Tuesday, 12 March 2013

Taxing Europe's way out of trouble

The current clamour for higher taxes in Europe may still fail to address its big deficits and rising inequality
By Jonathan Eyal, The Straits Times, 11 Mar 2013

"WE SHALL squeeze the rich until their pips squeak" is how a British finance minister once summed up his yearly budget. That was decades ago and, soon thereafter, the idea of punitive taxes on the wealthy fell out of fashion.

Yet it's back in fashion now, and with a vengeance. Europe recently adopted measures to limit the pay and raise taxes on wealthy bankers. France is threatening its rich with a 75 per cent taxation rate. And both India and Singapore have unveiled budgets which follow the so-called "progressive taxation" model of imposing higher tax liabilities on the wealthy.

But it is doubtful that the revival of progressive taxation will deliver better results than during the 1970s, when it was last tried wholesale in the industrialised world. It failed to eliminate social divisions and did not fill government coffers either.

There are two historic ways of looking at taxation. The first is purely utilitarian: Taxation is a method by which the state raises money to finance its activities. Who pays how much is less important than the task of collecting the right amount cheaply. But the other view is that taxation should be a government-controlled instrument of social engineering, by helping transfer wealth from the rich to the poor, or by persuading people to change some of their habits. This means a taxation system which is not value-free, but one which has a "soul", a moral purpose.

Taxes to change society

IN PRACTICE, the two concepts have long ago become inseparable in all developed countries. Even governments which deny any intent to use taxation for social engineering purposes impose bigger burdens on the wealthier members of their society, either through direct income tax or by hitting the rich with indirect taxes which apply solely to them, such as higher duties on luxury cars and expensive homes or the latest wheeze in Europe: special levies on business-class airline tickets.

And virtually all taxation systems aim to change bad habits - heavy duties on cigarettes and alcohol - or promote certain virtues, such as tax exemptions to newly-married couples. The global taxation debate is no longer about absolute principles, but more about the most appropriate mix of taxes to achieve the right policy outcomes.

It is tempting to blame the present fashion for progressive taxes solely on the global economic downturn - governments facing bankruptcy are desperate to raid the pockets of those best in a position to pay. But the real explanation lies much deeper.

Every developing economy usually starts with a simple, flat taxation system yet invariably ends up facing demands for progressive taxes the moment it joins the ranks of developed nations. This is partly because people's expectations grow, the list of services the state is expected to provide expands and wealth differentials become more pronounced. In this respect, the debate in Singapore about the merits of progressive taxation is utterly predictable.

The second underlying reason why progressive taxation is fashionable has less to do with the economy and more with the latest technological advances, which allow governments to collect, store and process a vastly larger and far more accurate amount of data about its citizens. This means that it is easier to identify the wealthy not just by their income, but also by their living habits and property. It's simply far easier to tax the rich than ever before. And wealthy individuals find it harder to avoid paying these taxes, as some German millionaires recently discovered when they were nabbed after their government matched electronic data stolen from tax havens such as Switzerland and Liechtenstein with other information it held about them.

Data-driven tax policies

THE availability of data has another consequence: a better understanding of the phenomenon of income inequality. Inequalities created as the result of people having different skills and aptitudes are not only inevitable, but actually necessary for a thriving economy. However, when these inequalities are the result of institutional barriers which hold down certain groups of people, then they are of great concern. That much was known for generations; now, however, we have precise statistics to measure the size of the problem, so governments face more informed clamour of demands to address such issues.

The recent spate of scandals about the salaries and bonuses of bankers also fuels demands for progressive taxes. For it's difficult to understand why a 20-something banker with no university education can pocket millions of dollars by just gambling with other people's money.

More profoundly, the rows over the banking system have

alerted voters everywhere to the fact that most of today's high- earners are in the services industry; the days when fortunes were made by intrepid industrialists are over. And although the ingenuity of someone running a hedge fund is probably comparable to that possessed by Henry Ford a century ago, the reality is that people do not see it this way.

Today's new millionaires are not admired for their industriousness or entrepreneurship; they are largely regarded as individuals who, with the aid of some clever wheeze, happened to scoop the jackpot in a lottery. Unsurprisingly, electorates are not persuaded by arguments that such people need to be protected from higher taxes so that they can make more money.

In short, the public supports progressive taxes, the wealthy have seldom been more unpopular, while governments have the means to tax more accurately and desperately need the cash. A more powerful combination of factors arguing in favour of progressive taxation can hardly be imagined. Still, the approach is full of pitfalls.

Income taxes and loopholes

FIRST, no progressive system taxes all income the same way: for a variety of very good reasons, investments are always taxed differently than yearly income. That's why US President Barack Obama paid 20 per cent in taxes on his US$789,000 (S$985,000) yearly family earnings, while Mr Mitt Romney, his Republican challenger in last year's elections, paid only 15 per cent on an annual income of US$21 million. The bulk of Mr Romney's income came from investments, which are taxed at a lower rate. So fairness is not the inevitable outcome of progressive taxation.

Progressive taxation also leads to a very complicated revenue collection system, partly because governments have to continue encouraging entrepreneurship but also because wealthy people have access to the best legal brains to exploit every tax deduction clause. The result is a constant race to close legal loopholes, as new ones are created. And this has perverse outcomes: Mr Obama, to continue using the US example, pays a lower percentage in taxes than his secretary, who earns barely a tenth of the President's income.

Supporters of progressive taxes always claim that multi-millionaires are their sole target. But the reality is that the number of such super-rich is small, and squeezing them never produces a substantial income. If French President Francois Hollande's plan to impose a 75 per cent tax on people who earn over €1 million (S$1.6 million) is implemented, the revenue raised will not account for even 1 per cent of the country's budget expenditure. That's why, almost without exception, a progressive tax creeps down the income ladder, catching in its net an ever- wider number of people.

During the late 1970s, someone in Britain earning the equivalent of S$150,000 in today's money was expected to pay a top income tax rate of 83 per cent; that's what happened with a tax supposedly aimed only at the "super rich". And, as the British subsequently discovered, the abolition of their top tax rate actually meant more money for their government, as taxpayers owned up to their real earnings.

None of this is to suggest that progressive taxes should never be considered. The element of fairness is a cardinal principle of any taxation system and, under specific circumstances, the extra revenue raised by progressive taxes can be valuable.

Still, the drawbacks to such schemes remain considerable. And their key objective - that of distributing income more fairly across the nation - is almost never met.

As former British prime minister Margaret Thatcher once famously said in dismissing such progressive tax schemes, they end up "preferring that the poor were poorer, provided that the rich were less rich".

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