the road to progressive taxation

public�policy�research�–�December�2008-February�2009 211

© 2

009

The

Aut

hor.

Jou

rnal

com

pila

tion

© 2

009

ippr

‘The necessaries of life occasion the great expense ofthe poor. They find it difficult to get food, and thegreater part of their little revenue is spent in gettingit. The luxuries and vanities of life occasion theprincipal expense of the rich, and a magnificenthouse embellishes and sets off to the best advantageall the other luxuries and vanities which they pos-sess. A tax upon house-rents, therefore, would in gen-eral fall heaviest upon the rich; and in this sort ofinequality there would not, perhaps, be anythingvery unreasonable. It is not very unreasonable thatthe rich should contribute to the public expense, notonly in proportion to their revenue, but somethingmore than in that proportion.’ Adam Smith, The Wealth of Nations (1776)

Many quote Smith when itcomes to debate on tax.His commitment to pro-gressive taxation has,perhaps deliberately,

been overlooked by some. Certain peoplehave simply ignored appeals for action on thisissue, but whatever else Chancellor AlistairDarling did by announcing an increase in thetop rate of income tax, he succeeded in break-ing the New Labour undertaking that incometax rates would never increase. In doing so healso made clear his thinking: it was, he said,essential that the best-off in our society madethe greatest contribution to our economicrecovery. At that moment the issue of progres-sive taxation returned to UK political debate.

It is an extraordinary change of heart. Inits aftermath a long-serving Labour MP told

me that he would need to relearn all thearguments for progressive taxation he hadforgotten in the last fifteen or more years.Joke as he might, there was, as in all goodjokes, a significant element of truth in whathe said. It may even be that Labour needs toremind itself of why government taxes, forthere is much more to this than the simpleneed to raise revenue.

The�basic�principles�oftaxationThere are five reasons for taxation, all con-veniently beginning with the letter ‘r’. Theyare to:

� raise revenue� reprice goods and services (tobacco, alco-

hol, carbon emissions and so on) in pur-suit of social objectives

� redistribute income and wealth� raise representation within the democrat-

ic process by being the consideration inthe social contract between those gov-erned and the Government

� reorganise the economy (fiscal policy).

In any argument for taking a new approachto taxation all of these reasons for taxingmust be taken into account: all must beexplained, and, most importantly, redistrib-ution has to reclaim its right to be consid-ered a key element within the taxation sys-tem. The overall message is a simple one:

The�road�to�progressive�taxationRichard�Murphy�examines�the�recent�increase�in�the�rateof�tax�for�high�income�earners�in�the�UK�and�argues�thatthis�should�be�the�beginning�of�a�journey�whosedestination�is�a�wholly�progressive�taxation�system.�

after decades of being told tax is a ‘badthing’ the message has to be reversed. Taxshould be seen as a ‘good thing’.

But why is that true of progressive taxation– taxation that takes a greater proportion ofthe income, gains and wealth from those whohave more of each of these measures of well-being than it does from people with less ofeach? What is the justification for this appar-ently unequal expectation or is this, as thoseon the right have so often argued, a simpleexpression of the politics of greed?

To answer this question it is possible torefer to Adam Smith again. Remarkably,and as some indication of the lack of pro-gressive thinking in this area, the four attrib-utes of a good tax system that he identifiedin The Wealth of Nations are still commonlyargued to hold good today.

A good tax system, Smith said, deliveredequity, certainty, convenience and efficiency.He clearly thought that equity required aprogressive taxation system, but that doesnot resolve the issue. Modern taxation iscomplex in a way unimaginable in 1776.The argument must move on and I suggestthat a good taxation system has ten attrib-utes with one over-riding characteristic towhich they all contribute. These requirethat the system is:

1. Comprehensive – in other words,broad-based

2. Complete – with as few loop-holes aspossible

3. Comprehensible – as certain as possible 4. Compassionate – it takes into account

the capacity to pay5. Compact – it is written as straightfor-

wardly as possible 6. Compliant with human rights – in a

way that discriminating in favour of

‘non-doms’ is not7. Compensatory – it is perceived as fair8. Competitive – it does not alienate an

activity the community would encourage9. Complementary to social objectives –

taxing cigarettes, for instance10. Computable – the liability can be cal-

culated with reasonable accuracy

All of which facilitate the chance that it willbe:

11. Competently managed.

Why�taxation�must�beprogressiveMy argument is simple: these objectivescannot be fulfilled unless we have progres-sive taxation. It is important to be explicitabout what progressive taxation is withinthis context. It is too simple to say that it is amatter of the proportion of income paid intax increasing as income rises. To do sowould ignore the numerous ways in whichincome is disguised and tax avoided in theUK tax system. It is, for example, relativelyeasy for income to be disguised as a capitalgain. Alternatively, some can easily reallo-cate their income to a company or trust,which in some cases can be in anothercountry or tax haven. The object, of course,is to reduce the rate of tax paid.

This can also be achieved by splittingincome between different members of afamily, and these comments simply relate toincome. When the taxation of property,transactions and wealth is taken intoaccount, the opportunities for planningincrease enormously. This is especially truefor those with wealth, who can afford thefees and inconvenience involved. This iswhy progressive taxation is not just aboutsetting tax rates: it is about the design of awhole taxation system and its relationshipwith the taxation systems of other countriesas well.

In this context we have a particularproblem in the United Kingdom. Over thepast twenty years or so changes to our taxsystem have been piecemeal at best and

public�policy�research�–�December�2008-February�2009212

© 2

009

The

Aut

hor.

Jou

rnal

com

pila

tion

© 2

009

ippr

A�good�tax�system,�Smithsaid,�delivered�equity,certainty,�convenience�andefficiency

lacking in any coherent strategy. The resultis that we have a tax system where vestedinterest has too much significance andchange is only assessed on the basis of theadvantage that it brings to taxpayers, withnone being expected to lose. This has creat-ed voluminous legislation, complexity andthe opportunity for abuse but withoutdelivering a tax system that conforms to thequalities noted above.

The result is that almost no one is nowsatisfied with what we have, and it is onlyby taking a principles-based approach toreform that progress can be justified. Someon the right have done this in arguing for ahighly regressive flat tax. It is essential thatthe left now takes the initiative to argue fora wholly progressive alternative.

In this context progressive taxation hasto be seen as a tax system in which theintent is to charge an increasing rate of taxas economic well-being increases. This is anappropriate concept as a significant amountof micro-economic theory is based on theconcept of utility, which is the measure ofwell-being first mooted by Jeremy Bentham.By implication this requires that a broadassessment of progressiveness be used, andin turn that the tax base must be compre-hensive to capture all those factors thatmight contribute to perceptions of well-being. This logic underpins the ten attrib-utes of a good tax system noted above.

This is apparent from the first attribute,‘comprehensiveness’. If a significant sourceof well-being is omitted from the tax basethen quite obviously the tax system cannotbe wholly progressive. More than that, ifthis happens, for the system to be progres-sive other contributors to well-being mustbe subject to more aggressive rates of taxincrease as well-being increases.

What this means is that a progressivetax system has to include a high degree ofhorizontal as well as vertical equity withinthe tax system. This in turn means that ifwe equate contributions to well-beingwith sources of cash (and while there areproblems in doing so it is absolutely stan-dard economic practice to accept thisequation) then whatever the source of

cash a person enjoys it should be taxedequally, as far as possible. As soon as onesource of cash, income or well-being (theterms are interchangeable, for practicalpurposes) is preferred over another, thechance of creating a wholly progressivetax system is reduced.

Completeness is simply the inverse ofcomprehensiveness: if all income streamsare included as contributing to well-beingbut some are subject to significant deduc-tions and reliefs while others are not, pro-gressiveness is reduced. It is quite clearly thecase that if reliefs are available against oneform of income and not available againstanother then the system will not producehorizontal equity.

Taking the idea of utility just a step fur-ther, the economic theory of marginal utili-ty says that as income rises the additionalvalue that a person attributes to each extrapound they earn decreases. The logic isobvious: if you earn £10,000 a year, a payrise of £1,000 increases your income by 10per cent and has a potentially huge impacton your well-being. To a person earning£100,000 an additional £1,000 may not beof much significance.

This has considerable implications forthe concept of fairness (or justice) as itrelates to taxation. In economic terms it canbe argued that justice is created if the mar-ginal loss of well-being to each taxpayer as aresult of the tax payment they make isequalised. Equity is created when this prin-ciple is applied across all taxes, and not justto any one tax in isolation. In that case it isobvious that it is essential that the opportu-nity each person has to describe theirincome in differing ways to manipulate thetax they pay be minimised, or else injusticeresults.

This, then, is the appropriate measure ofvertical equity within a tax system.Increasing tax rates by themselves are notenough: if progressive taxation is to be cre-ated the marginal utility lost by the taxpay-er as their income rises has to increase. Thesystem is neither compassionate nor com-pensatory to the poorest in the communityif that is not the case. ©

200

9 T

he A

utho

r. J

ourn

al c

ompi

latio

n ©

200

9 ip

pr


The following graph, produced byDoctor Sally Ruane and Professor DavidByrne (2008) makes clear the current distri-bution of the tax burden in the UnitedKingdom:

It is impossible to reconcile the data in thisgraph with the definition of progressive tax-ation offered above. The UK tax system isclearly regressive in deciles 1, 2, 3, 9 and 10since the rate gradient in these decilesincreases as income reduces. It is almost cer-tainly regressive for deciles 4 and 8 sincethe actual rate is almost flat but the margin-al utility cost of the payment of tax willalmost certainly be falling as income risesthrough the decile. In only deciles 5, 6 and7 is there evidence of a progressive taxationsystem, and it is by no means clear eventhen. What is certain is that we do have aregressive taxation system in the UK.

The prescription is complex and highlypolitical, but that is no excuse for avoidingit.

It is, for example, the case that the lowestdecile pays no income tax at all: compas-sion appears to be effective with regard tothis tax. That group does, however, have thehighest effective tax rates. Four taxes ensurethat this is the case: VAT, council tax, tobac-co duties and alcohol duties, and of thesefour the last three are the most significant.Council tax takes far too little considerationof the capacity to pay, while taxes on tobac-co and alcohol might complement socialobjectives but their impact is massively

skewed within society. Simple solutions arenot available in taxation, and it must berecognised that in some cases this designdifficulty cannot be overcome except bydirect compensatory payments. That is whyfull integration of the benefits and taxationsystems will never be possible.

Creating�a�system�ofprogressive�taxation�What, then, can be done? I can only offersome thumbnail insights, but they hint atthe scale and scope of reform that is possibleand necessary if the small step taken byChancellor Darling is to become a journeytowards a truly progressive tax system. It isto be stressed that this is not a menu: someof the options noted are alternative mecha-nisms for tackling an issue. Choice is avail-able when creating progressive taxation.

Start with one of the classic politicaldilemmas: the conflict between the returnto labour and the return to capital. It isabsurd that at present the national insur-ance system guarantees that taxation rateson income derived from labour are alwayshigher than those derived from capital,whether that be interest, dividends, rents orcapital gains (because national insurance isnot charged on the latter). This is aninequity that has to be tackled. Its persist-ence not only destroys horizontal equity inthe system, but taxing less the income ofthose with savings (by definition, part of thebetter-off in any society) inevitably con-tributes to a lack of progressivity in the taxsystem and increases the gap between richand poor as a result.

At one time this was tackled by what wascalled an ‘investment income surcharge’within the income tax system, whichcharged an additional 15 per cent tax onincome from these sources. This was abol-ished in the 1980s. There are, though, goodreasons for not reproducing this charge.First, income tax is too easily avoided, asnoted below. Second, income tax is insuffi-ciently discriminatory with regard to age.National insurance is, on the other hand,highly discriminatory with regard to age,


© 2

009

The

Aut

hor.

Jou

rnal

com

pila

tion

© 2

009

ippr

47 -

42 -

37 -

32 - - - - - - - - - - -1 2 3 4 5 6 7 8 9 10

Deciles

2006/07

Average over ten years

%�of�gross�income�paid�in�tax,�all�taxes

not being paid by those of over retirementage. A new class of national insurance, paidat the same rate as that paid by employeeson all investment income of more than£6,000 a year (which should mean that thetax will only be charged on savings of morethan £100,000) would tackle this issue, andleave pensioners exempt from this charge.

Next, the issue of tax avoidance must betackled. The above noted charge would,conveniently, also tackle one of the bigissues in tax avoidance at this time, which isthe use of private limited companies to shiftincome between partners in a family unit toreduce tax rates. This largely relies onnational insurance savings on dividends tobe effective. A national insurance charge onsavings would tackle a large component ofthis problem.

Some tax reliefs that create considerabletax administration are used largely by thewell-off and need to be tackled.Inappropriate incentives for saving such asventure capital trust reliefs and the enter-prise incentive scheme simply need to beabolished. They have no proven record ofdelivering economic benefit and if, as isdesirable, incentives need to be given forinnovation, this should be by way of directgovernment investment, grants, pub-lic/private joint ventures and university-linked partnerships, all of which haveproven track records of success, unlike tax-backed funds.

ISAs (Individual Savings Accounts) needto be questioned, too: there is again little indi-cation that they produce economic benefits.They simply allow the middle classes to notpay tax by shifting regular sums into tax-freeaccounts and reduce progressivity as a result.

Incentive has to be given to ensure thatpeople provide for their own well-being inold age, but sensible limits must be set. Atpresent these are largely related to the sizeof the pension pot. That is inappropriate,and the limit is in any case too high.Pension tax reliefs need to be withdrawn forthose earning over £100,000 a year by set-ting a minimum rate of tax they must pay.

As first recommended by the TradesUnion Congress in its report The Missing

Billions (TUC 2008), a minimum rate of taxshould be set for those earning more than£100,000 a year. At this level of income aminimum tax rate of 31 or 32 per cent seemsappropriate at present. This could beachieved by restricting the allowances andreliefs high income earners could claimagainst the proportion of their gross incomeexceeding £100,000 per year to ensure thatminimum tax rate is paid.

A first step in this direction was taken inthe Government’s Pre-Budget Report for 2008,as a result of which those earning morethan £100,000 will have the value of theirpersonal allowance restricted from April2010 onwards. But the move needs to bemuch bolder than that, and cover allallowances and reliefs on a progressive basisso that above a certain level (say £200,000)tax is paid on all income at the highest mar-ginal rate of income tax. This will guaranteea more progressive income tax system sinceit is apparent that the low effective rate oftax paid by the UK’s highest earners is gen-erated, at least in part, by the very highlevel of allowances and reliefs they claim. Atthis level of income people do not need taxincentives to change their investment, phil-anthropic or other behaviour. They havesufficient net income to make these choicesfor themselves. Such a flat rate of tax at thislevel of income is appropriate.

The mention of philanthropy indicatesanother area of change. At present any tax-payer making a gift to charity can do sousing ‘gift aid’ relief. The charity claimsback the basic rate of tax paid but the tax-payer can also claim higher rate tax reliefagainst their income tax liability. This isabsurd. There is no reason for a subsidy tobe given to a higher earning taxpayer toincentivise them to give to charity. Therules should be changed to achieve substan-tial administrative savings and the elimina-tion of tax abuse, firstly by allowing allcharities to reclaim basic rate tax on alldonations they receive except legacies, sinceit is highly likely that they will have beensubject to income tax before being donated,and secondly by abolishing the higher ratetax relief for donors. ©

200

9 T

he A

utho

r. J

ourn

al c

ompi

latio

n ©

200

9 ip

pr


After that, reform of small business taxa-tion is essential. It is ridiculous that byincorporating a company at a cost of under£100 a person can save significant amountsof tax on the income, albeit at a cost of anadministrative burden. If all small limitedcompanies were required to be re-registeredas limited liability partnerships, the admin-istrative burdens on those companies wouldfall substantially, but their profits wouldbecome tax transparent and be charged ontheir members at the highest marginal rateof tax as earned income, and therefore besubject to National Insurance. This wouldeliminate at one stroke large swathes of cur-rent ‘tax and National Insurance planning’,whereby small companies pay dividendsinstead of salaries to their owners, with partof those dividends being diverted in manycases to family members enjoying lowerrates of tax but who otherwise make little orno contribution to the profit of the enter-prise. The result would be that small busi-ness could focus on making money, not ontax avoiding, to the benefit of the wholeeconomy.

These are just the starting points. Clearlymore action is needed to tackle abuse with-in tax havens. Large corporations have topay an appropriate amount of tax or theywill in turn become the focus of the creationof inequality. The notion that taxation ofcorporate entities is a business cost andshould be reduced in order to maximisevalue has to be changed.

Capital gains have to be subject to taxat the same rate as income, albeit withsome appropriate reliefs provided.Inheritances have to be taxed, but there islittle doubt that this is best directed at therecipients, and not at the person makingthe gift. Council tax must be reformed sothat capacity to pay is taken into account

even if this falls short of a full localincome tax. Direct compensatory pay-ments need to be made to those on lowincome for the indirect sales tax burdensthey suffer.

And we must not forget that we need toinvest in a high-quality, well resourced andcompetently managed tax authority.Without that none of the above can happenor be sustained. News of impending joblosses in HM Revenue and Customs againstthe backdrop of an already low rate of pros-ecutions for tax evasion is of concern.

Adam Smith started a progressive taxa-tion agenda in 1776. Alistair Darling has hint-ed at its revival in 2008, a move that is to bewelcomed. A rallying of progressive taxationdoes, however, need to be full-blooded, justi-fied and delivered if progressive politiciansare to provide the solutions needed as weenter a major economic crisis. If the new 45per cent tax rate is an indication of a realbreak with the past then it must be followedby a reform of the tax system to deliver socialand economic justice. Perhaps most impor-tantly of all, though, reform could affirm taxas central to that near-forgotten social con-tract that binds the electorate together withthose they elect and which therefore under-pins the whole philosophy and process ofdemocratic government.

Richard Murphy is a chartered accountant, anAdviser to the Tax Justice Network and the TUCon taxation and economic issues and Director ofTax Research LLP

Ruane S and Byrne D (2008) The UK Tax Burden: Can Labourbe called the ‘party of fairness?’, Compass Thinkpiece 40,London: Compass, available athttp://clients.squareeye.com/uploads/compass/documents/Fairness%20Thinkpiece%2040%20REVISED_%20(2).pdf

TUC (2008) The Missing Billions: The UK tax gap Touchstonepamphlet no. 1, London: TUC


© 2

009

The

Aut

hor.

Jou

rnal

com

pila

tion

© 2

009

ippr

the road to progressive taxation

Documents