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In defence of earmarked taxes
Samuel Brittan: Financial Times 07/12/00

Whatever the verdict on its overall outlook, the recent Fabian Society report on the UK tax system contains valuable ideas

The British Labour government lost no time in putting clear water between itself and the report of the Tax Commission published by Labour's senior think-tank, the Fabian Society ("Paying for Progress"). It was wrong to do so. Like those of most such reports, its specific recommendations are partly good and partly bad. But it is the first comprehensive study of UK tax and spending for a number of years and much of the analysis will be useful to people of varying politics.

The commission's chairman, Lord Plant, should not have placed positive liberty - that is, "ability to" rather than "freedom from" - at the centre of the analysis. As a political philosopher he is entitled to his view. But one of the slogans we can learn from some US analysts is: "Do not insist on ultimate values." People from different philosophical stables can agree on specific proposals. Those Tax Commission members who were primarily interested in tax were probably happy to accept Lord Plant's formulation without quibbling. But it has made some of the report's findings unnecessarily controversial in the wider world.

The Commission's most interesting proposal is for a fully hypothecated tax - that is, one that covers the whole cost - for the National Health Service. It also favours environmental and local tax increases earmarked for specific projects. Unfortunately it is such ideas that attracted most opprobrium. Finance ministries have long detested "hypothecation" and the dissenting minority on the Commission included a former senior Treasury official.

The earmarking proposal stemmed from opinion research showing that while people were, in principle, in favour of paying more to fund health or education, they were extremely suspicious of the links between the taxes they in fact paid and improved public services. The commission's guiding idea is to "reconnect" payments and services. This should be equally acceptable to people who differ widely on the desirable extent of collective provision.

The problem with state provision relates to what some economists call "full line supply". Each customer coming into a supermarket can choose her own basket of goods. But there is no way in which different individuals can have different amounts of military expenditure. Moreover, policies are sold in vague bundles at election time. There is also no way in which I can vote for some moderation in public spending without also voting for intolerant Tory social attitudes, hostility to "Europe" and indifference to the ethical elements in foreign policy.

In spite of these drawbacks some services are better financed in part collectively than by relying on the private marketplace. A balance has to be struck between individual choice and public goods. Earmarked taxes cannot remove all the defects of state provision or finance. They cannot enable different voters to have different levels of provision to suit their personal preferences. But they can at least make sure that services come with a price tag and that voters know they will have to put their money where their mouths are.

If carried out carefully, earmarking ought to appeal both to those who want the state to spend much more and those who do not. Indeed, both left-of-centre and free market think-tanks have published papers in favour of earmarking. My own interest in the subject was restimulated in the run-up to the 1992 election when I saw militant, uniformed nurses arriving en masse at televised public discussions to insist that the NHS was underfunded. I often wondered how much would have to be spent before such lobbies could ever be satisfied. (I am, however, a little suspicious that these militant nurses are no longer quite so much in evidence now that the political colour of the government has changed; their place has been taken by the tabloid newspapers).

The only way citizens can know what is being spent on state medical provision, and whether they want to increase it, is to make it clear what they are paying for it. The commission's other ideas for re-establishing the link between taxes and public services are much more flimsy. They consist mainly of the popularisation in some form or other of tax and spending pie charts, such as the ones reproduced here. But such "good citizen" propaganda has been attempted many times in the decades since the second world war - and it has had as much effect as water dropped on to a duck's back.

It is true that earmarked expenditure has long had a bad name. A levy known as "ship money", raised by Charles I, helped to trigger the British civil war of the 17th century. This was partly because parliament did not give its approval and partly because it was levied on inland areas even though the purpose was supposed to be to defend the coastal towns. In more modern times, earmarked taxes have been debased. For instance, taxes on road vehicles were supposed to go to a road fund, which was quickly raided for general revenue.

Earmarking is worse than useless if the earmarked taxes do not finance the whole of the service in question (as I explained in a Viewpoint on December 15 1994). The Liberal Democrats fought several elections on pledges to raise the basic rate of income tax by 1 percentage point to finance extra expenditure on education. This was tokenism. The net effect was to give the impression that a big improvement in education could be had on the cheap. Similar remarks apply to the plan by Gordon Brown, the chancellor of the exchequer, to earmark increases in tobacco duties for increased NHS spending.

The specific form of hypothecation recommended by the Fabians is not the best one. They favour taking the yield from income tax and dividing it into two equal sections, one to finance the NHS and one for general spending. The danger is that some people would think that all their income tax went on the NHS and others would be so bemused that they would have no more feeling for the links than they have now.

A better idea is to earmark the proceeds either from value added tax or from national insurance contributions, each of which brings in almost exactly enough to cover planned spending on the NHS. Ideally, there should be periodic referendums on proposals to change either levy. The slightly regressive nature of VAT is a spurious objection. What matters is the progressiveness of the whole system of tax and public spending, to which the commission itself refers.

There is no need to be starry-eyed about hypothecation. Eventually even an earmarked NHS tax would go the way of the road fund. But for a few vital years it could segregate the NHS from the rest of the political debate and reduce the sanctimoniousness that surrounds the issue.

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