How Britain could pay for its public services

Should it raise taxes on income, consumption or wealth?

ALMOST every morning Britons wake up to another alarming story about their threadbare public services. Police cuts are being blamed for a rise in violent crime. Over the winter the National Health Service only just stumbled along. The number of rough sleepers in England has almost trebled since 2010. These pressures are likely to intensify in the coming years, thanks in part to an ageing population. Official forecasts suggest that to put the public finances on an even keel over the long term, tax rises or spending cuts worth around £80bn ($111bn), or 4% of GDP, will be required. Spending cuts are not really an option. So politicians are thinking about how to raise taxes. How should they go about doing it?

Broadly speaking, a government can tax three things: income, consumption and wealth. Economists like taxes to be simple, progressive and to avoid unintentionally distorting behaviour. Progressivity is the guiding force for Labour’s tax policy. It would raise corporation tax from 19% to 26% and jack up taxes on those earning above £80,000 a year. Yet it is not clear that the tax system needs a big extra dose of progressivity. It is already about as redistributive as the OECD average, reducing pre-tax income inequality by about one-third. And beyond a certain point, progressivity conflicts with efficiency. Research by the OECD suggests that income taxes, more than those on consumption and wealth, strongly discourage people from working, thus cramping economic growth. This implies that Britain’s relatively low income taxes are a strength, rather than a problem to be fixed.

That leaves consumption and wealth taxes. VAT, a consumption tax which is levied at 20%, looks ripe for reform. With a plethora of carve-outs—for food, children’s clothes and much else—Britain’s VAT covers only about half of what the average person buys. That makes it the seventh-leakiest in the OECD. A bold reform would be to extend VAT to nearly all spending, which might be enough to fill Britain’s fiscal hole. By itself it would be regressive. So the government would need to help the losers. The Institute for Fiscal Studies, a think-tank, reckons that it could get rid of most VAT carve-outs, compensate the poor (say, by boosting benefits) and still have a lot of money left over.

Increasing wealth taxes, levied on everything from property to financial assets, is the final option. Some say that the wealthy already pay enough. Britain raises more of its overall tax take from wealth taxes than any other OECD country. However, wealth taxes tend to be the most growth-friendly. And while bubbly house prices have led to the economy’s stock of wealth booming in recent years, the take from wealth taxes has barely budged. Going after home-owners is politically poisonous, but before long the government’s hand may be forced.