Flat Rate Income Tax - Just Wishful Thinking?

A Flat Rate Income Tax System - Just Wishful Thinking? - at www.moneyweek.com - the best of the international financial media

The idea of a flat rate income tax system is attractive, and the arguments in favour are well rehearsed. It is simple, transparent to the taxpayer and easy to manage, with low administrative costs; it enhances the incentive to work; if it is extended to investment income it encourages the saving and investment necessary to stimulate economic growth in a competitive global market; it attracts entrepreneurs from abroad to a business friendly environment; it provides the conditions for increased employment; counter-intuitively, and given a sufficiently generous non-taxable personal allowance, it favours the lower paid over the affluent; and it quickly leads to higher tax receipts that enable government spending elsewhere.

Flat rate income tax has existed for many years, but has only recently attracted widespread attention after its adoption, to good effect, by several East European countries. On the evidence, which is becoming extensive, there is little to object to and, yet, it is likely to be difficult to introduce such a system to the UK, principally for reasons of short-term affordability and popular perception. It is an unfortunate fact that, whilst the benefits of a flat tax have been widely discussed by a growing number of advocates, the considerable obstacles that could decisively frustrate its realisation in the UK have largely been ignored. These difficulties need properly to be exposed and addressed if flat tax is not to remain wishful thinking.

However desirable a flat rate may be, it is doubtful that such a radical change to our tax regime could or should be made without a prior 'in principle' general election commitment. Consequently, any proposal must have wide appeal and strong credibility, leave few losers (especially amongst low-income earners) and be demonstrably affordable with low risk.

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This is not easy. A single rate that, on its own, leaves income tax receipts broadly unchanged (around 18.5%) will disadvantage all but the upper quartile, and the personal allowance necessary to alleviate that penalty will inevitably push the rate higher still if receipts are not to be prohibitively eroded. Richard Teather's model in "A Flat Tax For the UK; A Practical Reality" assumes a 22% flat rate of tax and a £12,000 personal allowance to balance the equation. It leaves no losers, ensures that those on just-below average incomes benefit most, and sees that the poorest third of all earners gain proportionately more than the richest third. It is bold and inescapably eye-catching.

But it is also £50 billion short of cost neutrality, and relies upon unduly optimistic (and wildly different) assumptions to close the gap - notably, savings from public sector waste. Such efficiencies are notoriously difficult to realise and, in any case, £20 billion's worth identified by the Gershon Spending Review is already committed. Nor is it clear that the uncompromising discontinuation of allowances Teather proposes (with savings of up to £12 billion) is practical in the short term - the UK is not, like some others, starting with a near clean slate. Thirdly, whilst some benefit can be expected to accrue from the reduced bureaucratic cost of administering a simplified system, and from the reduced incentive to avoid tax, it is too unpredictable to rely on. And finally, it is unlikely that receipts will rise sufficiently over 3 years to cover the deficit, as Teather suggests. On the contrary, historical data indicate that it could take up to 6 years to achieve the 30% necessary increase in revenue. In sum, it would be imprudent to assume an initial funding gap of much less than £40 billion on Teather's model, and no measure can survive scrutiny that leaves a budgetary black hole equivalent to 9.5% of total public sector receipts and 138% of public sector in-year borrowing.

But nor will it be easy to reduce the deficit to more reasonable levels. A new flat rate cannot realistically exceed the current 22% basic rate without raising potentially insurmountable presentational difficulties (ie, the impression of a tax rise for most people), and a personal allowance of any more than the present £4745 will fail to achieve broad cost neutrality. Yet a significantly increased threshold will be necessary to spread the benefits equitably and widely, to maintain the projects allure, and to avoid (comparatively) insupportable disadvantages for low earners.

Another option is demanded, and a range of solutions, or contributory measures is possible to bridge the gap. Inevitably, they involve diluting Teather's - very attractive proposal or raising revenue by alternative methods at least in the short term - and there is a risk that they could undermine the credibility and appeal of the broader concept. Because of this, any enabling measure must form part of a transparent, structured and predetermined process that protects the public's confidence.

One partial solution may be to delay the full benefit of a reduced flat rate for the best paid, by temporarily retaining the 40% rate for earnings over £100,000 (£11.5 billion). Another may be to limit the personal allowance threshold to £8,000 (£25 billion) or £10,000 (£12.5 billion). Public sector expenditure could also be frozen in money terms (£13 billion), or more could be borrowed - an increase to 4% of GDP could generate £13 billion. More controversially, National Insurance Contributions could be increased, perhaps as a precursor to other reforms, such as funding for state pensions (a 1% increase in NICs could raise up to £6.5 billion); or Value Added Tax could be raised, temporarily, to the EU average of 19% (£6 billion) this would least affect those whose proportion of expenditure on non-VAT rated necessities was highest. This list does not pretend to be exhaustive but, given the vast sums involved, it is inescapable that income tax, VAT, NICs or public sector expenditure as a whole must form part of the solution.

Except, perhaps, for stopping the inexorable growth of the public sector (and, even here, the time may not yet be right), none of these options is attractive; each, for as long as it is necessary to implement, will detract from the beneficial effect of a low and flat rate income tax system; each brings with it a significant presentational challenge, perhaps none more so than increases in NICs or VAT which would need to be tied to a clear undertaking on subsequent intentions; each will limit the scope for other government measures and reforms, at least initially; each presses home the reality that having ones cake and eating it is not a choice.

Some may consider the short and medium-term cost ascribed here to introducing a flat rate tax to be unduly inflated, but the margin for error in any calculation of this sort is highly significant and, with huge numbers upon which to make an error, the potential downside is no less important, if only for the debilitating effect that it could have upon the credibility of the project and the government that sought to bring it in. Hence, a degree of caution is essential; it is far wiser to invest up front by selling the concept with its warts and all, subsequently to benefit (politically and economically) from any windfall that befell, than to be caught downstream without the proverbial barge-pole. What is clear is that an affordable solution is possible, albeit boldness is essential to making it happen.

Much relies on marketing - perhaps the greatest challenge of all, and the area that has, so far, been neglected. Many will be wary of change on this scale, because they are uncomfortable with change, because of the likely severity of even a marginal miscalculation, or because of the potential for unforeseen consequences; hence, there is a particular need for transparency and prudence. Many more will be un-persuaded, even by arithmetic evidence and historical precedence, that a flat tax will not benefit the wealthy at the expense of the least well paid. A popular consensus or strong presumption still exists, encouraged by a not-yet discredited or antiquated ideology, that only progressive taxes are fair; it will take a great deal (of time and careful effort) to dispel that notion, including amongst the affluent, who are content to pay a premium for their social conscience.

Nor, presently, can any political party be expected to champion the cause. The idea of a flat rate tax sits ill with the Labour and Liberal Democratic parties current philosophies, and the Conservative party lacks the confidence, both in itself and of the electorate, to pursue anything so boldly 'Tory' - indeed, for the moment, it would be counterproductive for them to enter the charge. Instead, the debate already taking place amongst politically interested think-tanks and academics needs to be broadened and transferred to the popular domain, so that the seeds of an idea can take root in people's consciousness.

Seminars and papers have their part to play, but real success lies in mobilising the very considerable power of the media, and this will rely on 'free'-thinking journalists and commentators entering the fray. It will still take time - perhaps years - but in the context of an increasing tax burden and far from assured economic stability, the marketing prospects are good. Without the popular debate, however, the concept will remain confined to the margins.

In summary, a flat rate income tax is attractive in principle and proven in practice. Introducing such a system to the UK will not be straightforward. For it to appeal which is prerequisite it must benefit most people and disadvantage very few, especially amongst the poorest. In the short term, bold measures will be necessary. Consequently, and despite the supporting evidence for a flat rate tax, transparency and demonstrable prudence will be critical to building the projects credibility and the public's confidence. The perception that a progressive tax is fair and that a flat tax can only be a sop to the wealthy needs to be dispelled. Political parties will either be disinclined or, for the moment, ill-placed to champion a flat rate tax, but the debate must be transferred to the popular domain if it is to gain traction. The political classes will be important in this, but the key lies, initially, with free-market thinkers in the media. Success is there to be claimed, but only if the realities - good and bad - are fully and honestly exposed. Nor is there any time to waste: the next general election is only 4 to 5 years away.

By Tim LaThe Adam Smith Institute

For more on flat tax proposals, visit free market think tank, the Adam Smith Institut