Why taxes should be slashed by half
The real cost of taxing people is often overlooked.
We are long past the acceptable limit.
By Jamie Whyte
The Times Online May 21st, 2008
On Monday, David Cameron gave a speech about taxation. He thinks it is a difficult topic. Although there is growing demand for government spending, “we have reached the limits of acceptable taxation and borrowing”.
He is wrong. We are miles past the acceptable limit of taxation. Mr Cameron fails to see this because his discussion of tax is uninformed by a concept that, though familiar in business, is nowhere to be found in the public discussion of taxation: namely, the “cost of funds”.
Suppose yourself the manager of a telecoms company. You are considering expanding into China. This will require an investment of £1 billion, from which you expect an annual operating profit of £100 million: that is, a 10 per cent return on investment. Should you do it?
The answer depends on how much it will cost you to raise that £1 billion. Businesses typically obtain funds from a combination of investors and lenders. Suppose the weighted-average cost of funds from these two sources is 8 per cent per annum. Then the Chinese venture will earn more than it costs to fund - and you should proceed.
Background:-
A company should keep raising money until its cost exceeds the return from spending it. That is the logic that guides the fundraising activities of businesses. And it ought to be the logic of taxation. The Government should raise taxes until the cost (to society) of doing so exceeds the benefit (to society) of the spending it funds.
So, what is the cost of raising another £1 via taxation? Tax imposes costs on society in four main ways. Among these is not the amount paid in tax. This is a loss to taxpayers, of course, but it is perfectly offset by the gain to Her Majesty's Revenue. The taxes themselves have simply been transferred from one bank account to another, with no net loss or gain to society. The real costs of taxation are the administrative, compliance, avoidance and deadweight costs.
The first three are familiar. The Government employs many thousands of people to administer and enforce the tax system, and businesses and individuals spend a great deal on avoiding and complying with the Government's demands. These costs are considerable: about two pence for every pound of tax raised. But they are negligible compared with the less familiar, deadweight costs of taxation.
Suppose you are willing to pay up to £10 an hour to have some work done, and the cheapest qualified labourers are willing to work for anything over £9 an hour. Then you should find someone to do the job. But if the Government taxes incomes at 20 per cent, the most the labourers can earn from you is £8 an hour and they will be unwilling to take on your job.
Sales taxes have the same effect. If I can produce a widget for £10 and you are willing to pay £11, then a widget will be produced - unless, of course, a sales tax drives the price of my widget up to £12. The greater the tax, the greater the wedge driven between the prices that sellers are willing to accept and buyers are willing to pay, and the greater the lost opportunities for productive activity.
Measuring the deadweight cost of a tax system is difficult. You cannot observe all the valuable things that are not made or done but would have been if not for taxes. But economists are clever, and estimates have been made (I will spare you the methodological details). Most put the deadweight cost of raising £1 of tax revenue at between 20 and 50 pence.
Though systematically ignored by politicians, this is a fact of the greatest importance. It means that just to break even, government spending must deliver a return of 20 per cent (or probably more).
Some of it passes this test. The most obvious examples are those where the Government provides public goods: that is, goods that people benefit from even when someone else buys them.
Rubbish collection provides a good example. If your neighbours pay to have their rubbish collected, then you need not. You can simply stuff your rubbish into their bins overnight. Since everyone can figure this out, no one will pay to have their rubbish collected, and soon we will have a public health crisis.
Without tax-funded local council spending on rubbish collection, it might not happen at all. And the return on this spending surely exceeds 20 per cent. The value people place on the aesthetic and public health effects of rubbish collection is far greater than its cost.
But most government spending is not aimed at avoiding such “free rider” problems. Most merely provides people with what they would otherwise buy for themselves, such as education, healthcare, housing, unemployment insurance and pensions. Given the enormous cost of raising funds by taxation, such government spending is ludicrous.
For example, a tax-funded school with an annual budget of £10 million costs society more than £12 million. So, to avoid imposing a net cost on society, state schools must provide education worth at least 20 per cent more than the educations provided by private schools with the same budgets. But how could they?
More than half of all government spending replaces what would otherwise be private spending. So Mr Cameron is wrong that tax is at its acceptable limit. It is at least double what it should be.
Given the politically sacred status of “public services”, eliminating this spending and taxation will not sound like a very nice idea. And Mr Cameron is determined to make the Conservatives seem nice. But imposing pointless costs on society is not really a nice thing to do.
Jamie Whyte is the author of Bad Thoughts: a Guide to Clear Thinking
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