Falling income tax receipts spell trouble for big government

It would be easy for people to start feeling good about the British economy. Growth has recovered, and we've just about clawed our way back to the level of output we hit before the financial crash of 2008.

Employment is rising, inflation is under control and wages are beginning to rise. The shops are busier, and people feel better about their prospects than they have donefor years.

There's just one problem and it is a big one. The government's finances are still in a shocking state.

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This month we learned that the deficit figures for April were terrible, with the government still borrowing over £11bn for the month, almost £2bn more than a year earlier, even though the economy is meant to be growing strongly.

At the top of the business cycle (which is what thisalmost certainly is), the government is meant to be reducing its borrowing, not increasing it.

Within that total, there was a particularly worrying figure. Income tax receipts were down by 6.8% on last year. We only have one year's figures to go on so far, but that may be a signal of trouble ahead. Income tax, along with VAT, is the core of the tax system.

It was certainly a bad month for income tax receipts. The Office for Budget Responsibility explained that away by saying there had been a big boost in April 2013, when people moved income into the new tax year to take advantage of the top rate coming down from 50% to 45%. Income taxes went up by 6.7% in the same month last year, so all we are seeing is that one-off factor coming out of the annual figures.

That's fair enough. But it's not quite the whole story. It still meant that income tax receipts were down by 0.1%. That is not what should be happening in a strongly growing economy, and one where other taxes were generating plenty of extra cash for the government.

VAT, for example, was up by 4.1% year-on-year and stamp duty up by a whopping 29%, thanks to higher rates and the strength of the housing market. Corporation tax was up 9%.

Despite all the flak about tax-dodging multi-nationals, some firms are clearly paying more. Against that backdrop, income tax was still down. What that suggests is that the tax is getting harder to collect.

Three reasons for the low tax

You can debate the reasons for that. But one thing is obvious. The self-employed, rather like firms, can play around with their tax bills.

Quite legitimately, they can shift income from one year to another depending on when they bill their clients, or they can turn themselves into companies, or take any of a range of steps to reduce their tax bills. They are a moving target for the tax man employees are sitting ducks. It is inevitably much harder to get tax out of the self-employed.

Next, it may be that income tax is now too high. The Laffer Curve famously predicts that at a certain point, higher taxes yield lower revenues because people work less, or put more effort into reducing their tax bills. It may well be that the 45% top tax rate is already there.

More importantly, the 40% tax rate has become the norm for many people, because thresholds have not been raised, and so in real terms, the tax kicks in at much lower levels. For most middle-class people 40% is now, in effect, the standard rate. That is very high.

It is quite possible that some people are working less, or taking pay in other forms, because they don't want to go into the 40% bracket.

You can guarantee that many of the new army of self-employed fall into that category. A freelance web designer who can make £40,000 working four days a week may well decide to take the fifth day off rather than work and pay 40% tax on the money earned.

Finally, income tax has been pushed up the income scale, with most of it collected from the wealthy rather than the poor. The top 1% of earners now pay 30% of all income tax, compared with 27% last year, and 21% back in 1999. The bottom half of earners now pay only 10% of total income tax receipts, compared with 12% in 1999. That is undoubtedly a lot fairer.

The rich have grown richer, so they should be paying more in income tax. The trouble is, they are also the people who can afford clever accountants to get their bills down. The more the tax system relies on the rich, the harder it will be to collect tax.

For all those reasons, April's figures may not be a blip. Income tax may be harder to collect in future than it was in the past. True, many of us might be relieved at that. No one likes paying income tax. The problem is that, along with VAT, it is the foundation of the system, and the only genuinely progressive tax.

Other levies will always vary wildly. Income tax should generate steadily increasing revenues. If it starts to go into decline, financing our bloated government is going to become hard to do.