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Letwin: We will simplify Gordon Brown's complex tax system

Speech to Politeia

I have to begin with an apology. This is not the speech you were expecting or hoping to hear.

That speech is about tax and spend - the level of government spending and the level of tax. That speech is in February.

This speech in January is about the structure of tax. It is about a new road-map for tax.

As I say, I apologise for confounding your expectations today. But I don't apologise for my subject matter - because whilst the debate on tax is vigorous, it is oddly incomplete.

The commentators talk a great deal about the enormously important question of the level of taxation but much too little about the structure of taxation.

In other areas of economic policy we have enriched the debate by moving beyond a purely quantitative analysis.

Public spending is a good example.

Taxpayers are increasingly disinclined to see their own money merely thrown at problems, when it is plain that the old prescriptions don't work. Our plans for radical reform of the NHS and schools are aimed at changing the culture and getting more 'bang for the buck' - by giving patients and parents the power to take taxpayers' money to the hospitals and schools of their choice, so that we can remove the vast top down bureaucratic systems and let the professionals get on with the job of satisfying the demands of their patients and parents. Through such new, open structures, in which professionals are freed and made accountable to consumers, we believe we can transform the quality of public services.

In the same way, when it comes to the question of tax, we should, as well as asking "how much?", pause from time-to-time to ask "how?"

Approaches

Gordon's geese

Gordon Brown's approach to the "how" of tax is partly inspired by Jean-Baptiste Colbert, finance minister to Louis XIV.

Colbert defined the art of taxation as "plucking the goose [so] as to obtain the largest number of feathers with the least possible amount of hissing."

It is odd that our latter-day Colbert did not heed the advice of his colleague, Frank Field, who said in 1997: "The age of the quiet taxpayer is peacefully drawing to its close; the time when we, as politicians, can happily put our hands into taxpayers' pockets and draw out at will is passing and will continue to pass with greater speed."

Field's warning came as New Labour took office, but Gordon Brown was nevertheless determined to gather his fistful of feathers.

From Colbert-Brown's point of view, the introduction of new taxes does not matter, the growing opacity of the tax system is not a concern and the bewilderment of taxpayers is no cause for regret.

If increased complexity is the necessary by-product of increased revenue, then that's OK with him.

Gordon's 'improvements'

The attitude of the current Chancellor is not, however, exclusively influenced by Colbert.

The Chancellor is also much influenced by his own brilliance. He has come to believe that, by exercising sufficient ingenuity, he can use the tax system to change the behaviour of investors and businesses, and thereby achieve a multitude of effects beneficial to the economy and the environment.

This sense of his own brilliance, and of the beneficial environmental and economic effects of proliferating tax schemes and tax incentives is another cause of increasing complexity in the tax system.

It is, of course, in the nature of Labour Chancellors to regard the complex thoughts of one man as superior to the simple decision making of the masses.

As HL Mencken once said: "A Progressive is one who is in favour of more taxes instead of less, more bureaus and jobholders, more paternalism and meddling, more regulation of private affairs and less liberty. In general, he would be inclined to regard the repeal of any tax as outrageous."

The problems of complexity

There is another body of opinion about tax structure that regards complexity, as a significant disadvantage.

According to this, other view - which I hold - the increasing convolutions of the tax system under Mr Brown have the potential to mislead and misdirect the taxpayer, creating impediments and distractions, incentives and disincentives that are at variance with economic efficiency, business instincts and common sense.

The signs that the tax system has become too complex abound. Tolley's yellow tax handbook, a guide to current legislation and statements of practice has ballooned in size to 7,344 pages spread across 4 volumes this year. In July 2003, the President of the Chartered Institute of Taxation said that: "people have difficulty in understanding how the system affects them. Not even MPs understand it". A recent NAO report revealed that about 30% of completed self-assessment tax returns required time-consuming "repair" by staff before they could be input, and the CBI recently commented, with admirable restraint that: "complexity is perceived to be an increasing problem".

I believe that a significant, though probably unquantifiable part of the explanation for the Chancellor's failure to close the so-called productivity gap is the adverse effect that his complex tax structures have had on managers - particularly the managers of small and medium - sized enterprises. For such managers, who cannot afford to create vast teams of lawyers and accountants to negotiate Mr Brown's thicket, complex tax schemes mean diverting time from concern with productivity and commercial competition into reducing tax bills. Ultimately, if the short-term rate of return on time invested in managing complex tax effects is greater than the short term rate of return on managing the business, then the temptation to attend to tax rather than business will be very great, even if the long term economic effects are poor.

The complexities of simplification

If complexity is the problem then simplicity is the solution.

But we cannot be simplistic about simplification.

Reforming the tax structure is fraught with complications.

Not least, there is the tendency of simple taxes to get more complex over time.

Consider the example of a straightforward tax on income - which would do nothing more complicated than to tax wages at particular rate.

Before long, one would see a shift from cash in the wage packet to benefits in-kind, thus undermining the tax base.

Of course, one could start taxing in-kind benefits, but which ones? And how would one assess their value? Very soon, the current complexities of our dearly beloved income tax could be replicated.

Another example is provided by the Chancellor's attempt to cash in on the house price boom by increasing Stamp Duty.

This is a simple tax, with higher rates kicking in as soon as the price of a house falls into a higher band.

To keep prices just below the trigger point, it is suspected that some sellers have been artificially reducing asking prices by artificially inflating the price of household items which are sold separately from the house itself and which do not attract Stamp Duty.

In response, tax officers have been dispatched across the country to assess the true value of our fixtures, fittings and furnishings.

So though Gordon Brown may not yet be ready to measure the curtains at Number 10, he's getting plenty of practice elsewhere.

The point is that changes to the tax structure are as much about evolutionary adjustment to reality as deliberate reform.

The temptation to tear up the tax structure and start again must be resisted, because it is unlikely that any grand plan for reform could be so sophisticated as to improve on decades of fine-tuning through trial and error.

It is more likely that a revolutionary Chancellor would be tied up in knots as the unforeseen consequences of wholesale change required endless modification.

Guiding principles

None of this means that we should abandon all hope of reform.

Indeed, we must embark upon a programme of methodical, long-term reform, working to a set of clear and consistent principles.

Today I want to set out five such principles, which together describe a road map to a better tax structure.

Neutrality

The first of these is neutrality.

Whether a truly neutral tax system is possible is a moot point.

There are certain tax-related value judgements that cannot be avoided - for instance, on the balance between the taxation of income and the taxation of consumption, or the balance between the taxation of business and the taxation of households, or the balance between the taxation of commodities and the taxation of assets, or the balance between the taxation of some commodities and the taxation of other commodities, or the balance between the taxation of some assets and the taxation of other assets—and so on and so forth.

Wherever the balance is struck, decisions on such fundamentals are bound to influence economic behaviour.

Moreover, there are other considerations which need to be borne in mind, and which frequently prevent neutrality from being fully achieved. I shall dwell on some of these in a moment.

But this doesn't mean that we should give up on neutrality, any more than the arguments against revolution mean that we should give up on reform. Starting from where we start, there is ample scope for evolution of the tax system towards a state of greater neutrality. The first step in such an evolution is to adopt an unwavering scepticism about the use of the tax system as a means of achieving an economic New Jerusalem.

Whilst is perfectly possible to structure changes in tax so that they favour long-term over the short-term investment, or manufacturing over the service sector, or R & D over labour, or almost any factor or type of production over almost any other factor or type of production, to do so is rational only if the Chancellor is in a better position to judge what will create economic efficiency than those whose business it is to make such decisions in relation to their own firms or their own money.

What gives anyone any reason for supposing that this is so? What vast Weberian advantage does the Treasury have over the market? Of course, there may be market failures. But why should we have confidence that the Government know what they are or how to cure them? Government doesn't know better.

Even if it did, the tax system provides the bluntest of instruments, imposing the same conditions on everyone, irrespective of regional variations, local conditions or any of a thousand other factors.

And even when a tax instrument can be fashioned to adjust more closely to particular circumstances, the resulting complexity is likely to result in compliance costs and distortions.

An interesting recent example is the present Chancellor's decision to award 100% immediate tax allowances for the production costs of low-budget British films.

Someone had presumably told the Chancellor that this provision would be cheap, and would encourage the growth of an indigenous film industry that investors were too stupid to invest in.

The Treasury estimated the fiscal cost at £40 million over 5 years. They turned out to be wrong by a factor of 10. The cost was in fact more than £400 million over five years, as Dawn Primarolo subsequently admitted.

This was partly because soap operas on TV started to benefit, and partly because—through sale and leaseback contracts—wealthy individuals found that they could shelter several years' entire income from tax, using the provision.

Inevitably, the Inland Revenue has taken action to plug these 'loopholes'—which were entirely of their political masters' own making—in a series of adjustments in 2002 and now, again, in the Pre-Budget Report this year. It remains to be seen what collateral and unintended damage these anti-avoidance provisions will do. But it can confidently be predicted that the Chancellor, whose £40 million scheme is now projected to cost him just shy of £1 billion, has not the slightest idea.

So when it comes to business, a Chancellor should exhibit a general tendency to mind his own. He should, so far as possible, aim at a neutrality which allows economics to take their course, rather than imagining that he is much cleverer than the market.

And that applies to environmental policy too.

Of course, to tax bad things, and leave good things alone, seems like common sense.

Certainly, it provides the thinking behind so-called 'green taxes'.

After all, shouldn't the polluter pay?

Yes indeed, but preferably through some form of direct payment to those who are adversely affected or to those whose resources are being used up. We should be deeply sceptical about efforts to achieve the same effect through the tax system.

And there are many reasons why:

As soon as one turns an environmental problem into a revenue stream, government has an incentive to perpetuate the problem.

Then there is a general distorting effect on environmental policy, which becomes skewed towards those areas most likely to generate tax revenues.

And by obscuring the fiscal rationale for a tax with non-fiscal considerations, the risk of inequitable taxation escalates, as was the case with the fuel tax.

This, is, of course, intended as a statement of direction, not of dogma. I accept that there will be occasions on which, for one reason or another, the argument for some particular tax or tax break to achieve or promote some particular effect are sufficiently strong to outweigh the general argument for tax neutrality. And I accept that no movement towards neutrality can be fast. But we need to be guided by lode stars, and neutrality is one of mine.

Economically and environmentally, tax neutrality has much to commend it.

Now, more briefly, I turn to the other four principles.

Competitiveness

The second principle is competitiveness, which can again be illustrated by the example of environmental taxation.

It is, as I have mentioned, characteristic of pollution that its cost is borne by persons other than the polluter, an example of what economists call an externality.

Green taxation is one way of dealing with such externalities.

Unfortunately, another characteristic of pollution is that it respects no boundaries.

And neither, in a liberal economy, does competition.

Thus in the absence of international harmonisation, the effect of green taxes can be to give a competitive advantage to the least responsible nations, which is economically and environmentally self-defeating.

Indeed, all uncompetitive taxation is self-defeating, eroding as it does the capacity of the taxpayer to pay tax - assuming, that is, the taxpayer hasn't left the country to pay tax at a more competitive rate elsewhere.

Efficiency

The third principle is efficiency.

While Conservatives oppose the Labour and Lib Dem preference for higher taxes, we seek to preserve a stable tax base.

Thus taxes should be structured so as to raise revenues reliably and predictably.

And, of course, efficiency requires that the cost of collection be as low as possible.

Transparency

The fourth principle is transparency - and the best way to make the system more transparent is probably to reduce the number of components. Nigel Lawson - who was a great, reforming Chancellor when it came to the search for neutrality and transparency in the tax system - had, I believe, an ambition to get rid of one tax per Budget. A truly admirable ambition.

It is not quite as difficult to achieve as one might suppose. There are currently 18 main taxes, not to mention all the fiddly bits. But some 92% of the total tax take comes from seven of them. At the other end of the scale, the Government's Aggregate Levy, for example, raises less than a tenth of a percent of total revenue, and can - I think - fairly be said to violate every one of my five principles. Such structures are almost as capable of alienating the people from their government as the burden of the taxation itself.

Fairness

The fifth and final principle is fairness.

Our tax system, like all other tax systems, abounds with injustices, anomalies and moral hazards.

Some are specific. For instance, many charities are unable to recover VAT, leaving them at a permanent disadvantage vis-a-vis public and private sector organisations when bidding for public service contracts. Or again, people who perform a social service by meeting the costs of caring for an elderly relative receive no recognition of their costs from the tax-man.

Others are general. For instance, many taxes rely on inadequately verified declarations that effectively place a tax on honesty.

Then there is the tendency of this Government to raise taxes, thinly disguised as fines, from the basically law abiding citizen who falls fouls of the tightening net of improperly placed speed cameras and other bureaucratic traps.

Meanwhile, as the easy cases are squeezed till their pips squeak, one has the dreadful sense that some real villains are so far outside the net that they are difficult for the system to catch.

The link between quantity and quality

While we're on the subject of fairness, it would be only fair to point out that the five guiding principles for a better structure are not always easily reconciled.

A neutral tax system may not be competitive if our competitors decide to slash taxes on certain industries.

An efficient tax system may not be fair if low collection costs are achieved by slashing exemptions that prevent people being taxed twice on the same income.

As always in politics there are compromises to be struck and hard choices to be made.

However, one thing is clear: the higher the level of tax, the harder it is to achieve any of our five objectives, let alone reconcile them to one another.

Or to put it another way, lowering the level of taxation raises the potential for a better tax structure - as this simple thought experiment makes clear:

Imagine that, due to tight spending controls and a growing economy, there is an overall reduction in the need for taxation. Imagine that, as a result, a particular tax is abolished wholesale. The Chancellor of the day will not have to be any kind of genius to find a tax, the abolition of which will make the system more neutral, more competitive, more efficient, more transparent and fairer.

Imagine, on the contrary, that loose control of public spending and sluggish long-term economic growth increase the overall need for taxation. How many Chancellors will have the ingenuity to find a way of adding a new tax that is simultaneously competitive, efficient, transparent and fair?

The general truth that emerges from this thought-experiment is part of the reason for the Conservative ambition to reduce tax.

We are motivated by the belief that hard working families should be allowed to keep more of their money, and by the desire to prevent inefficient public spending from damaging the economy.

But we are also motivated by the desire gradually to establish a better tax structure, which becomes possible for two reasons:

First, because as the thought-experiment illustrates, when the overall tax burden comes down, it becomes easier to abolish whole categories of tax - just as when taxes are raised, categories tend to multiply in order to spread, or at least conceal, the increasing load.

And second, because even the remaining imperfections in the tax structure don't cause as much discomfort when the burden is lighter.

Conclusion

In the last few years, we have been moving in the wrong direction. Tax has been rising - and, if Gordonomics continue, it will rise further. With the rises in tax levels, we have been seeing, and we will (under Gordonomic conditions) continue to see, rising tax complexity and opacity, diminishing tax-competitiveness in many areas, little regard for tax neutrality, and a considerable amount of unintended additional tax-inefficiency and tax-unfairness.

It will be one of our purposes, if we are elected as the next Government, to begin to reverse these directions of change. We acknowledge - as I have acknowledged today - that we cannot sensibly seek to re-invent the tax-structures overnight. But, fortified by a renewed emphasis on medium-term public expenditure control, we can, and we should and we will move towards a structure which is more neutral—bearing in mind, as we do so, that it should also, as far as possible, be more competitive, more efficient, more transparent and fairer. By being less confident of our ability to improve matters through tax, we hope in practice to do less damage through tax.

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