Why taxing consumption makes sense in the age of technology

Tax reform has not been on this Chancellor's agenda, but there are serious questions his successor ought to think about before he opens the red box
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The only really important question about next Tuesday's Budget is how much the basic rate of income tax will fall - or so you might judge from the acres of discussion. It is a sign of how impoverished the Government's thinking on taxation has become that this one rate has become the only aspect of policy it thinks has any political relevance in a juvenile "mine's smaller than yours" contest.

Tax reform has not been onthis Chancellor's agenda, but there are serious questions his successor ought to start thinking about long before he opens the traditional red box in the House of Commons a year from now. A thought-provoking paper on the shape the tax system will have to take next century sets out some of the most important issues.* Presented recently by Mervyn King, chief economist at the Bank of England and a hot tip for even greater things under a Labour government, it argues that there are three trends that will transform tax policy.

The first is that taxes will have to shift from income to consumption: for individuals, that means taxing what we spend via something like VAT rather than what we earn through income tax. The second is that information technology will make it harder to monitor what taxes should be paid. The third is the pressures on national tax systems imposed by growing international links between economies.

Mr King, the co-author with John Kay on the most influential textbook on the British tax system, starts out with the observation that in 1896 almost half of government revenue came from customs and excise duties. (It was also, co-incidentally, a year in which unexpectedly high tax receipts meant the budget surplus was the highest for 50 years.)

During the course of the subsequent century, much of the growth in the size of government was funded by increasing taxes on income, including income from capital. The system that has developed is a bit of a hybrid, adjusted to cope with various practical difficulties. It does not consistently tax income or spending. For instance, it is not practicable to calculate a person's income accruing from their employer's contribution to a pension scheme, so these are not subjected to the income tax regime. Likewise, in some countries it has been considered undesirable or impossible to tax capital gains at the same rate as income.

The result has been a system that taxes different types of income from capital at different rates, causing economic distortions. The best-known example of the consequences is the fact that debt-financed investment is liable to less tax than equity-financed investment, and is sometimes subsidised by the tax system.

Tax reform during the 1980s has concentrated on trying to find a consistent and broad definition of the tax base and applying the same low rate of tax as far as possible to all forms of income. This will probably continue. However, Mr King argues that in the longer term the system will evolve away from income tax and towards a consumption tax. This is a trend that has clearly got under way in the UK with the Conservatives' emphasis on income tax reductions.

Other countries are likely to follow. The ever-closer integration of the world economy means taxes on capital income are increasingly hard to enforce. It might even become impossible the more footloose investment becomes. The downward pressures on personal income tax are less, but already exist for the mobile corporate executive. Reducing the income tax burden is high on the political agenda, anyway.

The added attraction of a tax on consumption is that it applies to observable transactions rather than a calculated definition of income or profit. In simpler times, applying an income tax was not too tricky. Most earners worked for big companies and stayed longer in their jobs. Companies did a lot of the work for the Inland Revenue. Furthermore, family structures were more stable and less varied than they are now. Even so, some of the world's biggest computer systems are those that were designed for the administration of tax.

The only trouble with a consumption tax is that the things we are spending money on are becoming less and less tangible - and therefore harder to monitor - the more important information technology and services become in the economy. Italy finds it hard enough to collect the VAT on goods in the shops. Italians are required to hold on to their till receipts in case a VAT inspector is lurking outside the shop door.

It is much harder to monitor sales of anything over the Internet, satellite television transmissions and any other "dematerialised" economic activity. It will be harder still when retail customers can pay in "real time" via computer. Technology could signal the end of money as a means of payment. When value added can pass down a telephone line or bounce off a satellite and money can move back along the same routes, Mr King writes, "the idea that Microsoft or BT may have a more important role in payment systems in the future than Midland or Barclays Bank is not one to be dismissed lightly".

He concludes that governments might have to get closely involved in the regulation of information technology if they are to retain a broad tax base. However, his arguments point to another solution. That is taxing spending on precisely those things that can not dematerialise; and licensing so that the responsibility for tax collection is effectively devolved to an organisation closer to the action than the government can get.

Examples of taxes linked to spending with an unavoidable physical presence are road tolls, petrol taxes, vehicle excise duty, landfill tax and so on. William Pitt's tax on windows would be another example. So would domestic rates or council tax. So is the TV licence. To the credit of the Liberal Democrats, their pre-budget document suggests placing greater reliance on some of these, although for reasons of environmental protection rather than technological necessity.

It is not difficult to imagine a world where all the tax revenues to build roads are raised directly by auctioning licences to claim tolls to a private company. This is a direction for tax reform which could be shaped to appeal to a Conservative government as much as a green-tinged Liberal Democrat one. The shape of the tax system is a political issue as well as a technical one. And the political dimensions are far broader than the question of whether Tuesday will see another penny lopped off the basic rate.

* "Tax Systems in the 21st Century", by Mervyn King, presented to the 50th Congress of the International Fiscal Association in Geneva, September 1996.