Why squeezing the rich helps poll ratings more than the Exchequer

Diane coyle on closing up tax loopholes

WEALTH is seriously out of fashion. The tide turned earlier this decade, partly in reaction to the conspicuous excesses of the late 1980s. The Nineties have been a decade of downshifting, saving not spending, pensions rather than Porsches. Two American economists proposed, a couple of years ago, a special consumption tax on luxury items to pay for public services for the poor, arguing that wasteful expenditure ought to be discouraged by the tax system.

And the Labour Party milked fat cats - to mix metaphors - for all they were worth in the run-up to last year's election, profiting from general resentment about the extent to which the lucky few were pulling away from the rest. That accumulated resentment, along with a spot of embarrassment over Geoffrey Robinson's financial arrangements, is the political fuel driving the Chancellor's expected crackdown on tax avoidance in next week's Budget.

On the face of it, the rich present an irresistible target. Take the argument about spending on luxury goods like expensive cars and designer clothes. Ever since Thorstein Veblen first analysed the phenomenon of conspicuous consumption, it has been understood that some goods command a higher price because of their status rather than their intrinsic value. Rolex watches are not necessarily better at telling the time than far cheaper watches, and many would argue that they don't even look any nicer. But they certainly flaunt their owner's wealth.

The economist Paul Krugman has recently pointed out that status goods like this represent a market failure. The reason is that there is an externality involved in my purchase of a Rolls-Royce or a Rolex or, the latest hot fashion item, a pair of Gucci slingbacks. I reduce the value existing owners of these items derive from theirs by reducing the scarcity value. This is why status goods are either extremely expensive, so that they can be rationed by price, or fall out of fashion very quickly, as the herd catches up with the trend-setters. A few, like Van Gogh paintings, are rationed by genuine scarcity but, in general, conspicuous consumption creates a form of congestion. It is just like traffic congestion where every extra car on the roads makes the use of a car less valuable and more expensive for those already driving.

In other words, the rich engage in an arms race of conspicuous consumption that eats up resources in a way that is not only frivolous but actually reduces well-being for others. Professor Krugman suggests we might want to encourage the status-seekers to do something else, like give their money to charity or the arts, or even work less and spend more time with their family. Taxing their conspicuous purchases heavily might be another way of discouraging their welfare-reducing activity.

Another policy option, and the one on Gordon Brown's agenda, is making very sure the wealthy pay all the taxes they ought to anyway. Tax avoidance is perfectly legal, but most people who are not doing it think it shouldn't be allowed. Public fervour about "missing billions" in tax revenue is easily whipped up. Some wild estimates put the amount gone astray from the government's coffers at as much as pounds 100bn, when total tax revenues are just over pounds 300bn.

There is no shadow of a doubt that wealthy individuals and businesses alike go out of their way not to pay unnecessary tax. After all, the rich are different; they have accountants. But the policy debate ought to recognise that tax avoidance is the other side of the coin of government attempts to shape people's behaviour. For every tax break eventually becomes a tax loophole. They just seemed a really good idea when they were introduced.

All the big tax reliefs many of us enjoy fall into this category - mortgage interest relief, profit related pay, Peps and Tessas. To list them is to see how governments end up seeing all these attempts to achieve desirable outcomes such as harder work or more saving as loopholes that are costing too much in foregone revenue and need plugging.

The same is true of less obvious tax breaks too. When business expansion schemes could invest in property they became a hugely popular way for relatively well-off people to shelter some of their savings from tax. And consider the Chancellor's introduction of superior allowances for investment in the film industry. For most rich people this is not an attractive tax shelter because it involves a big risk of losing all the money if the film flops. But for a company which might think about investing in films anyway, and for which losses could prove useful to reduce its other tax liabilities, it is a dream tax break. As Fox Searchlight, a Rupert Murdoch company which funded The Full Monty, discovered, the film might even make a huge profit. The rumoured increased allowances for investment in small high-technology firms will turn out to be the same kind of break.

But does this mean such tax incentives are misguided? Not necessarily. A thriving economy does need thriving small and growing businesses in cutting-edge industries. It is an unfortunate but unavoidable fact that entrepreneurs are the kind of people who will devote much ingenuity to avoiding paying taxes they can legally avoid. After all, it is the desire to make money that makes them entrepreneurs in the first place. But this does not mean that we should not want entrepreneurs. They are essential to the health of the economy. If the government thinks we want more investment in certain specific areas, a special tax break is a sensible way of encouraging it. After all, they can always be revoked later.

Corporate avoidance of taxes is another matter because some companies do exploit both the difficulty for the revenue authorities of keeping track of internal transactions which cross national borders and the increasing competition between countries to attract investment. There has been a bit of a race downwards in corporation tax rates over the past decade or so - good if it boosts investment in total, but not so good if it simply deprives one country of investment and relocates it in another. This is a problem that member governments of the OECD are trying to tackle collectively.

As for a consumption tax on status goods, this would have an economic downside. It would reduce sales of luxury goods, some of which are made in Britain - Rolls-Royce cars, Vivienne Westwood dresses, Mulberry bags. Given that the economic harm from conspicuous consumption affects only the wealthy, a cost-benefit analysis might show the envy-adjusted national interest, giving a higher weight to the masses than to fat cats and other rich people, would be maximised by simply letting those who want to chase status get on with it - as long as they pay their fair share of the other taxes.