statutory rate of 17.5 per cent, to increase or decrease it by up to percentage points). 10 While such a statutory instrument can only continue in force for up to a year, it can be replaced or varied by further orders without limit, provided the rate does not vary by more than 25 per cent from the original statutory figure. Similarly, section 1(1) & (2) of the Excise Duties (Surcharges or Rebates) Act 1979 provides that for (broadly) all excise duties except those on tobacco products the Treasury may make a statutory instrument varying the duty payable by up to 10 per cent for a period of up to a year. 11 While this flexibility is partly a matter of Parliamentary choice, it is also the case that indirect taxes lend themselves more readily to ad hoc changes of rate, because (unlike direct taxes) they relate in general to individual transactions rather than to the results of a period taken as a whole. 6.5 The position of taxpayers Clearly, where the advantage of a particular tax to the authorities is that the administrative burden is transferred to taxpayers, this represents a corresponding disadvantage to those taxpayers. Nevertheless, taxpayers are not a homogenous group. In theory, individuals may welcome an indirect tax system that transfers the burden of administration to businesses, in preference to a direct tax system that involves them in extensive reporting for income tax purposes. However, The term was used in the Chancellor s speech at speech.htm. The Value Added Tax (Change of Rate) Order 2008, SI 2008 No 3020, made under these powers, reduced the VAT rate from 17.5 per cent to 15 per cent from 1 December 2008 to 31 December Recent statutory instruments made under this power are the Excise Duties (Surcharges or Rebates) (Hydrocarbon Oils etc) Order 2008, SI 2008 No 2168 and the Excise Duties (Surcharges or Rebates) (Hydrocarbon Oils etc) (Revocation) Order 2008, SI 2008 No

12 personal taxpayers are unlikely to see any great benefit from a shift to indirect taxation unless either direct taxation of individuals is abandoned completely, or large numbers of individuals are lifted out of the income tax net by greatly increased personal allowances. So long as individuals have to make tax returns, the size of the tax liability that arises is of little significance as regards the administrative burden. This objection disappears to the extent that it is possible to eliminate reporting requirements while retaining the tax liability, as is the case for many taxpayers in the UK, by systems of deduction of tax at source (either from employment income under the PAYE system or by a flat rate deduction from savings income). 7 Behavioural effects 7.1 Expenditure-based taxes Clearly, expenditure-based taxes that are particular to specific goods or services will discourage that particular type of consumption. This mechanism can be used by governments to deter behaviour that has harmful effects on health (such as use of alcohol or tobacco) or on the environment (such as consumption of fossil fuels see further at 7.5). It could also be used to discourage behaviour that was seen from any particular political or ideological perspective as anti-social or otherwise undesirable, such as expenditure on private health care or education, or on gambling. Specific expenditure taxes can thus enable governments to fine tune behaviour in a way that a more general policy decisions on the distribution of the tax burden between income taxes and general expenditure taxes (such as VAT) cannot. The objective in particular cases may be to encourage more careful use of resources, rather than to discourage their use altogether. So, for example, a tax on heating fuel may encourage expenditure on thermal insulation, or a tax on new products may encourage recycling, as in the case of the UK s Aggregates Levy Direct taxes Direct taxation may also be used to encourage particular behavioural changes, by giving reliefs for expenditure on what are seen as desirable objectives; for example, on research which is considered to be for the public good, such as that into vaccines against specific diseases, 13 or for expenditure on the purchase of environmentally beneficial technology Inward investment Lower rates of tax on profits will tend to attract inward investment to the country concerned and, similarly, higher rates may encourage emigration by companies. Rates of indirect taxes will tend not to have the same effect because the burden of the tax normally falls, in theory at least, on the consumer rather than the business. Even where, in economic terms, the burden of the tax is in fact borne by the business in the form of reduced profits, this will not always be clear and the Sections 16 to 49 and Schedules 4 to 10 Finance Act Section 54 and Schedule 13 Finance Act 2002 give relief for research into vaccines for prevention or treatment of tuberculosis, malaria and HIV. Sections 45H, 45I and 52 Capital Allowances Act

13 position may vary from industry to industry. The headline rate of tax on corporate profits is likely therefore to be the more significant factor. This may account in part for the fact that direct tax rates are typically falling as discussed at 2.2, so that indirect taxes are assuming increased importance to governments. 7.4 Carrot or stick? When tax is used in an attempt to influence the particular way in which consumers allocate their expenditure, reliefs for good behaviour can arguably never hold as significant a place in the policymaker s armoury as charges on bad behaviour. In part this is because socially acceptable ( good ) alternatives do not exist for all harmful actions; there is, for example, nothing that consumers can be encouraged to smoke instead of tobacco. Much of the emphasis must therefore simply be on reducing the extent of such harmful actions (for which indirect tax charges appear to be more effective) rather than on substituting other actions (for which direct tax reliefs may often be more appropriate). In addition, even where alternatives exist, it may be easier to deter taxpayers from harmful behaviour than to attract them to beneficial behaviour, because it is often easier for a deterrent to gain purchase than it is for an incentive; there is usually more economic activity that it may directly affect. 15 In particular, where direct tax reliefs are available they tend to be given at the level of business, where they affect a limited number of decision-makers, whereas indirect tax charges either apply at the level of the consumer, or feed directly through to that level as a cost component of the retail price. A further issue is that an individual incurs no cost in responding to an indirect tax charge intended to deter expenditure. Indeed, he or she saves money. A direct tax relief for investment in particular activities, by contrast, requires the taxpayer to be prepared to incur expenditure, even if the amount of that expenditure is reduced by the relief. This would not necessarily be the case if the direct tax relief took the form of exempting a designated income stream, but such an approach is unusual; an example in the UK (with negligible impact) is an exemption from income tax for sales of surplus electricity arising from a domestic microgeneration project. 16 Even in such cases, however, investment will often be required before the taxpayer is in a position to take advantage of the relief. An exception to the general superiority of indirect taxes in affecting specific behaviours might perhaps be claimed where direct tax reliefs are given for donations to charity. In one sense it is true that these reliefs are apparently very effective in encouraging a specific well defined class of behaviour. However, it is a very wide class; such reliefs can have no influence on the particular destination of the funds concerned (though it might be possible to limit the reliefs to defined categories of charity). It might also be argued that charitable giving is more akin to an This sentence, and the preceding paragraph, draw on material in the author s paper Taxation and the Environment, March 2008, available at Reference may also be made to that paper for a much more extended discussion of the use of taxation to affect behaviour. Section 782A Income Tax (Trading and Other Income) Act 2005, inserted by section 20 Finance Act

14 appropriation of income than to an item of expenditure. In one sense the funds are spent, but they do not represent personal consumption. 7.5 Environmental taxes Where indirect taxes are used to affect behaviour as regards the environment, they are often based on the polluter pays principle. The theory behind this approach is that tax should be used to internalise the externalities ; ie, to bring within the polluter s own cost basis the negative externalities associated with its activities, such as the costs of damage to the environment, that are currently borne by the state or by other members of society. Often the introduction of new environmental taxes is preceded by calculations of such externalities, and the tax is set at a level that is intended to recoup that sum (before taking account of behavioural changes which will reduce both the tax revenue and the damage to the environment). Such taxes are sometimes called Pigouvian or Pigovian taxes, after the English economist Arthur C Pigou 17 who developed the concept. The theoretical basis for such taxes is explored further in the author s paper Taxation and the Environment Incentives to work The laws of supply and demand suggest that to impose tax on any activity, thus increasing the cost of engaging in it (or decreasing the benefit obtained from it) will discourage the activity concerned. Thus an income tax (and, specifically, an increase in income tax) will, prima facie, discourage work. The individual who might work hard in order to gain promotion to a more highly paid job; the employee offered the choice of working overtime; the self-employed person with the opportunity of increasing his or her output by working increased hours all these may be deterred from making the effort if they see that the Government will take away 41 pence 19 out of every additional pound they earn, and leave them with 59 pence. This argument is subject to a number of qualifications. People are not motivated to work only by the financial rewards; issues such as self respect, status, and a requirement to be occupied may also play a part, in varying proportions in the case of different individuals. In addition, many workers (employees in particular) may not have the option of working less hard, or for less hours, in return for lower remuneration. Their job demands a certain level of commitment and a certain number of hours, and they can either do the job on those terms or not at all. A third factor is that for those, predominantly the lower paid, who by choice or necessity spend all their post-tax income in order to achieve what they deem an acceptable standard of living, the loss of post-tax income as a result of tax rises will act as an incentive to earn more rather than less. If an increase in income tax discourages work, then a reduction in rates may be expected to give an additional incentive to engage in it. However, this will not necessarily follow. Not everyone is motivated to earn as much as possible; some are content to earn what they see as sufficient for to Available at available at This paragraph draws on material from that paper. This is the marginal rate of tax in the UK for those aged up to 64 who are earning above 43,875. The 40 per cent higher rate of income tax applies above that level, as does the 1 per cent rate of employees Class 1 or self-employed Class 4 national insurance contributions. 14

15 their needs. A reduction in tax rates means, broadly, that an individual can earn the same aftertax income in return for less hours of work. Some will be content to do so, and to enjoy additional leisure. 7.7 Incentives to save Savings may also be discouraged by an increase in direct taxation because, as with earnings, the reward obtained from them in terms of interest or dividends will be reduced by the tax charged. Equally, if indirect taxation is reduced as a proportion of the total tax burden (which is another way of expressing the same shift of balance), then expenditure will be encouraged by lower prices and savings will be discouraged. If the shift in the balance of taxation moves in the opposite direction, increased expenditure taxes may encourage individuals to save rather than to spend, in order to avoid paying those increased taxes, and reduced direct taxes will have the same effect by increasing the post-tax return on savings. Opinions may differ as to whether increased saving is a desirable result. Traditionally thrift has been regarded as a personal virtue, and a high savings ratio as a desirable thing from the point of view of the national economy. In the present recession, however, there is a considerable body of opinion that sees it as desirable to encourage spending, in order to stimulate the economy, rather than to encourage savings. 20 This was the motive underlying the reduction in the standard rate of VAT from 17.5 per cent to 15 per cent from 1 December 2008 to 31 December 2009, announced by the Chancellor of the Exchequer in the Pre-Budget Report on 24 November The differences of view that exist on this matter are not perhaps so much about whether saving is a good thing or a bad thing, but about what level of savings is appropriate to the particular economic circumstances of the moment. 8 Social policy 8.1 Progressive and regressive taxes Expenditure-based taxes (unless specific to particular luxury goods) will tend to be regressive in their impact; ie, they will bear more hardly on the poor than the rich, because in the nature of the case they cannot take account of the personal circumstances of particular taxpayers. This means that governments (and the individuals who vote for them) may hesitate to rely too heavily on indirect taxes, whatever they may perceive to be their revenue-raising, economic, behavioural or administrative advantages, because they are constrained by considerations of morality or social policy. Political factors may also be a consideration if the poor, or those who feel a responsibility to the poor, constitute a significant portion of the electorate Broadly, a Keynsian view. See the discussion in Devereux, Michael and Fuest, Clemens, A Fiscal Stimulus Package for the UK, available at ABF7-AFE CF/0/FiscalStimulusPolicyBriefingNote.pdf. The Chancellor described this in his speech as being intended to deliver a much-needed extra injection of spending into the economy right now. See speech.htm. 15

16 Just as expenditure taxes will almost always be regressive, so taxes on income will almost always be progressive; ie, the rich will pay a greater proportion of their income in tax than the poor. This would not be the case if there was a single rate applied to all income, but a personal allowance or nil-rate band, even if followed by a single rate of tax on the remainder of the income, will always ensure a certain measure of progressivity, in that the average rate of tax on the total income rises towards the nominal rate as income increases, without ever quite reaching it. Any significant degree of progressivity, however, will rely on a graduated scale of rates. The regressive effect of indirect taxes may be a less significant consideration if the government considers that there are in fact very few members of the population who are poor, or that the effects of a regressive tax system on the poor can be adequately compensated for by the operation of the welfare system. However, if (as is usual) poverty is defined in relative rather than absolute terms, then it will always exist as a feature of any society other than one where resources are distributed on an entirely equal basis. 8.2 Redistribution Governments may regard it as part of their function to achieve a more equal distribution of wealth within society, either by means of the tax system or by their spending policies. It is not, however, the case that (progressive) direct taxes will always contribute to that aim while (regressive) indirect taxes will not. Taxes that are proportionate to income, progressive or regressive may all have a redistributive effect. A proportionate or flat rate tax levied at a single rate on all income will have the effect of redistributing from the better off to the less well off, because the better off will pay larger sums in tax while (in theory at least) all may draw equally from the benefits provided by the state. Similarly, a progressive tax redistributes to a greater extent, in the same direction. A regressive tax may redistribute in either direction, or not at all, depending on whether the absolute sum paid by the poorer taxpayer (rather than the proportion that it represents of his or her income) is greater or smaller than the absolute sum paid by the better off taxpayer. As indicated, this analysis assumes that rich and poor benefit equally, in some sense, from the services provided by the state. (This might be an equality of benefit, an equality of outcome, or an equality of opportunity, depending on the particular services in question.) Where they do not in fact benefit equally, this will result from the redistributive effect of spending decisions or personal circumstances rather than of decisions on taxation Economic effects Taxation may be employed by governments as a means of adjusting the economy, contributing to the control of such matters as inflation and money supply. In general the size of the total tax burden will be of more significance in this context than its allocation between direct and indirect taxes. Governments may also wish to consider the effect of tax measures on the health of particular industrial sectors, with the consequential effects on employment and consumption. While particular direct or indirect taxes may affect different industries in different ways, and these will need to be explored before decisions are made, there are (it appears) no useful 22 The last three paragraphs draw on material from the author s paper Taxation and the Environment, March 2008, available at 16

17 generalisations to be made as to the relative impact of direct or indirect taxes as a whole in encouraging or discouraging economic activity. Reductions in indirect taxes will stimulate consumption by lowering prices but, equally, reductions in direct taxes will have a similar effect by increasing purchasing power. The effect of tax changes on inflation is more uncertain. Any reduction in tax will increase purchasing power, and may lead to demand pull inflation. On the other hand, increases in indirect tax may themselves contribute to cost push inflation, while reductions (particularly in VAT) may have the immediate effect of reducing retail costs. There is no entirely predictable relationship; the interaction of taxation with many other factors will need to be taken into account. 10 The UK s VAT system: a special case? The UK s VAT system is unusual in that a significant number of transactions are zero-rated; in particular most foodstuffs. Zero-rating ensures that no VAT cost is passed on to the final consumer. No charge is made by the trader on the sale, but because such zero-rated supplies are treated as taxable (albeit at a zero rate) rather than as exempt, input tax incurred on the costs related to the supply is fully recoverable. This contrasts with the position of exempt supplies, where no VAT is charged on the sale, but neither is a deduction available for any input VAT incurred by the supplier on related costs, so that this forms a cost component of the final sale. Clearly, zero-rating a broad class of everyday purchases limits the effectiveness of VAT in raising revenue. Equally, it limits the impact of the tax on consumers, and thus considerably lessens the regressive effect of VAT, given that the poorest sections of the community are likely to spend a higher proportion of their income on food than the better off, even if they spend less in absolute terms. The effects on behaviour are more difficult to analyse, because of the relatively inelastic core demand for foodstuffs. Keeping the price of food low by not imposing VAT might be seen as encouraging its purchase; however, there is a limit to the demand that can be generated in this way because there is a limit to what anyone can eat. On the other hand, imposing a tax would certainly reduce demand to some degree, but to the extent that food must be purchased in any case a VAT charge would simply reduce the surplus funds available to consumers to spend on less vital goods and services. Thus a tax on one category of goods would have the effect of deterring a different category of expenditure though it might be difficult to say exactly which category. 11 Freedom : an ideological argument Ideological arguments are sometimes made for indirect taxes on the ground that they preserve individuals freedom of behaviour; if they do not like the tax that is imposed on a particular supply, the argument runs, they can avoid paying it either by spending their money on other goods or services, or by saving it. Direct taxes on income, by contrast, leave them with no choice. 17

18 There are a number of objections that weaken the force of this argument. First, some goods are necessities or near-necessities if a reasonable standard of life (however defined) is to be maintained, so there is no choice as regards purchasing these. Any indirect tax imposed on them effectively becomes compulsory. It is true that in some countries, such as the UK, foodstuffs are not charged to VAT. However, this does not mean that the prices charged for these goods are unaffected by indirect taxes more generally; for example, the costs of manufacture may be increased by the climate change levy on power supplies, or the cost of transporting the goods may be increased by excise duty on road fuel, and these costs will be reflected in the retail price. At a more remote level, the cost of living (including indirect taxes) will be reflected in wage settlements for the workforce involved in manufacturing, selling or otherwise dealing with the goods. Secondly, indirect taxes may indeed offer the taxpayer a choice, but a choice between two forms of constraint does not constitute freedom. An individual who would like to purchase certain goods or services, or to engage in certain activities, but is deterred by the cost, has had his or her freedom of action limited as certainly as the individual who must pay direct taxes. Thirdly, if the ability to opt for an unsatisfactory lifestyle in order to save tax on expenditure is to be accounted freedom, then the individual who opts to earn (and spend) little in order to avoid direct taxes is enjoying the same sort of freedom. It is true, however, that choices as regards direct taxes are more likely to be all or nothing lifestyle choices (for example, decisions on what employment to accept), whereas efforts to save indirect tax can be undertaken on a much more selective and piecemeal basis. 12 Conclusions There is no clear winner in the contest between direct and indirect taxation. Indirect taxation probably has the advantage for governments in terms of revenue raising, flexibility and administrative convenience. It also enables the achievement of more precisely targeted behavioural effects than direct taxation. Its major disadvantage is its regressive impact, which may well conflict with governments social objectives or require compensating measures to be put in place through the welfare system. For taxpayers, the balance of advantage depends very much on their individual circumstances, and on detailed government decisions on particular taxes, rather than on the simple choice between direct and indirect taxation. Again, however, the regressive nature of indirect taxes may have a major impact on preferences. 18