Hamish McRae: Tax if you must, but do so effectively

First and foremost tax must raise revenue; but then only at the lowest possible cost
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Should you focus taxation on wealth or on income? It is a question raised by the Lib Dems' "Mansion Tax", intended to raise funds to cut income tax at the bottom of the scale. Though the plan has been modified with the threshold increased from £1 million to £2 million – they clearly don't want to lose too many votes in leafy South West London – the issue remains a hot one.

The issue is hot not because this particular wheeze is going to happen but rather because we are about to go though the greatest squeeze on public spending that will ever have occurred in peacetime, coupled inevitably with some increases in taxes. That is not politics; it is arithmetic.

We have the largest fiscal deficit relative to the size of our economy of any large country in the entire world, developed and emerging nations alike. If it were not tackled we would find our debt downgraded and long-term interest rates rising. As the investment bank Morgan Stanley has just warned its clients, Britain is the first of the major economies to risk flight of capital and a full-blown debt crisis over coming months were sufficient action to correct the deficit not taken.

The UK is not alone in having such a problem; it just has a more serious version than anyone else. Countries in less of a mess are also taking action – France announced a plan yesterday to cut its deficit to 3 per cent of GDP by 2013 – and that will put more pressure on us.

The trouble is correcting the deficit will pitch people against people. There is no nice way to do it. As the Lib Dems suggest, most of the adjustment will have to come in the form of spending cuts and that will heighten the tension between the public sector and the private sector. But some will have to come in higher taxation. That will pitch people in London and the South East against people in the North and in Scotland and Wales. It will pitch young against old and working people against retirees. And inevitably it will pitch the wealthy against, not so much the poor, but the middle-earners. We have already seen some hostility against high-earners, particularly in the financial services industry but also in other parts of the economy, including Parliament itself. We will, I am afraid, experience much more of it.

The core of the problem is that we require taxation to do different things. Of course it has, first and foremost, to raise revenue, but it has to do so at the lowest possible cost. There is no pointing bringing in a tax that costs almost as much to administer as it takes in revenue. A good, or maybe bad, example of an inefficient tax is Inheritance Tax, where about one third of the revenue raised is absorbed by the cost of collection. The London congestion charge is similarly inefficient.

Taxes should also, in the main, distort the economy as little as possible. You don't want a tax that hits one bit of the economy at the expense of another. A prime example of that was the Selective Employment Tax in the 1960s, which put an extra tax on employment in service industries but not on manufacturing. It was abandoned as unworkable but not before all sorts of arguments as to what was a service and what was not. Newspapers, you will be pleased to know, were and are manufacturing as we produce a physical product. If you want to support British manufacturers hang in there.

Then there is fairness. We all want a fairer world, and the core idea of a progressive taxation system is that it should compensate for inequalities of income and wealth. It does so on a massive scale. Here in Britain the top 1 per cent of earners pay nearly a quarter of income tax, while the top 10 per cent pay half of it. Indeed the increase in the top tax rate to 50 per cent may make the tax system less progressive, not more, for it seems likely to cut the revenues from high earners, rather than increase them. We cannot know for sure but the Institute for Fiscal Studies reckons the higher rate will make no difference to revenues. It seems that once income tax rates approach 50 per cent people make adjustments to their lifestyle – they move abroad, work fewer hours, retire earlier – and the net result is a reduction of tax paid. Fairness, even if we could agree on what it constitutes, is hard to achieve.

There is the conflict between targeting and complexity. You do ideally want taxation to be targeted: to take into account different people's circumstances and adjust for that. Gordon Brown, while Chancellor, went down the targeting route, with all those announcements of small amounts of money being spent on new "initiatives" and the much more substantial tax credit system. We now can see that the initiatives had little impact, while the tax credit system – a good idea in theory – was too complicated to be administered effectively. As a result billions have been wasted.

There are further problems. Tax systems have to be competitive at a company level or companies move their headquarters, maybe even their entire operation, to another country. Tax is not the only issue of course; availability of skilled labour, wage rates and so on matter too. Like many people I don't have a lot of time for companies, or indeed people, who bleat about moving abroad and then don't. But plainly, if a company does move its headquarters it will be hard to get it back. And it does not make much sense to give some foreign company a grant to build a factory in the UK at the same time as pushing our own companies to move offshore. As for people moving, ask yourself why so many of our top sportsmen and women live in Switzerland or Monaco – or why so many rich Swedes live in the Home Counties. Human capital is mobile and the more people earn the more mobile they are.

One apparent virtue of the Liberal's mansion tax is that you cannot move a house but ponder what might actually happen were it to be introduced. There would certainly be a plunge in top-end house prices. People would split large houses into two flats, as they have in the past, and maybe give part to their children. Or they would not trade up in the UK but buy a property abroad. Or they would simply spend less on their home and more on holidays. Not so bright after all.

Ultimately taxation has to be by consent. It has to be accepted as fair not just by the broad mass of the electorate but by the people who pay it. That requires a better-crafted tax system, one that is simple and straightforward. That is the mountain the next government will have to climb.