Is the UK’s tax burden too high?

Introduction

On December 2 2018, Jacob Rees-Mogg tweeted “The tax burden is too high”. His assertion derived from an analysis of historical data undertaken by the Taxpayers’ Alliance (TPA) which had been commissioned by the Sunday Telegraph. The TPA reported that the tax to GDP ratio had reached a new high of 34.6%, breaking the previous high of 34.3% seen in the early 1960s.

What does “too high” mean?

It seems reasonable to assume that “too high” in this context means that the tax level is impeding GDP growth; it’s not easy to think of a second reason for tax to be too high. This made me wonder whether there is an objective basis for asserting that tax is too high and prompted me to investigate whether a link between a nation’s GDP and its tax level exists.

Methodology

I chose the year 2016 (for which complete data exists), and because it is recent, to examine whether a link exists. I used all 35 countries comprising the OECD (Lithuania was not then a member) to get a sampling frame of sufficient size and because these countries are considered to be developed. The UK is a member of the OECD.

To measure the tax level of a country I used “tax as a percentage of GDP” published by the World Bank for the year 2016. I then classified each country as “high tax” if the country’s measure was higher than the OECD average (published by the World Bank) and “low tax” if the measure was below.

To measure the affluence of a country, I used “GNI per capita” (at PPP) for 2016, also published by the World Bank. I classified each country’s affluence as “rich” if its GNI/capita was above the published OECD average and “poor” if the GNI/capita was below. The terms “rich” and “poor” to denote a county’s affluence have been assigned for convenience and are not intended to be literal.

I then set up a 2 x 2 contingency table and applied a Chi-squared test with one degree of freedom to test whether a significant link between tax level and affluence existed. I used Yates’ continuity correction  in calculating the test statistic as recommended by the literature. The contingency table is show below.

Chi Squared table

Results

The Chi-squared test statistic, adjusted for Yates’ continuity correction, came to 0.00288.   This is well below the 5% significance level of 3.84 for a Chi-squared variable with one degree of freedom. A test statistic value of above 3.84 would be strong evidence that a nation’s tax level and national income are linked (one influences the other). Because the test statistic returned such a low value there is insufficient evidence to support a hypothesis that national income and a nation’s tax level are linked, at least for OECD members. In plain English, there is no discernible link between a nation’s level of taxation and its national income.

Conclusions

The claim made by Jacob Rees-Mogg and the Taxpayers’ Alliance that UK tax is too high does not stand up  when a cross sectional analysis is undertaken. A simple time series analysis on the UK’s “tax as a percentage of GDP”, as conducted by the TPA, is insufficient to conclude whether tax is either too high or too low. This is because the time series analysis says nothing about the consequences of tax levels on national income (or some other variable of interest).

Jacob Rees-Mogg is remunerated (rather well) by taxpayers. Many voters would say they deserve better than his shoddy, scantily-evidenced assertion.  It is also disappointing to discover that the study by the Taxpayers’ Alliance lacks sufficient rigour to support a meaningful conclusion. The TPA’s audiences should be wary – this example shows it does not seem to engage in research of sufficient depth to support its conclusions!  Is the TPA subordinating sound methodology to ideology  here? It seems so. Readers beware!

Appendix: World Bank source data

World bank data

 

 

Value Added Statements for Dummies

This is a short presentation to demonstrate how value added statements are prepared and to explain how they differ from the accountant’s traditional profit or loss account. A single example will be used which will capture the essential differences.

Example

Below is shown a firm’s statement of profit or loss and value added statement. The two statements are shown side-by-side for ease of comparison.

During the period, the firm purchased plant and machinery for use within the business at a cost of £30m. Because this is capital expenditure, there is no entry in the statement of profit or loss to record this purchase. In the value added statement, the £30m cost appears against “bought-in materials, goods, and services” to obtain the “net value of output” figure. The firm’s investment activity is then shown by the investment adjustment to arrive at “net value added.”

VAS for dummies

Derivation of value produced figures

Bought-in materials, goods and services is equal to the purchases figure taken from the profit or loss statement (£80m) plus the capital expenditure (£30m).

The inventory adjustment is equal to the closing inventory minus the opening inventory. If this figure is positive then it represents additional investment in inventory. If negative then it represents disinvestment in inventory.

The depreciation adjustment is the total depreciation charged to the profit or loss account. This will usually be shown as a negative figure in the value added statement and represents consumption of capital in the period.

The investment adjustment is equal to the capital expenditure during the period. If this adjustment is positive then investment in new productive capacity has occurred. If negative, then disinvestment in productive capacity has occurred. The new productive capacity may consist of either tangible or intangible assets or some mixture.

Derivation of value distributed figures

To pay employees is the wages figure taken from the profit or loss account. The figure should include employer’s on costs, including employer’s National Insurance Contributions, and other employment taxes where they exist

To pay government is the sum of business rates and corporation tax charged to the profit or loss account. The figure represents the contribution the firm makes to the upkeep of the nation’s infrastructure and public services that enable firms to flourish.

To pay rentiers is the sum of property rents, licence fees, patent and copyright charges and the like. Payments to parties who derive income from ownership rather than from provision of a service or goods are recorded under this heading.

To pay financiers is the sum of interest charges in the profit and loss account plus dividends paid in the year. Payments of interest and dividends paid should be offset by interest and dividends received. Interest and dividends received are distributions of  value added produced by other firms. 

Undistributed value is equal to the retained profits shown in the profit or loss statement.

Negative Income Tax For Dummies

Personal Allowances

The UK income tax system ostensibly gives all income tax payers an identical allowance which exempts the first slice of an individual’s market income from income tax. This exemption is known as the personal allowance and is set by parliament each year. For the current year it stands at £11,500.

Basic Rate (20%) Tax Payers

The personal allowance typically reduces the amount of income tax a basic rate tax payer must pay on their market income by £2,300 pa. However, if a basic rate tax payer’s market income is below £11,500 p.a. they do not receive the full benefit of the annual personal allowance. This is arguably a weakness with the UK’s current income tax arrangements.

Example

Susan earns £10,000 p.a. Her tax-free personal allowance is £11,500 p.a. This means she currently pays no income tax and her disposable income (ignoring her National Insurance Contribution) is £10,000.

Comment

If Susan had no personal allowance she would have paid income tax of £2,000 (£10,000 x 20%).  The personal allowance has saved Susan £2,000. Had Susan earned £11,500 in the year she would have saved £2,300 in income tax. Because she had only £10,000 of income to offset against her personal allowance of £11,500 Susan has £1,500 of unused personal allowance remaining. In the UK personal allowances can not be carried forward to be utilised in following years. Nor can personal allowances normally be transferred  to someone else or be traded –  it’s a case of use or lose.   

Is there a better way of administering income tax whereby surplus personal allowances would not be wasted if they remain unused at the end of a tax year? An answer to this question is “Yes, negative income tax”.

Negative Income Tax

Giving a taxpayer an annual personal allowance of £11,500  costs the government up to £2,300 in lost tax revenue. In Susan’s case, because her market income is below £11,500, the cost to the government of Susan’s personal allowance is £2,000 in lost tax.

Negative income tax departs from the current income tax system by paying out the value of the personal allowance (the tax shield) in cash to each and every qualifying citizen. To  help fund this apparent largesse, income tax would be collected and calculated without reference to personal allowances.

In Susan’s case, income tax of £2,000 would be deducted by her employer and remitted to HMRC. Susan’s net pay from her employer would therefore be £8,000.  Susan, along with all qualifying citizens, would receive from HMRC an annual amount equal to the value of her tax shield (£11,500 x 20%)  The following table summarises:

Tables

At the year end Susan’s income is £300 higher than her gross market income. This £300  is the value of her surplus personal allowance (£1,500 x 20%). So effectively Susan has been allowed to claim back the value of her unused personal allowance as a “refund” from HMRC. 

Cost

In Susan’s case, HMRC has paid out to Susan £300 more than she has paid to HMRC. So HMRC has a deficit while Susan has a surplus. So how will HMRC fund its deficit? 

Firstly, because Susan is on a low income there is a probability that she is on a means tested benefit, such as the dreaded Universal Credit, to augment her low market income. The benefits agency (DWP) may reassess Susan’s financial circumstances and adjust her award to take account of Susan;s additional source of non-market income. So the government may claw back all or part of Susan’s increased income to eliminate its deficit at HMRC.

Secondly, although Susan has a surplus with HMRC, many taxpayers will have a deficit. It is only qualifying citizens with market incomes below £11,500 who will be receiving more from HMRC than they pay in income tax.  Many taxpayers will be paying income tax far in excess of the £2,300 they will be receiving each year from HMRC. Deficits and surpluses would offset  each other

Purposes of Negative Income Tax

Firstly, to make the income tax system fairer. Currently, those with a market income of above £100,000 do not receive a personal allowance. Introducing a non-means tested negative income tax would enable policy makers to restore the tax shield to high income recipients. 

Secondly, to provide an enhancement to low incomes,  albeit a modest one.

Thirdly, to give every qualifying citizen a guaranteed, obligation-free income, although a small one. It should help individuals to better absorb and weather the shocks that humans are heir to, including those shocks administered by DWP.

Unlike Universal Basic Income (UBI), the purpose of NIT is not to replace contingent benefits, although some means’tested benefits may be reduced as a consequence of NIT’s introduction.

Qualifying Criteria

Every natural person of working age AND registered to vote in UK elections should qualify, irrespective of income. Qualifying individuals would include job seekers, students, disability benefit claimants, employees, self-employed persons, stay-at-home parents, rough sleepers, and prisoners (subject to voting rights). People of state pension age would be excluded.

Summary and Conclusions

The aims of the particular NIT scheme discussed are modest. The scheme is specific to the UK’s income tax system. The scheme provides an opportunity to equalise treatment of different income groups in respect of the operation of personal allowances, otherwise referred to as a tax shield. The parameters of the proposed scheme, that is the NIT rate and the size of the personal allowance, are under the control of the UK parliament and can be altered to suit. The scheme shares features of Basic Income, eg, it is obligation-free, it is not means tested, its coverage is universal (subject to fraud safeguards), and it supports active enfranchisement of disengaged voters. It also provides a small cushion against  loss of income and failure of the social security system. Although modest, the benefits would be real and in excess of its costs. 

Appendix 

The impact of Negative Income Tax on higher and additional rate taxpayers

Higher Rate (40%) Taxpayers

 

Example

Stephen has an annual market income of £80,000

Stephen 1

Stephen 2

Stephen would pay £2,300 more under this particular NIT scheme than he does under the current income tax system. This is because HMRC is paying out at 20% x £11,500 while the lost personal allowance brings in 40% x £11,500 to HMRC.  HMRC is in surplus.

 

Additional Rate (45%) Tax Payers

For annual incomes above £150,000 the income tax rate rises to 45% and no personal allowance is available. 

Example

Frances has an annual market income of £170,000

Frances 1

 Frances 2

Frances would pay £2,300 less under this particular NIT scheme. This is because in the current income tax regime taxpayers with market incomes above £100,000 have had their personal allowances completely withdrawn. The receipt of NIT of £2,300 from HMRC consequently would reduce tax payable in cases such as this. 

Should the poor be afraid of a “Flat-rate” tax?

I believe it depends on three things:

  1. How income is defined;
  2. The tax-free personal allowance; and
  3. The tax rate

Realised comprehensive income

In the UK there are three taxes that could be consolidated into a single income tax. These three taxes are Inheritance Tax, Capital Gains Tax, and the current income tax. All three levy tax on assets that flow from one party to another. Each of the three taxes has a separate and different  tax free allowance associated with it and are taxed at different rates.

A realised comprehensive income tax would make no distinction between these asset flows – all flows would be taxed as income. The annual inflows of assets received by an individual from the three sources would be aggregated and taxed as realised comprehensive income after deducting the individual’s annual tax-free personal allowance.

The advantages of a realised comprehensive income tax are:

  1. Simplification. Inheritance tax and capital gains tax would be brought under a single regime;
  2. Less incentive would exist to engage in tax avoidance;
  3. Legacies would be taxed according to the recipient’s circumstances, not the donor’s. This is more just as the recipient’s entitlement to the assets has not been derived through labour or through an identified contribution to society. Many donor’s feel resentment when it is their circumstances that determine the tax due on bequests, as is the case currently.

The annual tax-free personal allowance

Rolling up all three types of income into one obviates the need to have separate tax-free personal allowances for each of the three sources. Setting a single annual tax-free personal allowance of, say, £50,000 would provide generous relief to those whose comprehensive incomes are low or in the middle. It also supports simplification of the tax system.

The tax rate

In the presence of an annual tax-free personal allowance a flat-rate tax would by definition be a marginal rate (not an average rate).

Many ‘small-staters’ and their ilk hold that the state’s share of someone’s income should never exceed 50%. Setting the marginal rate of income tax to 50% respects this limit because of the annual tax-free personal allowance. In fact, many individuals with taxable income will have average tax rates that are far below the marginal tax rate of 50%.

Example 

Suppose the annual tax-free personal allowance has been set to £50,000 and the single rate of tax is 50%. An individual with a realised comprehensive income (earned + unearned + capital gains + bequests) of £100,000 would be liable for tax of

 0.5 x (£100,000 – £50,000) = £25,000

which is 25% of realised comprehensive income received in the year.

Here is a graph which shows average tax rates against realised comprehensive income in a flat-rate tax system with the parameters described above.

Image

The average tax rate will get ever closer to the 50% marginal rate as comprehensive income gets larger and larger.

Conclusions and Summary

What I have shown is that flat-rate taxes, so often proposed by ‘small-staters’ et al, should not axiomatically be feared. This is because the fairness of such schemes can depend on their parameters and the definition of income. Flat-rate taxes need not mean low-taxes, as hoped for by their proponents. The battleground is really about the parameters of such a scheme, not about whether a flat-rate tax system is desirable in itself. A judicious selection of parameters can ensure equity, whilst simultaneously meeting the objections of ‘small staters’ to wealth taxes and high average tax rates on conventional income.

I suggest, in the wake of Piketty, that taxing flows of assets as income is a more feasible way of addressing runaway inequality than imposing taxes on stocks of assets (wealth taxes). The exception to this rule would be a land value tax, which can be perceived as a rental charge on privately sequestered natural assets. It is difficult to sustain a moral objection to taxing  a stock in the case of land.

I have not attempted to cost out this flat-rate tax proposal, either with the proposed or alternative parameters. It may be that a flat-rate tax system would raise less than the current sum of capital gains tax, inheritance tax and conventional income tax. If so, then perhaps a Land Value Tax would be needed to plug the gap. The challenge, as I see it, is to find ways of financing generous public services whilst simultaneously defeating the (sometimes spurious) moral objections that Libertarians et al advance.